Earnings Yield as a Predictor of Return on Assets, Return on Equity, Economic Value Added and the Equity Multiplier

Abstract

This study identifies earnings yield as a measure of financial performance that is based on a firm’s ability to sell profitable goods. It excludes the irrationality that can confound market-based measures of financial performance by emphasizing a firm’s ability to earn profits as the indicator of superior performance. For the full sample, the differential effects of earnings yield on return on assets, return on equity, stock returns, economic value added and the equity multiplier are determined for firms of different size and volatility. The analysis is conducted both across industries and within the oil and gas, computer software, biotechnology and retail industries. For the full sample of NASDAQ stocks from 2010-2014, earnings yield significantly explained return on assets, return on equity, stock returns, economic value added and the equity multiplier beyond book value and book to market. The influence of earnings yield on return on assets was predictable with linear relationships and autocorrelated residuals, while that for small firms was unpredictable with nonlinear relationships between earnings yield and all outcomes with heteroscedastic residuals. In the oil and gas industry, small producers with low market risk and high firm-specific risk, i.e. drillers in new locations with existing technology, found that earnings yield was related to all outcome measures, while large, high-market risk firms, or drillers using the new shale rock techniques strove for operational efficiency through higher return on assets and return on equity. Market risk demarcates small biotechnology firms with those with low market risk demonstrating the explanation of return on assets by earnings yield, while earnings yield is significantly related to economic value added for high market risk firms. In large biotechnology firms, earnings yield was significantly related to all outcomes. Similar results were obtained for the computer software industry. Retail is in retrenchment with small retailers selling traditional product lines emphasizing return on assets or being operationally efficient for survival, while large retailers borrow against large-scale investments in assets, as shown by the significant explanation of the equity multiplier by earnings yield. It may be concluded that earnings yield measures multiple dimensions of financial performance for firms of different size and volatility levels in multiple industries. For small firms, the ability of earnings yield to measure the productivity of capital through economic value added is noteworthy. For large firms, earnings yield is particularly effective in predicting operational efficiency or return on assets.