The Little Book That Still Beats the Market Ch. 3: Earnings Yield

"Earnings yield is simply how much a business earns relative to the price you pay for it." — Joel Greenblatt

Investment Context

The formula's second half looks for cheapness, measured by earnings yield.

Imagine buying a small business for $1 million. If it earns $100,000 this year, your yield is 10%; if it earns $20,000, your yield is 2%. As a buyer you want the most earnings for the lowest price.

The Wall Street Translation

Wall Street usually reaches for the P/E ratio. Earnings yield is essentially its inverse, but Greenblatt makes it far more accurate by accounting for debt.

1. Enterprise Value Instead of Market Cap

Rather than share price alone, Greenblatt uses enterprise value = market cap + debt − cash, because buying a company means assuming its debts.

A worked example: Companies A and B both carry a $1bn market cap and both earn $100m in operating profit, so their P/E ratios look identical. But A is debt-free with $200m of cash, while B carries $500m of debt. On enterprise value A is $800m — a 12.5% yield — while B is $1.5bn, yielding just 6.7%. The P/E shows them as equally cheap; enterprise value reveals A is nearly twice as cheap.

2. EBIT Instead of Net Income

Net income is distorted by interest expense and tax rates. Using EBIT lets you compare raw earning power across companies regardless of how they are financed or taxed.

This mirrors the approach in Security Analysis elsewhere in this library: Graham likewise insisted on restating accounts back to the operating business, stripping out differences created purely by capital structure.

3. Ranking and Combination

The formula ranks every stock by EBIT ÷ enterprise value, cheapest first. The actual mechanism is adding the two rankings together.

B wins despite topping neither list. The formula does not want extremes; it wants both dimensions to be simultaneously good — which is exactly "a good company at a fair price" expressed quantitatively.

Actionable Trading Rules

1. Always use enterprise value: Include debt and cash when computing yield, or heavily indebted companies will masquerade as bargains.
2. Benchmark against the risk-free rate: A yield only means something relative to Treasuries. If government bonds guarantee 5%, a 6% yield on a risky stock is inadequate — demand at least double.
3. Beware cyclical peaks: Companies at the top of their cycle post enormous but unsustainable earnings, producing a flattering yield. Be especially cautious with homebuilders, steel, and shipping.

Relevance to a Retirement Portfolio

Earnings yield gives retirees a common yardstick across asset classes.

You can place equity earnings yields, bond yields to maturity, and rental yields on property side by side on one page. When the broad market's yield sits well below Treasuries, equities are usually priced aggressively — a useful warning for anyone in the withdrawal phase who cannot absorb a deep drawdown.