Using Yield-based measures to value stocks: Say Yes to Yield

Say Yes to Yield

1.  Earnings yield

Earnings yield
= Earnings/Price

The nice thing about yields , as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas bond payments are fixed.)

For example:
In late-2003:
Risk-free return from 10-year treasury bond: 4.5%
Earnings yield of Stock with P/E of 20 = 5% (This is a bit better than treasuries, but not much considering the additional risk taken.)
Earnings yield of stock with P/E of 12 = 1/12 = 8.3% (This is much better than the treasury bond. The investor might be induced to take the additional risk.)

2.  Cash return

Cash return
= Free Cash Flow/Enterprise Value
= FCF/(Market capitalization + long term debt – cash)

However the best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E.

To calculate a cash return, divide free cash flow (FCF) by enterprise value. (Enterprise value is simply a stock’s market capitalization plus its long-term debt minus its cash.)

The goal of the cash return is to measure how efficiently the business is using its capital – both equity and debt – to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole company, including the debt burden. An investor buying the whole company would not only need to buy all the shares at market value, but also would be taking on the burden of any debt (net of cash) the company has.


An example of how to use cash return to find reasonably valued investments:
Company A’s
In late 2003,
Market cap = $9.8 billion
Long-term debt = $495 million
Cash in balance sheet = $172 million
Enterprise value = $9,800 + $495 - $172 = $10,100 million or $10.1 billion.

Review its FCF over the past decade
In 2003, FCF = about $600 million

Therefore,
Cash return of Company A = $600/$10,100 = 5.9%

In late 2003:
Yield of 10-year treasuries = 4.5%
Yield on corporate bonds = 4.9% (This is higher but still relatively paltry.)
Cash return of Company A = 5.9% (Looks pretty good. Moreover, this FCF is likely to grow over time, whereas those bond payments are fixed. Thus, Company A starts to look like a pretty solid value.)

Cash return is a great first step to finding cash cows trading at reasonable prices, but don’t use cash return for financials or foreign stocks.
• Cash flow isn’t terribly meaningful for banks and other firms that earn money via their balance sheets.
• A foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally, as the definitions of cash flow can vary widely in other countries.


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Free Cashflow to Capital

FCF/Capital
=FCF/ Total Capital Employed
= FCF/TOCE
= FCF / (Total shareholders equity + Debt)

The Stock Performance Guide published by Dynaquest Sdn. Bhd. gives data on Free Cashflow (FCF) to Capital.  FCF is the amount of nett cashflow left after paying for re-investment in fixed and current assets. FCF measures the ability of a firm to pay out dividend.

FCF/Capital compares the FCF of a firm with the total capital employed (defined as total shareholders equity & debt). The higher is this ratio, the more efficiently is the firm using its capital.

Cash cows are those companies with FCF/Capital of > 10%.

FCF/Capital is not the same as Cash Return discussed above.