I often like to view the ownership of a mature operating business as owning a perpetual bond. As the name suggests, a perpetual bond never matures. Similarly, a viable business with rational management and a strong balance sheet should be in existence for a very long time. A good example is a stock I owned a decade ago called Grolsch Brewery (SABMiller acquired in 2007). It was a beer company founded in 1615 – now that’s an established and mature business!
What’s nice about perpetual bonds is they’re easy to value (cash flow/discount rate = price). Valuing an established business in this manner is also simple. For instance, if a company is expected to generate $10 million in free cash flow a year indefinitely and you demand a 10% return on investment, the value of the business is $100 million (to make even simpler I assumed a 0% growth rate).
Similar to perpetual bonds, companies provide investors with cash flows. As such, they also provide investors with yields. While most equity investors focus on dividend yields, I’m more interested in the business’s normalized free cash flow yield. Over the long-term, free cash flow is often similar to net income; therefore, I believe it’s reasonable to label an equity’s free cash flow yield as its earnings yield. In the above example, assuming the business has a market value of $100 million and normalized earnings of $10 million, its earnings yield is 10%. I define normalized earnings as the average earnings a business is expected to generate annually over a full profit cycle.
For all of you valuation wizards, I apologize as I know this is all review and below your pay grade. Even though the normalized earnings yield is a very simple calculation, I believe it’s an underutilized measurement of value and potential return. When was the last time you saw a normalized earnings yield in a presentation or portfolio fact sheet? Historical returns are much more popular, but in my opinion, less valuable and informative. For example, when investors view the small cap options in their 401k plans, what do they see? Currently they see most of their small cap choices have generated approximately 15% annualized returns over the past five years. 15% a year? That will work – sign me up!!!
Instead of focusing on past performance, what if the portfolio’s current normalized earnings yield was also included? This would be very helpful, in my opinion. Let’s assume that one of the 401k investment options in the example above was a typical small cap fund or the Russell 2000. According to Bloomberg, the Russell 2000 trades at 49x earnings (unadjusted). What if instead of showing an investor that the fund generated 15% a year for the past five years, they were also informed that the fund’s holdings were only generating an uncertain 2% earnings yield? I believe including the earnings yield would raise some important questions. For instance, what is a better indicator of future returns, the portfolio’s current 2% earnings yield or the past five years of 15% annualized performance? Or maybe an even more relevant question is how does an equity portfolio generating a 2% earnings yield provide investors with a 15% annualized returns going forward?
My current buy list is trading at 30x earnings and provides a meager 3.3% earnings yield. I don’t have an aggregate normalized earnings estimate on my 300 name buy list, but I believe profit margins (on average) remain above historical levels. Therefore, normalizing earnings of my buy list stocks would most likely cause the aggregate earnings multiple to increase and its earnings yield to decrease. The Shiller P/E is currently 28.1x, or provides a 3.6% normalized earnings yield. Since 1980, the Shiller earnings yield has ranged from 2.3% to 15%. Investors who bought when the earnings yield was high did considerably better than investors who bought when it was low. Buying stocks when normalized earnings yields are high, is simply another version of buy low sell high, or common sense investing.
And that’s one of the things I like so much about the normalized earnings yield. It’s an easy to understand valuation metric that is founded on common sense. Does receiving an uncertain 3% coupon on equity investments appropriately compensate investors for risk assumed? This is an especially relevant question when the 30-year Treasury is also yielding 3%. Or when the long-term bonds (higher up on the capital structure) of many of these companies are yielding 3%-6%.
The normalized earnings yield is a very simple, but effective valuation metric. In my opinion, providing or knowing a portfolio’s normalized earnings yield would benefit asset allocation decisions that have historically been heavily influenced by past performance. If the normalized earnings yield was included alongside past performance, I believe some investors may think twice about allocating their retirement savings into such low yielding risk assets. And at current equity prices and valuations, maybe a splash of reluctance and prudence wouldn’t be such a bad thing.