When everyone talks bonds, they talk about yields. A $100 bond earning $5 per year yields 5/100 or 5%. For every dollar you invest, the bond earns you 5%. Nobody ever looks at it the other way around, however. You don’t hear a banker promoting a bond selling at 100/5 or 20 times earnings. Then why, may I ask, do we do that for stocks?

Stocks are always evaluated in terms of P/E. P/E is the price of a share divided by the earnings per share. GOOG closed at $315.36 and its earnings for the past 4 quarters were $3.40 per share and therefore its P/E is 92.75. But what exactly does that mean? How can you compare that to risk-free US Treasury bonds or any other types of investments? You can’t. It’s like comparing apples with oranges.

GOOG P/E = $315.36/$3.40 =  92.75
US Treasury Bonds (2 yr) =   4.00%

Fortunately, there is an easy solution to the problem. Stocks instead should be evaluated with E/P – the reciprocal of P/E. E/P is the earnings per share divided by price per share. Google’s E/P is $3.40 divided by $315.36 which equals 1.08%. In other words, for every dollar you invest, the company earns 1.08%. This is also called the “earnings yield”. Now that both numbers are in percentages of earnings, the picture suddenly becomes clearer.

GOOG E/P = $3.40/$315.36 =  1.08%
US Treasury Bonds (2 yr) =  4.00%

Evidently, US Treasury Bonds yield 4 times more than Google. Of course stocks, unlike bonds, have large appreciation potential and that is why you pay a premium. That is why you accept the higher risks. That is why you accept lower yields. But at least now we are comparing apples with apples. It is always good to know what you are getting compared to lesser- or no-risk investments.

Let’s look at some more examples. One of my favorite stocks, AFG (31.65), has a P/E of 6.80 and therefore an earnings yield of 14.70%. DHOM (16.52) has an E/P of 9.09%. MRC (30.99) has an E/P of 3.52%. CHK (25.85) has an E/P of 4.88%. A one-year ING Direct CD yields 4.20%. An ING Savings Account - with no fees or time restraints - yields 3.40%.

AFG                              14.70%
DHOM                              9.09%
CHK                               4.88%
ING Direct CD (1 yr)              4.20%
US Treasury Bonds (2 yr)          4.00%
MRC                               3.52%
ING Direct Savings Account        3.40%
GOOG                              1.08%

In sum, one should always think about earnings yields rather than P/E. When buying stocks, you are buying part or all of a business. Therefore, as a shrewd business owner, you should expect a large return on your investment. Either the company should yield considerably more than risk-free bonds, or have large growth potential, or both. Otherwise, why take the risk?