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Earnings price ratio

What Is Earnings-price ratio?

The earnings-price ratio (E/P) is a financial valuation metric that indicates the proportion of a company's earnings per share relative to its current share price. It is essentially the inverse of the more commonly cited price-to-earnings (P/E) ratio. As a tool within fundamental analysis and financial valuation, the earnings-price ratio helps investors gauge the earnings generated for every dollar invested in a stock. A higher earnings-price ratio suggests that a company is generating more earnings relative to its stock price, which can imply a more attractive return on investment from an earnings perspective. This ratio is part of a broader set of metrics used by investors to make informed investment decisions.

History and Origin

While the concept of comparing a company's earnings to its market price has likely existed informally for a long time, the formalization and widespread use of such ratios gained prominence with the development of modern financial markets and corporate accounting. The earnings-price ratio, being the reciprocal of the price-to-earnings (P/E) ratio, shares a parallel history. Academic researchers and financial practitioners have long analyzed the relationship between a company's profitability and its stock valuation. Noted economist Robert Shiller, for example, has extensively documented historical stock market data, including earnings and prices, dating back to 1871, providing a robust dataset for analyzing such ratios over long periods.10, 11 His work, which includes the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, inherently involves the earnings-price relationship by smoothing out earnings volatility.9

Key Takeaways

  • The earnings-price ratio (E/P) is a stock valuation metric calculated as a company's earnings per share divided by its current share price.
  • It is the reciprocal of the price-to-earnings (P/E) ratio and is often expressed as a percentage.
  • A higher earnings-price ratio generally suggests that a stock may be undervalued or that it offers a higher earnings yield relative to its price.
  • This ratio can be useful for comparing the attractiveness of stocks to bond yields or other fixed-income investments.
  • While a useful indicator, the earnings-price ratio should not be used in isolation, as it has limitations and does not capture all aspects of a company's financial health or future prospects.

Formula and Calculation

The earnings-price ratio is calculated by dividing a company's earnings per share (EPS) by its current share price. The resulting value is often multiplied by 100 to express it as a percentage, which can make it easier to compare with interest rates or bond yields.

The formula is as follows:

Earnings-Price Ratio (E/P)=Earnings Per Share (EPS)Share Price\text{Earnings-Price Ratio (E/P)} = \frac{\text{Earnings Per Share (EPS)}}{\text{Share Price}}

Where:

  • Earnings Per Share (EPS) represents a company's net profit allocated to each outstanding common share. This figure is typically derived from the company's income statement, found within its financial statements.
  • Share Price refers to the current market price at which one share of the company's stock is trading on the stock market.

For example, if a company reports annual earnings per share of \$2.50 and its stock is currently trading at \$50 per share, the earnings-price ratio would be:

E/P Ratio=$2.50$50.00=0.05 or 5%\text{E/P Ratio} = \frac{\$2.50}{\$50.00} = 0.05 \text{ or } 5\%

This indicates that for every dollar invested in the company's stock, an investor effectively "earns" \$0.05 in company profits.

Interpreting the Earnings-price ratio

The interpretation of the earnings-price ratio largely depends on its magnitude and comparison with other investment opportunities. A high earnings-price ratio suggests that investors are paying a relatively low price for each dollar of a company's earnings. This can indicate that the stock might be undervalued, or it could reflect higher perceived risk or lower growth expectations by the market. Conversely, a low earnings-price ratio means investors are paying a higher price relative to current earnings, which might imply high growth expectations or that the stock is overvalued.

Investors often compare a company's earnings-price ratio to that of its industry peers, the overall market, or even to prevailing interest rates, such as the yield on government bonds. A higher earnings-price ratio relative to bond yields might suggest that equities offer a more attractive potential return. For instance, if the S&P 500's aggregate earnings yield is significantly higher than the 10-year Treasury bond yield, it could indicate that stocks are relatively more appealing than bonds. However, this comparison, sometimes referred to as the "Fed Model," is a disputed theory of equity valuation.

Hypothetical Example

Consider two hypothetical companies, Tech Innovations Inc. (TII) and Steady Growth Corp. (SGC), operating in different sectors.

Tech Innovations Inc. (TII):

  • Current Share Price: $150
  • Earnings Per Share (EPS): $5.00

Calculate TII's Earnings-price ratio:
E/P Ratio (TII)=$5.00$150.00≈0.0333 or 3.33%\text{E/P Ratio (TII)} = \frac{\$5.00}{\$150.00} \approx 0.0333 \text{ or } 3.33\%

Steady Growth Corp. (SGC):

  • Current Share Price: $80
  • Earnings Per Share (EPS): $4.00

Calculate SGC's Earnings-price ratio:
E/P Ratio (SGC)=$4.00$80.00=0.05 or 5.00%\text{E/P Ratio (SGC)} = \frac{\$4.00}{\$80.00} = 0.05 \text{ or } 5.00\%

In this example, SGC has a higher earnings-price ratio (5.00%) compared to TII (3.33%). This suggests that SGC is generating more earnings for each dollar of its market capitalization than TII. An investor seeking higher current earnings relative to price might find SGC more attractive, while an investor prioritizing potential future growth might still favor TII despite its lower current earnings-price ratio.

Practical Applications

The earnings-price ratio is a versatile tool used in several areas of finance and investing:

  • Comparative Valuation: It allows investors to compare the earnings generation capability of different companies, particularly those within the same industry. A higher ratio might signal a potentially undervalued asset, while a lower one could suggest overvaluation, though industry averages and growth prospects must be considered.
  • Market Sentiment Assessment: Aggregating the earnings-price ratio for an entire market index, such as the S&P 500, can provide insights into overall market valuation. Historically, shifts in the aggregate earnings yield have sometimes coincided with significant market trends, with higher yields sometimes indicating more attractive buying opportunities, as observed following periods like the Great Depression.7, 8
  • Bond vs. Equity Analysis: The earnings-price ratio serves as a common point of comparison with bond yields. When the earnings yield of equities is significantly higher than the yield on long-term government bonds, it can suggest that equities offer a more compelling relative value. Conversely, if bond yields become much higher, fixed-income investments might appear more attractive. Data on historical S&P 500 earnings yield and Treasury yields is often tracked by entities like the Federal Reserve to analyze market conditions.5, 6
  • Quantitative Investing Strategies: Some quantitative investing strategies, like "Magic Formula" investing, incorporate earnings yield as a key factor in identifying potentially undervalued stocks. These strategies often rank companies based on multiple metrics, including this ratio, to select investments.
  • Regulatory Filings: Earnings data, which forms the numerator of the earnings-price ratio, is a core component of mandated financial disclosures. Public companies in the United States, for instance, file comprehensive financial statements, including their income statements, with the U.S. Securities and Exchange Commission (SEC) in documents like the annual Form 10-K, making the necessary data publicly accessible for ratio analysis.3, 4

Limitations and Criticisms

While the earnings-price ratio offers a direct look at a company's earnings relative to its stock price, it has several limitations and criticisms:

  • Backward-Looking Nature: The earnings-price ratio often uses historical earnings (e.g., earnings from the past 12 months), which may not be indicative of a company's future profitability. A company's past performance does not guarantee future results, and changing economic conditions can significantly impact future earnings.
  • Impact of Accounting Practices: Earnings figures can be influenced by varying accounting methods and one-time events, which might distort the true underlying profitability. Non-recurring items can temporarily inflate or deflate reported earnings, leading to a misleading earnings-price ratio.2
  • Inapplicability to Loss-Making Companies: Companies that are not profitable or have negative earnings do not have a meaningful earnings-price ratio, as a negative earnings figure would render the ratio uninterpretable or misleading. This is particularly true for early-stage or high-growth companies that prioritize expansion over immediate profitability.
  • Ignores Growth Prospects: A high earnings-price ratio might indicate a "value" stock, but it does not account for a company's growth potential. A company with lower current earnings but high expected growth might be a better investment over the long term, a factor that the raw earnings-price ratio does not capture.
  • Industry Differences: The "ideal" earnings-price ratio can vary significantly across industries. Comparing a utility company's ratio to that of a technology startup may not be insightful due to differing business models, capital structures, and growth trajectories.
  • Capital Structure Differences: The ratio does not inherently account for differences in debt levels. Two companies with similar earnings but vastly different amounts of debt could have the same earnings-price ratio, yet the one with more debt carries higher risk. Some adjusted versions of earnings yield attempt to account for debt and taxes.
  • Limited Predictive Power: Some studies suggest that while P/E (and by extension, E/P) ratios are simple and widely used, their predictive power for short-term stock returns can be low.1 Additionally, the "Fed Model," which compares aggregate earnings yield to bond yields, has been critiqued for its theoretical flaws and inconsistent predictive ability over long periods and across different markets.

Earnings-price ratio vs. Price-to-Earnings (P/E) Ratio

The earnings-price ratio and the Price-to-Earnings (P/E) ratio are intimately related, as one is simply the mathematical inverse of the other. The key difference lies in their presentation and common interpretation.

The Price-to-Earnings (P/E) ratio is calculated as Share Price / Earnings Per Share (P/E = P/EPS). It expresses how much investors are willing to pay for each dollar of a company's earnings. A high P/E ratio generally suggests that investors expect higher future growth, or it could indicate that a stock is overvalued. For example, a P/E of 20 means investors are paying $20 for every $1 of earnings.

The Earnings-price ratio (E/P = EPS/P) reverses this, showing the earnings generated for each dollar of investment. It is often presented as a percentage. For instance, an earnings-price ratio of 5% means that for every $100 invested, the company is generating $5 in earnings. This makes it directly comparable to yields on other assets, such as bonds or other fixed-income securities, which are also expressed as percentages. While the P/E ratio is more widely used for quick comparative valuation of companies, the earnings-price ratio is particularly useful when comparing equity returns against bond yields.

FAQs

What does a high earnings-price ratio mean?

A high earnings-price ratio means that a company generates a substantial amount of earnings relative to its current share price. This can suggest that the stock is undervalued, or it might imply that the market perceives higher risk or lower growth prospects for the company, leading to a lower price relative to its earnings.

How is earnings per share (EPS) calculated?

Earnings per share (EPS) is calculated by dividing a company's net income (profit) by the total number of its outstanding shares. This figure is typically found on a company's income statement, a key component of its financial reports.

Can the earnings-price ratio be negative?

Yes, the earnings-price ratio can be negative if a company has negative earnings per share, meaning it is operating at a loss. In such cases, the ratio loses its interpretative value for traditional valuation purposes.

Is the earnings-price ratio more useful than the P/E ratio?

Neither ratio is inherently "more useful" than the other; they are simply inversions of each other and offer different perspectives. The P/E ratio is more intuitive for understanding how much investors are paying for earnings. The earnings-price ratio, when expressed as a percentage, is often preferred for direct comparison with yields from other asset classes, like bonds, to assess relative attractiveness. Both are valuable tools for fundamental analysis.

Where can I find the data to calculate the earnings-price ratio?

You can find the necessary data, such as a company's share price and earnings per share, in its publicly available financial statements. These are often accessible on the company's investor relations website or through databases provided by regulatory bodies like the U.S. Securities and Exchange Commission (SEC).