A price to earnings ratio is the earnings a company has earned in the trailing twelve months divided by the market capitalization. Where as the earnings yield is inverse to the P/E ratio, showing a percentage return of earnings to market capitalization (Earnings divided by Market Cap = Earnings Yield) and is a more practical comparative valuation metric when comparing present 10-Year AAA bond yields to potential earnings power.
Benjamin Graham discusses the approach as more logical and more scientific, he also states he would typically aim to double the earnings return in comparison to the present interest rate or AAA bond.
Using the earnings yield also quickly allows the investor to see if the company’s dividend distributions can easily be met or if retained earnings have consequently been building up allowing “economic goodwill” to increase. In relative terms if the income statement lines are converted to percentages in relation to gross revenue it may be more easily analyzed.
When looking at the current market picture and the continuing bull market I could argue that although we are at historical averages for the S&P500 (presently approximately 18.2x earnings & 2% dividend yield versus average of 15.4x earnings & 4.4 dividend yield) we could continue to see an increase in multiple expansion until interest rates begin to rise, narrowing the S&P500 earnings yield vs AAA bond spread. Historical averages would indicate approximately 6.67% earnings yield against 5.38% 10-Year T-Bond (risk premium would obviously be added to earnings yield) (1.29% spread)