Earnings, dividend and free cash flow yields

In simple terms

Valuation ratios like P/E say how many rupees you pay for each rupee of profit. Yields turn this around and express what you get as a percentage of what you pay. That makes shares easier to compare with each other and with bonds or deposits, which are quoted as yields.

Three yields

• Earnings yield is the profit you buy for each rupee, whether or not it is paid out.
• Dividend yield is the cash actually paid to you each year, as a percentage of the price.
• Free cash flow yield is the cash the business generates for its owners after investment, which could be paid out, used for buybacks, used to repay debt or reinvested.

Free cash flow yield

Free cash flow yield is often the most informative, because free cash flow is harder to flatter than profit and represents what the business can genuinely return. Variants use enterprise value instead of market capitalisation, with free cash flow to the firm, to allow for debt.

A company with a high free cash flow yield and a sound balance sheet is generating a lot of cash for its price. But check that the free cash flow is not temporarily high, for example from cutting investment below what the business needs.

Comparing with bonds

It is tempting to compare a share's yield directly with the interest rate on a government bond or a fixed deposit. The comparison is useful but needs care.

Shares' cash flows can grow. A bond pays fixed interest; a company's earnings may grow over time. A share with an earnings yield of 4% whose profits grow 10% a year may be a better investment than a bond yielding 7% with no growth. So a share yield below a bond yield can be perfectly reasonable.

Shares' cash flows can shrink. Profits can fall, dividends can be cut, companies can fail. A high share yield sometimes reflects the market's expectation that earnings will decline.

Shares are riskier. A government bond's interest is about as certain as payments get; a company's earnings are not. Investors therefore require a higher expected return from shares, an extra return called the equity risk premium, covered in the cost of equity lesson.

Interest rates move valuations. When bond yields rise, investors can earn more without risk, so they tend to demand higher yields from shares too, which means lower share prices for the same earnings. When bond yields fall, the opposite.

Why it matters

Yields put valuation in terms everyone understands: what you get back for what you pay. They link the share market to interest rates, which helps explain why share prices often fall when rates rise. Free cash flow yield in particular focuses attention on the cash a business produces rather than reported profit.

Limitations

Yields are snapshots based on one year's figures, which may be unusual. They do not show growth, risk or the quality of the business directly. Comparisons with bond yields rest on assumptions about future growth. Dividend yields depend on payout policy as much as on the business.

Common mistakes

• Comparing a share's yield with a deposit rate as if both were fixed.
• Assuming a low yield means overvalued, without considering growth.
• Chasing a high yield without asking why it is high.
• Ignoring the difference between profit and free cash flow.

Try it yourself

1. Choose a listed company and find its market capitalisation, net profit, free cash flow and dividends for the last year.
2. Calculate its earnings yield, free cash flow yield and dividend yield.
3. Find the current yield on a ten-year government bond from the Reserve Bank of India's website.
4. Write a sentence on what growth the company would need for its shares to offer a better expected return than the bond.