Defining yields
Yields include two key components and can be viewed as a formula with a numerator and a denominator. The numerator is a variable representing a company’s financials, while the denominator is simply the price. A commonly used yield metric is the earnings yield, which is essentially the inverse of the price-to-earnings (P/E) ratio.
Since the price-to-earnings ratio is price/earnings, its reciprocal is the earnings yield, which is earnings/price. For example, let’s say company A has a P/E ratio of 10. The company’s earnings yield would be 1/10, or 0.1, but since yields are usually expressed as percentages, it is 10%. If company B’s P/E ratio is 50, then its earnings yield would be just 2% to illustrate this further. Similarly, we can express yields the other way around — if company C’s earnings yield is 20%, then its P/E is 5. In yield analysis, company C is the most attractive, with the highest earnings yield, followed by company A and, finally, company B.
Yield analysis is versatile, as it can be applied to any standalone financial figure and compared to the price-to-yield ratio. Since this is the case, investors must expect the financial figure used in the numerator to become more desirable as the company grows. For example, if operating income grows, the operating income yield will be higher, which is great. However, if, say, debt were used, then a higher figure or yield would not be desirable. Aside from earnings yield, cash flow yield is a useful metric for assessing a company’s profitability. Next is the most widely used and known yield — the dividend yield. Other metrics, such as the reciprocal of enterprise value (which comprises the price, under market capitalisation) to ebitda can also be used.
See also: Understanding price and value in the context of investing, Part 2
Using yields in quantitative analysis
Yields imply how attractive a company is based on its financials. Since yields change with price, a company can have both an attractive and an unattractive yield within a quarterly or semi-annual financial period. Yields are a good reflection of how undervalued a company is at a given point in time; its historical financials should carry less weight in yield analysis.
For example, if a company’s earnings yield was 10% five years ago and 5% today, that does not necessarily mean its financial performance has eroded, because yields are affected by the stock price. If the stock’s share price doubled over this period, its earnings have also grown significantly, but not as much as the price. The point here is that the company’s earnings, which represent its fundamentals, have grown, but not enough for an investor to find it attractive compared to five years ago.
See also: Understanding price and value in the context of investing, Part 1
One way to utilise yields in quantitative analysis is to compare them with those of other companies, usually within their peer group, as illustrated by the example of companies A, B, and C. Since investing heavily involves the concept of opportunity cost, yields can be utilised to compare with the next-best investment option or with a risk-free investment as a benchmark. If the country’s risk-free rate is 3%, a dividend yield above 3% would be considered attractive.
Yields can also be used to project whether a company’s financials will be attractive, based on expected financials. This is called the forward yield. Since the yield depends on prices, price growth should, to some extent, be projected. This is necessary only for yields, because if they did not, using a forecast of earnings or dividends would be sufficient.
Valuations-wise, if the P/E ratio of a company is 10 times, then an investor would be paying $10 for every $1 of the company’s earnings. In other words, an earnings yield of 10% is generally attractive. However, does an earnings yield of say, 1% mean that the company is not attractive? It depends: a lower P/E ratio generally indicates the company is undervalued, while a higher P/E ratio could indicate the company expects high earnings growth.
Hence, investors should not be immediately put off by lower yields, but only in the case of non-dividend yields. For dividend yields, since dividends are actual returns earned by investors, lower yields are generally not favourable. It could also be the case that companies use their earnings to grow the business rather than pay dividends, resulting in a high earnings yield but a lower dividend yield, if they choose to pay dividends.
Another factor investors should be wary of is extremely high yields, which the company may not be able to sustain. This may be due to extraordinary or one-off income, perhaps from a windfall year or disposal of assets. To circumvent this, investors should use normalised operating income or cash flow, and, for dividends, use dividend yields excluding special dividends.
That said, investors conducting quantitative analysis, specifically yield analysis, can filter companies based on earnings, cash flow, and dividend yields for investors seeking periodic payments on their stock investments.
Table 1 shows the earnings yields, forward one-year yields, and free cash flow yields for companies in the Singapore Straits Times Index (STI), excluding banks and REITs. Almost all companies appear attractive relative to the risk-free rate based on their earnings yields. However, for the expected growth in earnings yield, which compares the forward yield against the current yield, only a handful of companies are expected to be more undervalued. Jardine Matheson Holdings, Singapore Technologies Engineering, Yangzijiang Shipbuilding Holdings and Wilmar International are expected to grow yields by more than 1% over the next 12 months, with adequate free cash flow yields.
Table 2 shows the current and forward dividend or distribution yield of all stocks on the STI. Given the Singapore 10-year risk-free rate of 2.02%, most stocks are attractive from a dividend perspective. However, after accounting for expected dividend growth, CapitaLand Integrated Commercial Trust, Yangzijiang Shipbuilding Holdings, City Developments and Frasers Centrepoint Trust are the most undervalued.
Separately, Chart 1 shows the five-year historical dividend yield for the three banks, while Chart 2 shows the five-year historical dividend yield for the REITs. Although the dividend yields of all banks have historically moved in tandem, there has been a slight divergence recently. Regardless, the yields of all three banks are attractive, with UOB currently the best. For REITs, distributions have fluctuated significantly over the past five years. However, in recent periods, the three Mapletree REITs and two Frasers REITs have been the most promising in terms of dividend yields.
