Earnings yield: the price-to-earnings ratio flipped over
Earnings yield is the inverse of the price-to-earnings multiple. A stock with a 10 multiple has a 10 percent earnings yield; a stock with a 20 multiple has a 5 percent earnings yield. Earnings yield is directly comparable to a bond yield — both express what the security currently earns expressed as a percentage of its current price.
Graham's test: earnings yield minus bond yield
Quantitative Margin of Safety (percentage points) = Earnings Yield − AAA Corporate Bond Yield
Adjusting the test for the interest-rate climate
| AAA bond yield environment | Graham defensive threshold (earnings yield) | Implied maximum price-to-earnings multiple |
|---|---|---|
| 3 percent (low-rate regime) | About 6 percent earnings yield (two times AAA) | Roughly 16 to 17 times earnings |
| 5 percent (medium-rate regime) | About 10 percent earnings yield | Roughly 10 times earnings |
| 7 percent (high-rate regime) | About 14 percent earnings yield | Roughly 7 times earnings |
Why the bond-yield comparison is essential
The rate-regime adjustment is the load-bearing part of the test. Applying a fixed multiple cutoff from a low-rate decade to a high-rate decade — or vice versa — silently changes the margin in dangerous ways. The honest application is always to compare the current earnings yield to the current AAA bond yield, not to a fixed numerical threshold lifted from a different era.
What the quantitative test cannot tell you
What the test does not do. The quantitative margin test cannot tell you whether the earnings number you fed it is real, sustainable, or growing. A cyclical business at the peak of its cycle can show a deeply attractive earnings yield right before the trough collapses the number. An asset-light business with declining returns on capital can show an attractive yield even as its long-run economic value erodes. The yardstick screens for price-to-current-earnings cheapness; it does not screen for business quality, durability, or the honesty of the accounting. Graham himself paired the quantitative test with separate filters for earnings stability over a multi-year window, an unbroken dividend record, and a strong balance sheet.
Run Graham's test on a company you own
When passing the price test is not enough
The test measures cheapness, not quality
Sit with the ideas.
Whitcombe Industrial trades at $48 per share, earns $4.80 per share in normalized operating earnings, and operates in an environment where AAA corporate bonds yield about 5.5 percent. Apply Graham's quantitative margin-of-safety test in its rate-adjusted form — how attractive is the stock by the test, and what does the result actually tell you?