Investors often use P/E ratio and other valuation metrics to pick undervalued stocks with solid upside potential. However, one can also use another interesting ratio. Earnings yield, expressed in percentage, is calculated as (Annual Earnings per Share/Market Price) x 100. While comparing stocks, if other factors are similar, investors can look out for the one with higher earnings yield. This is because stocks with earnings yield have the potential of providing comparatively greater returns.

Firms with higher earnings yield are considered underpriced, while those with lower earnings yield are seen as overpriced. Earnings yield captures both the tangible and intangible yield of the firm as opposed to dividend yield, which only takes into account the tangible yield. The ratio of dividend yield to earnings yield indicates the proportion of earnings directly distributed in the form of dividend payout.

Importantly, earnings yield can also be used to compare the performance of a market index with the 10-year Treasury yield. For instance, when the yield of the market index is more than the 10-year Treasury yield, stocks can be considered as undervalued than bonds. In this situation, investing in the stock market would be a better option for a value investor.

Earnings Yield: Simply the Inverse of P/E

Earnings yield is nothing but the reciprocal of one of the most popular valuation metrics, i.e. the P/E ratio (stock price/earnings per share). Thus, a firm having a P/E ratio of 10.2 will logically have an earnings yield of 9.8% (100/10.2). In fact, as the concept of earnings yield is already indirectly captured in the P/E ratio, earnings yield as an investment valuation metric is not as widely used as the P/E ratio.

Having said that, it should be noted that earnings yield is an important tool for investors with exposure to both stocks and bonds. In fact, with regard to this, earnings yield can be more illuminating than the traditional P/E ratio as the former facilitates comparison of stocks with fixed-income securities.

Screening Parameters

We have set Earnings Yield greater than 10% as our primary screening criterion but it alone cannot be used for picking stocks that have the potential of generating solid returns. So, we have added the following parameters to the screen:

Estimated EPS growth for the next 12 months greater than or equal to the S&P 500: This metric compares the 12-month forward EPS estimate with the 12-month actual EPS.

Average Daily Volume (20 Day) greater than or equal to 100,000: High trading volume implies that a stock has adequate liquidity.

Current Price greater than or equal to $5.

Buy-Rated Stocks: Stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have been known to outperform peers in any type of market environment.

Our Choices

Below we have highlighted five of the 51 stocks that made it through the screen. Each of the below-mentioned stocks sports a Zacks Rank #1.

Winnebago Industries (WGO - Free Report): Winnebago is a leading producer of recreational vehicles in the United States. The Zacks Consensus Estimate for fiscal 2021 sales and earnings suggests year-over-year growth of 24.8% and 73.3%, respectively. The consensus mark for fiscal 2022 sales and earnings suggests year-over-year growth of 2.4% and 11.7%, respectively

Meritage Homes Corporation (MTH - Free Report): Based in Scottsdale, AZ, Meritage Homes is one of the leading designers and builders of single-family homes. It has an expected EPS growth rate of 22.6% for the next three-five years. The Zacks Consensus Estimate for 2020 and 2021 earnings suggests year-over-year growth of 50.2% and 21.6%, respectively.

Pampa Energia S.A. (PAM - Free Report): Pampa Energía is the largest fully-integrated electricity company in Argentina. It has an expected EPS growth rate of 6.5% for the next three-five years. The Zacks Consensus Estimate for 2021 revenues suggests year-over-year growth of 16.4%.

Quest Diagnostics Incorporated (DGX - Free Report): Headquartered in Madison, NJ, Quest Diagnostics is one of the largest providers of commercial laboratory services in North America. It has an expected EPS growth rate of 17.1% for the next three-five years. The Zacks Consensus Estimate for 2020 and 2021 earnings suggests year-over-year growth of 35.8% and 0.3%, respectively.

The Michaels Companies Inc. (MIK - Free Report): Based in Irving, TX, Michaels is one of the leading arts and crafts specialty retailers in North America. It has an expected EPS growth rate of 1.3% for the next three-five years. The Zacks Consensus Estimate for fiscal 2022 earnings suggests year-over-year growth of 13.7%.