Understanding Earnings Yield: A Key Metric for CFA Level 2 Candidates

How is earnings yield (EY) calculated?

• A. EY = Total Assets / Total Shares
• B. EY = EPS / (Share Price)
• C. EY = (Dividends paid / Earnings)
• D. EY = (Price Earnings Ratio) / EPS

Answer: (B)

Earnings yield (EY) is a critical metric used to assess the relative attractiveness of an investment, and it is calculated using the formula EY = EPS / Share Price. This calculation helps investors understand how much earnings they are receiving for each dollar invested in the stock. Breaking down the components, EPS (Earnings Per Share) reflects the company's profitability on a per-share basis, while the share price represents the market value of a single share of the company's stock. By dividing EPS by the share price, investors can obtain the earnings yield, which is expressed as a percentage, allowing for easier comparisons with other investment opportunities, such as bonds or alternative stocks. This makes the earnings yield a valuable tool for investors seeking to determine if a stock is overvalued or undervalued relative to its earnings. In contrast, the other formulas provided do not accurately describe the calculation of earnings yield, as they refer to different financial metrics or relationships. For example, the total assets to total shares ratio does not take earnings into account, while dividends paid does not reflect the share price or earnings specific to the share. The Price Earnings Ratio divided by EPS also does not lead to a clear measurement of earnings yield and misrepresents the relationship intended.

Earnings yield (EY) is a vital metric that every aspiring Chartered Financial Analyst (CFA) should understand, especially those gearing up for Level 2 of the CFA exam. Essentially, it gives us a look at how much profit we're making from a stock investment relative to its market price. Now, that’s a significant insight, isn't it?

So, how do we actually calculate this? The formula here is straightforward: EY = EPS / Share Price. You might be wondering, what's EPS? Good question! EPS stands for Earnings Per Share, and this figure shows how much profit a company earns for each share of its stock. Pairing that with the current share price gives you the earnings yield expressed as a percentage.

For instance, if a company has an EPS of $5 and its stock is currently trading at $100, the earnings yield would be 5%, meaning you're earning $0.05 for every dollar you invest in that stock. It’s like having a little light bulb go off — suddenly, those numbers seem more tangible and relevant. You know what? This percentage helps investors navigate the murky waters of stock valuation.

Now let’s tackle the other options you might see, which, frankly, don’t let you round the corner towards earnings yield. The formula EY = Total Assets / Total Shares? Nope, not even close, because it doesn’t factor in earnings. Similarly, EY = Dividends Paid / Earnings leaves out the all-important share price aspect. Lastly, if you try EY = (Price Earnings Ratio) / EPS, you're not getting the clear picture you want.

What makes earnings yield so compelling? Well, it allows you to juxtapose stocks with bonds or even other stocks. When comparing investments, higher yields typically suggest better returns for your investment risk. So, if you're pondering whether a stock is overvalued or undervalued, just look at the earnings yield!

Now, imagine this scenario: You're eyeing two different stocks. One has an earnings yield of 6%, and the other is at 4%. Assuming similar risk profiles, wouldn't you gravitate towards the one with the better yield? It's little insights like this that can make a potent impact on your overall investment strategy.

Arming yourself with tools like earnings yield is not just about cranking numbers but rather about cultivating a mindset that deepens your understanding of market opportunities. As you prepare for the CFA Level 2 exam, nurturing this knowledge isn’t just helpful — it's essential. So keep honing those analytic skills, and remember that each piece of financial knowledge you gain brings you one step closer to mastering your investment strategies!