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.

 

Negative interest rates – what does it mean and what must you do?

Negative Interest Rates Everywhere

Negative interest rates are all the rage among central bankers these days. Today even the usually so moderate swedes lowered the policy rate to a negative -0.1 per cent.

What should you do about it? What does it mean for your job security, stock portfolio, pension etc.? Read on…

(or skip to the very end for a few quick points on education, mortgage and stock market strategies in a NIRP world; Negative Interest Rate Policy).

Earlier this year, the Danish central bank did the same (several times, actually, over the course of a few weeks; going deeper and deeper into negative territory).

The European central bank, ECB, had since long cast off its previously conservative German heritage and gone negative. The same goes for the Swiss National Bank.

Not even the U.S. or Japan have gone negative (yet)

Amazingly, neither Japan or the U.S. have tried negative rates – otherwise strong advocates of monetary experimentation.

They prefer the more “moderate” stratagem of printing trillions of new dollars to purchase newly minted treasuries and bonds from their friends at the big banks instead. (The Treasury issues bonds that the banks buy. Moments later, the latter turn around and sell the bonds to the central bank at a slightly higher price, pocketing the difference. It’s a nifty way to enrich banks while simultaneously circumvent the rules against central banks buying bonds directly from the Treasury).

What Draghi (ECB) & Ingves (Sweden) et al. are trying to do vs. what actually happens

In theory lower interest rates, including negative ones, are supposed to:

lower  borrowing costs for companies (Lower borrowing costs mean more investments will be profitable and thus companies borrow more, invest and hire more people. Higher employment means more consumption and even more hiring in a virtuous cycle)

make banks safer (increased profits and strengthened balance sheets, thanks to lower funding costs due to, e.g., lower deposit rates paid to clients and lower coupons, or yields, on issued bonds)

lower the costs for households (lower interest rates on loans both directly and indirectly, as real estate and other companies get lower interest costs)

lower the borrowing costs for the government (reducing the burdens of a welfare state, enabling more transfers and subsidies)

stimulate more risk-taking (moving savers from zero-interest investments, like accounts and bonds, to equity and start-ups, thus promoting growth)

Increase inflation (higher prices and stable tax rates mean higher tax income for the state, thus making more room for welfare transfers. Higher prices on everything also means that loans [that are nominal] will fall as a proportion to income and asset prices. The latter is good for everybody with loans, but bad for everybody with savings)

What’s so special about negative rates?

Nothing really. What matters is the difference between nominal rates and inflation, adjusted for risk.

However, psychologically, nobody wants to pay money for the “privilege” of owning a bond or keeping money at the bank. Hence, people and decision makers feel forced to do just about anything with their cash, except keeping it idle at the bank.

In theory, when rates go negative, people spend their cash on more shopping and shares on the stock market.

Quantitative Easing (bond buying for newly printed money) aims to boost the effects of low rates

The Swedish central bank (SCB) today decided to accompany the negative policy rate with some bond buying. Most central banks do that nowadays. The Bank of Japan, of course, has done it for several decades (all but proving it doesn’t do any good).

The SCB started carefully with 10bn SEK (1.2bn USD), which would be equivalent to approximately 40-50bn USD in the US. The Fed typically buys in the trillions (1 Tn/year) so don’t worry; the Swedes still honor their heritage of moderation.

A 500% interest rate was the best they could do

A historical note: 23 years ago, when I was still at business school, the SCB raised its policy rate to 500%, manifesting beyond all doubt that it had no clue at all to what it was doing. Now the SCB is trying negative rates instead. I dare predict future economists won’t look back with admiration to today’s experiment either.

QE is thought to relieve weak hands of their bonds and put cash in their hands.

That cash then needs to be reinvested (and hardly in anything paying negative interest). The cash thus moves up the risk ladder into, e.g., longer term bonds, large corporate bonds, or even stocks with historically stable dividends. Gradually, investors at all levels are pushed further up the ladder and some money ends up at the very top; in new investments and start-ups, which should promote economic growth.

So, why ever have have positive or high, instead of negative interest rates? (or, what really happens is this)

If you buy into the Keynesian world view, where it’s a good thing to have politicians manipulate the economic cycle by varying interest rates and budget deficits, why not go “all in” and set negative rates once and for all?

Why not have ever falling rates, plunging deeper and deeper into the negative every year? Why have taxes at all, why not just issue debt to cover all welfare costs and let the central bank buy it all?

The intuitive answer is easy: It’s impossible, you can’t print wealth.

Money isn’t worth anything if you can’t get anything for it. Somebody has to work and produce. Somebody has to postpone consumption (a.k.a. “save”) for there to be anything to invest, for there to be anything produced. With negative rates there will be very little saving going on, but a lot of speculation and consumption instead.

Everybody knows you never go full retard in monetary policy.

The lessons from Zimbabwe, Venezuela and not least Germany (1923), are still fresh and raw in the memory of most economists. The death of money or hyperinflation is the most devastating economic phenomenon there is. Production ceases completely and an ever increasing bulk of money chases after an ever diminishing pool of assets and goods, fueling wild speculation and zero long-term investment.

Apart from doomsday scenarios, this is what negative rates means for you

In short, it actually means a doomsday scenario, just very slowly. The lo-down:

You’ll earn less interest on your bank account. Since most people don’t have any cash this is probably not a problem for you. If you have retired and live off a state pension, cash savings or bond coupons – tough luck!

Your variable interest housing loan becomes cheaper. Good for you, more money over for other things. Get out there and splurge!

Share prices, house prices and other asset prices rise for a number of reasons (most of them temporary and psychological). Good for you if you have all the assets you want. Bad if you were planning to buy more.

Companies start investing in anything they can find that might produce more return than the cost of borrowing. This means a lot of investments with lower return than usual get done. These lower quality projects fail more often. In addition, if interest rates rise, investors lose money even if the projects deliver as promised.

Short-term, the economy gets a boost, unemployment falls etc, as it did in 1996-2000 and 2003-2007, but when the low quality projects mature or interest rates rise, the true costs of low quality investing (malinvestment) become obvious. Remember that central banks lowered interest rates, to no avail, all the way down in the 2001-2002 and 2008 stock market crashes.

Longer-term, jobs disappear, banks fail.

The economy’s resilience and growth potential has been hollowed out by low quality investments. The easy job gains in real-estate, financial markets, service industries and consumption during the NIRP* induced boom are soon lost again. The loans for second houses, stocks, third cars, watches and other consumption go bad, consumption fall, and banks fail (subsequently rescued with tax money – congratulations all tax payers, they’re doing it again. But, no worries, the bankers will get to keep their bonuses from the boom).

*NIRP=Negative Interest Rate Policy

Inflation takes hold. Sooner or later inflation takes hold, due to more money and less goods. Then interests rise and many holders of variable rate mortgages will be toast. There actually already is rampant inflation – it’s just that it’s in assets, instead of goods. Whatever inflation there is in goods, the authorities choose not to include in the calculations, but there is a limit to how much they can hide.

Banks take more risk (and sooner or later go bankrupt) since they know the state and central bank will save the bank with tax payers’ money when needed. Up until the bankruptcy/state rescue bankers can pocket their bonuses and get to keep the money after the inevitable collapse.

Financial markets fall (they always do, sooner or later – and have already halved twice in less than 10 years; 2001-2002 and 2008-2009). Whatever artificial appreciation of stock prices accomplished today will be gone tomorrow. Bank failures in the wake of higher interest rates, malinvestments and bad loans is often a reliable way to start a market crash.

The value of a stock today is the discounted sum of about 25-50 future years of cash earnings after tax. Those earnings are being eroded, due to easy money, by current malinvestment and speculation, instead of sound long term investments in production. A mania in the wake of negative interest rates actually reduces the value of stocks, leading to lower lows in the downturn than what otherwise had been the case. Thanks Draghi! Thanks Ingves!

Enough with the economics and Fimbulvetr stories. What should you do now?

Should you fix your mortgage rate, borrow more, buy stocks, study, WHAT?

To start with, -0.1% isn’t that different from 0% or +0.25%, so you really could ignore the whole circus. As you were. In theory though… (and ceteris paribus):

In the short term things will look better. More employment, higher stock prices, higher house prices. In the long term things will still turn ugly.

This is how I would prepare:

Make yourself change resistant; don’t take your job for granted. Acquire more skills, make yourself indispensable, look for future-proof work places. Many will relax in the easy times of negative rates, but you should work harder than ever to secure your place in the job-less future to come.

Amortize your loans, or fix the rate for 7-10 years. Interest rates have never been as low as they are today. Don’t just do as all the other lemmings and go deeper into debt with variable interest rate – be contrarian and either reduce your debt (you can afford to amortize now that your monthly interest cost is so low) or fix the rate for a long time, in case inflation eventually ramps.

The family of two medical doctors I lived with when I studied finance asked me in 1990-92 whether I thought they should change their mortgage to variable interest (10-12% or so) or continue with 5-10 year fixed rates at around 12-15%. I repeated what I had learned in school (“you have always gained from variable rates”, except the very recent period). I hope they listened, because they were quite worried that rates might rise again, from 12%!

The coming decade, 2015-25, we are due such an exception again, where fixed rates are better than variable. Do you dare to time your fixing? Early 2015, late 2015? 2016? 2017?

I wouldn’t buy stocks or more living space. A very short summary of the entire article and the consequences of ultra-low rates would be “This already happened“. As I said, the small increment lower doesn’t change anything much. Stocks (everywhere) and house prices (Sweden; they never fell in Sweden during the financial crisis) have already skyrocketed due to ultra-easy money.

Stocks: Guess what will happen when rates rise, when profits fall, when speculation loses its luster, when growth expectations crumble… Do you think stocks will rise or fall then? Once again, remember that stocks crashed more than -50%, twice, while the Fed kept lowering its policy rate.

Once speculation fades and stocks are seen as risky (potentially negative returns to the tune of -10-60%), then zero or even negative rates in risk-free instruments will be seen as superior investment alternatives. As John Hussman keeps telling his readers, the writing is already on the wall in that respect, as gauged by increased dispersion of market internals (yield spreads, stock sectors etc).

In other words, investors are becoming more and more anxious and any little thing can topple that first crucial domino that fells the rest.

Stocks overshoot, and stocks undershoot. Respect that cycle and use it to your advantage rather than the other way around.

 

Obviously no consequence coming...

Obviously no consequence coming…

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Are you too ‘smart’ to short the market? Then do this

Unlike most smart investors, financial pundits, TV commentators…

 

…and not least my eloquent friends at Wall Street Playboys,…

 

I do time the stock market, and I don’t shy away from making my recommendations or investments public.

 

Right now every fiber in my body screams to short the stock market:

  • Risk aversion is on the rise (seen in general market dispersion, chaotic and nervous intraday patterns, loss of trend uniformity, increasing High Yield spreads) and any little event could topple that first crucial domino that sets off the rest. The whole market is nothing but an unstable pile of fingers of instability.
  • The rally is extremely long in the tooth and some robot traders could just as well take that as a cue to try the downside (NB: 80% of the trading is automated robot trading)
  • Oh, did I mention the US stock market is the most expensive it has ever been (on some measures, and just 10-20% below the epic peak of year 2000 on others)? Swedes hoping for a safe haven in dear old Stockholm should note that the OMX index usually mirrors the US indices perfectly in downturns, no matter if OMX lagged a little before.

The stock market in a nutshell (pic from Hussman)

Why you should short stocks

Directly from Hussman, just as the picture above: The yellow shaded areas show points where credit spreads might be defined as “rising.” For simplicity, I’ve shaded all points where credit spreads had advanced 90 basis points from their 6-month low, and were greater than their 150-day moving average. Observe that the steepest losses we’ve observed in the S&P 500 in recent decades have been concentrated during those periods of objectively widening credit spreads. I’ll say this again: low and expanding risk premiums are the root of abrupt market losses.

The purple shading identifies only a subset of those points that also match the market return/risk profile that we currently observe (basically identifying recently overvalued, overbought, overbullish conditions that were then joined by deteriorating market internals or widening credit spreads).

 

But, I get it, you just don’t want to short the market. It seems immoral, dangerous, unnatural… You’d rather just wait for a good buying opportunity – and you don’t want your money to sit idly on a zero per cent bank account meanwhile.

You could copy my strategy, which is to slowly accumulate investments that have already become somewhat cheap (but, as always, risk becoming cheaper, much cheaper, further ahead) and trade others opportunistically (I like gold and currencies, since they don’t really have ‘intrinsic values’ like stocks. That makes it easier to disregard the dangers of picking unknown pennies in front of an unknown bulldozer)

 

So, what am I doing exactly? I mean, I have retired, I am officially a retarded hedge fund manager. I could live splendidly off of my capital for the rest of my life. However, as the retard I am, I want to prove that I am right. Just saying I said so afterward simply isn’t enough. I want to make some money too.

 

Except for my big short (which is waaaaay under water) on the Swedish stock market, this is what’s currently in my direct financial portfolio (except apartment, pension funds, private companies like the publishing company and the floating sauna company, russian art etc.)

 

  • Software as a service: A convertible loan and a sell option in a Human Resources software company – if things look okay, I’ll convert to shares and later use the sell option, if they look really good, I’ll convert and keep the shares for a while. If things turn really ugly, I’ll end up with a large mansion in the countryside
  • Cash at the bank (dry powder)
  • Loans to friends (not that dry gun powder, but perhaps I’ll get to call on these when the time comes – at least they stick to regular amortization schedules)
  • Gold (albeit “paper gold”) SPDR Gold shares ETF – gives me some USD exposure as well as some insurance against Yellen’s next move (+21% so far on this trade)
  • Gold mines (senior = actually producing gold) Market Vectors Gold Miners ETF – like above but with more juice (+24% on this trade so far)
  • USD 3x leverage – I halved my position in the USD yesterday (75% profit in a year) but still have a fair amount left. The Swedish Krona, SEK, usually falls in times of trouble. If China falters probably doubly so due to Sweden’s export dependency to Asia. The USD on the contrary, despite all its shortcomings, is the safe haven of first choice for most investors (incl. americans themselves selling foreign assets). The Fed might even consider raising rates this year which I can’t see any other central bank doing.

Smaller investments and speculative short-time bets (oil):

  • Creditsafe – small unlisted credit service company, provides credit quality information on companies and private individuals
  • Oil (Brent) 5x Leverage (entered today )
  • Peptonic medical – oxytocin pioneers (very small investment)
  • Opus – small investment (testing services and testing equipment mainly for the auto industry – hopefully a secular growth story, the share price has recently halved and that’s why I stepped in. However, the shares will likely fall a lot more before this is over)

 

My suggestion to you (except shorting stocks) is:

  • Invest in a business (your business perhaps?) or learning a skill
  • Keep cash ready for opportunistic buying in the case of a (flash) crash
  • Think outside your geographic region (stocks, currencies)
  • Slowly, slowly accumulate stocks that really excite you and have become forgotten by other investors that chase a shrinking pool of rising large caps
  • Consider buying things like gold or oil, but do your homework first, don’t just follow my lead