Using Earnings Yield to Screen Stocks

If you could only use one metric to screen for undervalued stocks suitable for options strategies, earnings yield would be it. Simple to calculate, easy to understand, and incredibly effective at finding companies where the market has created genuine opportunities for patient investors.

TL;DR

• Earnings yield = annual earnings ÷ stock price: This shows what "return" you're getting on the earnings power of the business
• Compare to bond yields: If earnings yield is significantly higher than 10-year Treasury rates, the stock might be undervalued
• Aim for 8%+ earnings yields: This typically indicates stocks trading at reasonable valuations with room for appreciation
• Quality filter still applies: High earnings yield on a declining business is a value trap—focus on stable or growing companies
• Perfect options screening tool: High earnings yield companies often make excellent candidates for covered calls and cash-secured puts

The Simple Math That Reveals Hidden Value

Earnings yield flips the P/E ratio upside down. Instead of asking "How many dollars am I paying for each dollar of earnings?" (P/E), you ask "What percentage return am I getting on the company's earnings power?"

Formula: Earnings Yield = (Earnings Per Share) ÷ (Stock Price) × 100

If a company earns $5 per share and trades at $50, your earnings yield is 10%. Think of this as the "interest rate" the business is paying you based on its current earning power.

Why is this so useful? Because you can directly compare it to other investment options. If 10-year Treasury bonds yield 4% and you find a quality company with a 10% earnings yield, you're potentially getting 2.5 times the return for owning a piece of a productive business instead of lending money to the government.

How This Powers Your Options Strategies

For covered calls: Companies with high earnings yields often trade at reasonable valuations, giving you two sources of return—the earnings growth over time plus the premium income from selling calls.

For cash-secured puts: When you find a quality company with a 10%+ earnings yield, getting assigned at an even lower price (your put strike) could set you up for excellent long-term returns.

For screening efficiency: Instead of analyzing hundreds of stocks, focus your research on companies with earnings yields above 8-10%. This narrows your universe to potentially undervalued situations.

A Real Numbers Example

Let's compare three companies you might consider for options strategies:

TechGrowth Corp:

• Stock price: $200
• Earnings per share: $4
• Earnings yield: 2%
• Analysis: Expensive relative to current earnings power

ValueCorp:

• Stock price: $60
• Earnings per share: $6
• Earnings yield: 10%
• Analysis: Attractive earnings yield suggests potential value

CyclicalCorp:

• Stock price: $30
• Earnings per share: $6 (peak cycle earnings)
• Earnings yield: 20%
• Analysis: High yield might be misleading if earnings are unsustainable

ValueCorp looks most interesting for options strategies. The 10% earnings yield suggests you're getting reasonable value, and if the company grows earnings at even 5% annually, you could see both stock appreciation and decent option premiums.

Advanced Screening Techniques

The Bond Comparison Method: Current 10-year Treasury yield: 4% Target earnings yield: 2-3x the bond yield = 8-12% This gives you a margin of safety over "risk-free" bonds.

Historical Comparison: Look at the company's earnings yield over the past 5-10 years. If it's currently at the high end of its historical range, the stock might be temporarily undervalued.

Sector Relative Screening: Compare earnings yields within the same industry. A bank with an 8% earnings yield might be cheap if other banks are yielding 5%, even though 8% might be average for industrial companies.

Quality Filters to Avoid Value Traps

High earnings yield isn't magic—you need additional filters:

Earnings stability: Look for companies where earnings have been relatively stable or growing over the past 5 years. Avoid companies with wildly fluctuating earnings.

Debt levels: Calculate debt-to-equity ratios. High earnings yield with excessive debt could signal financial distress rather than value.

Industry trends: Be cautious with industries facing secular decline (newspaper companies might show high earnings yields because their earnings are disappearing).

Management quality: Research whether the company has competent leadership with a track record of creating shareholder value.

Building Your Earnings Yield Screening Process

Step 1: Use a stock screener to filter for earnings yield above 8% Step 2: Remove companies with negative earnings growth over 3+ years Step 3: Filter out companies with debt-to-equity ratios above 0.6 Step 4: Focus on industries you understand Step 5: Research the remaining 10-20 companies manually

This process typically yields a manageable list of genuinely interesting opportunities rather than hundreds of mediocre options.

What Could Go Wrong?

Falling for "peak earnings" situations: Some companies show high earnings yields because their earnings are temporarily inflated by unusual circumstances.

How to avoid this: Look at normalized earnings over 3-5 years rather than just the most recent year. Adjust for one-time gains or losses.

Ignoring competitive pressures: A company might have high current earnings yield but face disruption that will destroy future earnings power.

Mitigation: Research industry trends and competitive dynamics. Ask yourself: "Will this company's earnings be higher, lower, or similar in 3-5 years?"

Overemphasizing the metric: Earnings yield is a starting point, not the final answer. You still need to understand the business and its prospects.

Prevention: Use earnings yield to generate candidates, then do thorough fundamental analysis before making any investment or options trading decisions.

Combining with Options Strategy Selection

Once you've identified companies with attractive earnings yields:

8-10% earnings yield: Good candidates for covered calls or cash-secured puts 10-12% earnings yield: Potentially excellent opportunities, but verify business quality first Above 12% earnings yield: Proceed with extra caution—this often signals problems rather than opportunity

The sweet spot is typically companies with 9-11% earnings yields that have maintained stable or growing earnings for several years. These tend to offer the best combination of current value and future appreciation potential.

Next Steps

• Learn to use stock screeners (many brokers offer them free) to filter by earnings yield
• Practice calculating earnings yield manually for 5-10 companies to build intuition
• Create a watchlist of companies with 8%+ earnings yields and track them over time
• Research historical earnings yields for quality companies to understand typical ranges
• Combine earnings yield screening with other value metrics for more robust analysis

Remember, earnings yield is your first filter, not your final decision. Use it to identify potentially undervalued companies, then dig deeper into their business fundamentals, competitive position, and growth prospects. When you find quality companies with high earnings yields, you've discovered the raw material for successful options strategies that can generate income while you wait for the market to recognize their true value.

This screening approach works particularly well when combined with an understanding of intrinsic value and knowledge of what makes wonderful companies worth owning for the long term.