One of my favorite investors is Pat Dorsey. Dorsey is the founder of Dorsey Asset Management and he’s also the author of two books, The Five Rules for Successful Stock Investing and The Little Book that Builds Wealth.
Recently I was re-reading The Little Book That Builds Wealth and came across the following piece, which is a way to value businesses using what Dorsey calls the ‘cash return’. He says that cash return is an improvement on the earnings yield calculation and is calculated as Free Cash Flow/Enterprise Value, which is one of the metrics we use here in our stock screens to find undervalued stocks.
Here’s an excerpt from the book:
Say Yes to Yield
If we turn the P/E on its head and divide earnings per share by a stock’s price, we get an earnings yield. For example, a stock with a P/E of 20 (20/1), would have an earnings yield of 5 percent (1/20), and a stock with a P/E of 15 (15/1) would have an earnings yield of 6.7 percent (1/15). With 10-year Treasury bonds trading for about 4.5 percent in mid-2007, those both look like reasonably attractive rates of return relative to bonds. Of course, you’re not guaranteed to receive the investment returns on those two stocks, whereas the T-bond is backed by Uncle Sam, a fairly trustworthy guy. However, you’re balancing out the additional risk with something positive: The earnings stream from a company will generally grow over time, whereas the bond payments are fixed in stone. Life is full of trade-offs.
We can improve on an earnings yield with a neat little measure called the cash return, which is simply the annual cash yield you’d get if you bought a company, paid off all its debt, and kept the free cash flow. Going back to our apartment-building analogy from the preceding chapter, think of cash return as the income stream, as a percentage of the purchase price, that you might get from owning an apartment building outright after paying for maintenance and upkeep.
Cash return tells us how much free cash flow a company is generating relative to the cost of buying the whole company, including its debt burden. This measure improves on the earnings yield because it looks at free cash flow (owner earnings) and incorporates debt into the company’s capital structure. To calculate cash return, add free cash flow (cash flow from operations, minus capital expenditures) to net interest expense (interest expense minus interest income). That’s the top half of the ratio. The bottom half is called “enterprise value,” which is the company’s market capitalization (equity) plus long-term debt, minus any cash on the balance sheet. Divide free cash flow plus net interest by enterprise value, and there you go—cash return.
As an example, let’s take a quick look at Covidien Ltd., a huge health-care company that was part of Tyco International before that company broke itself up. In 2007, Covidien posted about $2 billion in free cash flow, and it paid about $300 million in interest. So, $2 billion plus $300 million equals $2.3 billion, and there’s the top half of the ratio. The company has a market cap of $20 billion and long-term debt of about $4.6 billion, and the sum of those numbers, less $700 million in cash on the balance sheet, is Covidien’s enterprise value of $23.9 billion.
We divide $2.3 billion by $23.9 billion, and we get a cash return of 9.6 percent, which is pretty juicy considering that that cash stream should grow over time, because Covidien sells into a number of health-care markets with solid prospects.
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