Calculate the sustainable free cash flow yield, to get an intuitive valuation feel

Executive summary: Single stock valuation

Cash Flow / Stock price = yield

That’s actually the entire message of this post. Yes, true, you can move on to your next task of the day now.


 

Forget valuation multiples, DCF analysis, EVA etc. Just calculate the ‘yield’ of your holdings: “Profit”/market capitalization

5.4% yield? Good or bad? Worth the risk, the wait? You decide.

Is the yield high enough for you to hold on to the security forever, or do you require some price increase as well to be satisfied, to cover your costs, to reach your risk adjusted required rate of return?

Best guess is that if the yield is high you’ll get a price increase as well, because more investors will flock to the high yielder, whereas a low yield will come with a (at least an interim) price fall.

That’s it. That’s all you need. Well,… and love. Actually, love is all you need. The yield is just icing on the cake.

Gigi hugs

Gigi hugs from Flickr

Or frosting. Think about that.


 

Read this first

Before moving on, please note that this is purely a hard core finance article. There is no humor, no personal development ideas, no tips and tricks, no memes and no great mindsets to contemplate. It’s just numbers.

math brain retarded hedge fund manager novelty plasticity

There is not even a tangible specific stock example… or a picture… or stock chart. But you can always go back to the Amazon example from a few weeks back for that.

 

“Is this stock worth buying?”

Let’s say you are more or less happy with the general investment environment (see last post about index outlook). Now, you just wonder if a particular stock is worth your time and money…

Here is one way of getting a feel for it.

What’s the latest annual profit? After taxes? After necessary investments in various operating resources? What’s this year’s free cash flow available for dividends , hoarding and re-investment?

 

That last question is key: Free cash flow, FCF

 

The cash flow is a much better measure of real economic profit than the operating profit or net income, since it’s for real. It’s really there in the bank account after everything is said and done, after all the accounting gimmicks, staff stock options etc.

Divide the FCF number with the company’s total market capitalization, FCF/MCap, and you get the cash flow yield. That’s your annual return on your original investment, if the price stays the same. Compare it to your bank account, a private loan to a friend, a government or corporate bond, e.g.

  1. FCF/MCAP = yield

How high a yield do you demand, require, on average, to buy the shares, given there is a risk associated with equity investments? 6%, 10%, 15%, 25%? That’s not for me to say, but the riskier the company, the more you probably want to demand in return.

The stock market in general has produced around 6% annual real performance, including dividends, over a century. That’s around 8% nominal return per year. If some kind of general Required Rate Of Return [RRR] was 6% / 8% during the same period, the stock market has on average been priced just right.

It makes sense as a starting point, that the market on average over a century was neither a bargain, nor a rip off. Hence the RRR was about the same as the annual return.

What’s your RRR for your stocks? What’s your “base” RRR and how much do you adjust for specific stocks. That’s entirely up to you and depends of thousands of subjective variables.

However, if you just want to fit in with everybody else, stay around 5-10% for most large caps (big, well-known firms), maybe as low as 2-4% for very stable business models, and up to 15-30% for newly IPO:d stocks with limited information or unproven or high-risk business models.

So, what are your RRRs?

 

Ask more of your shares

Statistically, a single stock is riskier than a group of stocks. Thus, you should typically require a higher rate of return from your single stocks than a broad index of companies, but I’m not judging anyone. 

Given your RRR and the actual yield, the upside/downside on the stock (for you) is thus pretty simple:

2. Stock potential = yield/RRR-1

3. Stock value = FCF/RRR

As an example, your company has a FCF of 50, a market cap of 400, and your RRR (return demand) is 7%. Then there is an (50/400)/7%-1 = 79% upside to the stock for you. The actual price of the stock could rise to FCF/RRR=50/0.07=714, before its yield was as low as your RRR.

Of course, the stock might never appreciate that way, since other investors have different RRRs and valuation models, but to you it is worth 79% more, so just keep buying as long as you have money to spare and the stock potential is positive.

NB: An asset returning 4% when you demand 8% is worth just half the price to you, since 4/0.5=8

Again: Let’s say you find a stock that costs 100 and has a cash flow of 4. If you can buy the stock at just 50 you would get a 4/50=8% yield.

 

Complicating things just a tad

There is just one problem; This year’s cash flow probably isn’t representative of the entire future of the company.

What to do? Easy! Make it representative. That’s easier said than done, but you can at least try. This is how:

The most important variables to normalize, make sustainable and believable, are profit margins, net working capital requirements, investment needs and tax rates. Simply adjust current year’s profits and cash flows according to long term sustainable margins, NWC, investments and taxes.

Unfortunately, even a professional investor or analyst that has spent 10 000 hours on that company alone still can’t do that with any precision. On the other hand, that leaves room for you to give it a stab too.

Think and guess. Is a 10% operating margin likely? Why? Why not? Competition? Tax rates in the future? Cash flow conversion (credit conditions, invoice routines, DSO…)?

If nothing else, you can piggyback on the analyst community, and assume that 3-5 years out, all variables have been normalized to the best of everybody’s ability. Be careful in the smaller caps though. Analysts and investors tend to be overoptimistic there.

piggyback

Take the margins and other variables from, e.g., t+4 years and use them on the latest available 12 months sales numbers, or this year’s expected full year sales. Then use the resulting free cash flow as your basis for a yield and share potential calculation.

4. Sales at t=0 multiplied with margins etc. at t+4 => normalized cash flow at t=0, and normalized yield

Just as before, keep buying as long as the normalized yield is higher than your RRR. You’ll get at least your RRR on your investment, as long as you don’t have to sell the stock at lower prices, or your assumptions on future cash flow returns turn out to be wrong.

DONE!

Calculate normalized cash flow yields and compare them to your required rate of return, and invest accordingly. Period.

 

The master class

Oh, I almost forgot. Then there is the question about growth after the normalization period.

If the company keeps some of its FCF, its equity will rise. If the company’s business is growing too, next year’s FCF will be higher as well. Depending on growth rates, the valuation of its equity, and your RRR, the relation between your RRR and the company’s yield will change.

E.g., if the growth in FCF is higher than your RRR, even by just the most minuscule amount, the value of the company should theoretically be infinite to you. Weird, and hardly practical.

Price = Cash Flow / (RRR-g)

It’s complicated. I’ll leave it at that. This was never meant to be a full course for stock valuation, just yet another Quick And Dirty piece of the valuation puzzle. By the way, as soon as you start complicating things or involve too much math and formulas, you risk losing your intuitive feel for the investment. Leave that to professional number crunchers. They are wrong often enough.

Does it seem hard? Difficult? You have no idea where to begin…?

Alrighty then, let’s do all the things that you wanna do! Here is a summary

 

Summary

  • Find the most recent annual profit, or a reliable estimate for the current year
  • Adjust it to get to free cash flow
  • Change margins etc. to long term sustainable levels
  • Divide the sustainable cash flow by the stock price
  • That’s your yield
  • Is that yield higher or lower than what you want out of an investment with that risk profile?
  • Is the yield higher or lower than what you estimate the market in general requires of that kind of stock?

Remember that the yield is “real”, i.e. if the company grows, the yield rises. That gives you an inherent margin of safety

On the other hand, the yield isn’t safe, neither is the stock price. You have to be prepared to hold the stock through thick and thin and never be a forced seller. The yield valuation method doesn’t say what other investors think, but what do you care if the stock moves up or down if you are going to hold it forever? You can always buy more on dips.

 

Did you hate this post? I feel you. I hated myself for writing it. Now, share it with somebody whose evening you want to ruin.

If you are new here, join thousands of other intelligent investors (personal and financial) and sign up for my newsletter and free eBook.

 

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5 Comments

  1. I’m lovin’ it.

    Although I don’t get some of the expressions/jargon.

    This is really valuable for when I’m eventually gonna start buying stocks instead of index funds.

  2. Mikael,

    Could you explain how you got 79% in the example?

    Tried a manner of calcs and whilst I’m getting something related to it, it’s not consistent.

    Thanks

  3. I am really bad in accounting. I’ll let my accountant do the tasks. I’d also like to read article like this to be knowledgeable and to be able to improve myself. Thanks for sharing this article.

  4. I totally agree with what you said. I think that we really should not be a forced seller. I think that we must be really evaluate and check things out first so that we’ll avoid future problems. Thanks for sharing this article.

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