Someone who reads my articles asked me this question:
Geoff,
My question now is why are you referring to the earnings yield instead of free cash flow yield in this article? Even though I should now use EBIT instead of FCF for my return on capital calculation, that doesn't mean I should use the earning yield instead of my free cash flow yield for valuation. Correct?
I've always known you to use FCF yield in most of your articles and this constant reference to earnings yield threw me a bit of a curve ball.
Thanks,
Chad
This is a great question. It's not that easy to answer. The truth is a bit – theoretical.
Basically, an asset is worth its future cash flows discounted to reflect the timing of those flows. But, this causes some people confusion.
For example, is it okay if a stock never pays dividends?
Sure.
Why? How will you make money if you own a stock for 20 years – and it never pays a dividend while you own it?
Because 20 years from now, the guy who buys the stock from you will buy it – in a sense – for its ability to pay him a dividend.
So, if a stock can pay a dividend but it doesn't pay a dividend – does it become worth less?
No. It only becomes worth less if by retaining each $1 it could pay out results in an increase in its ability to pay future dividends that is less valuable than the $1 it retained.
Quick example. If a stock retains $1 in earnings for a full year that it could pay out today if it wanted to – but it'll be able to pay $1.15 next year if and only if it retains that $1, is it now worth more or less by retaining the earnings than it would've been by paying them out?
Clearly, it's worth more. If you're using a discount rate higher than 15% today – you're doing something wrong. That's an excellent return on retained earnings. So any company that can keep an extra $1 today and pay out an extra $1.15 next year should do that.
Well, all stocks work that way. I! n fact, all assets work that way.
I think I mentioned once that Hetty Green made a fair amount of money in real estate. The odd thing about what she did is that she generally did not rent out her real estate.
She just left the land she owned undeveloped as other folks developed everything around her. Finally, when she sold her empty plot – it was very, very valuable. And her cost to keep that land all those years was basically nil.
So what was her return on her land? For many, many years it was 0%. But then it was a very big number at the end. The question is whether that very big number received very far in the future was enough to equal – discounted for timing – what she could've earned by developing the land and renting the property.
Moral of the story: don't put more into an asset (like slapping a building on your land) unless the return you can get on the extra bit you put in is better than what you could get elsewhere.
That doesn't necessarily mean you should buy the shares of companies that are as tight with their money as Hetty Green was with hers.
It's fine to put nothing into an asset. And it's fine to put everything into an asset. What's not fine is putting more into an asset than you get out of it – over time.
This is the key part of Warren Buffett's philosophy that folks overlook. He talks a lot about return on retained earnings. Whether keeping an extra dollar in a business tends to result in an extra dollar being added to the market cap.
So, a company that grows value doesn't have to pay anything out. You don't need free cash flow if you have real owner earnings.
Neither owner earnings nor free cash flow are exactly the same as reported earnings. So, I won't say that earnings are as good as free cash flow. At a lot of companies, I would put owner earnings at least a few percentage points lower than reported earnings.
The way accounting works, you'll tend to see companies have 95 cents of owner e! arnings �! �� and call that $1 of GAAP earnings.
That's not what we're talking about here. That's an accounting issue we can talk about another day.
Today, we'll just talk about whether a company should be valued according to earnings or free cash flow.
Which should you use? Earnings yield? Or free cash flow yield?
It depends. If you want to know how much money there is available to:
· Pay dividends
· Buy back stock
· Pay down debt
· Make acquisitions
Then use free cash flow. If that is what you imagine your equity "coupon" – like the interest paid on a bond – is then FCF/Market Cap is the number you are interested in.
But, if you want to know:
· I own a snowball. How much bigger will the snowball get this year?
Then the correct number to use is an earnings based number – definitely not a free cash flow number.
Think of it this way. Copart (CPRT) opens a new facility. They have to either buy somebody out (in which case you might not penalize them in free cash flow) or buy and develop a new salvage yard from scratch (in which case, almost all FCF calculations will punish them for this cap-ex).
But, if you really believe that Copart can achieve anything like a 27% return on net tangible assets (my estimate of what they've done in the past) – should you be penalizing them at all?
Isn't a $1 increase in inventory, receivables, and/or land that is going to earn 27 cents a year worth every bit as much as if it was paid out to you (or was sitting in cash at a bank)?
So, aren't earnings for a company that earns a 20%+ return on tangible investment clearly worth every bit as much as free cash flow?
I would say yes. If and only if you believe the future return on the earnings retained by the business today (the marginal return) is in a sense co! mparable ! to the average return in the past.
Don't confuse how fast a car is moving at this instant with how much distance it's covered in the past hour.
The past average is just the past average. It is not the same as what the company will earn on the next dollar of capital it puts into the business.
But it can be used as a guide. Especially for wide moat businesses.
Like any rough guide – you want to leave a big margin of safety. So, if you think you can make 10% on the money in your brokerage account and the company you are investing in has an average unleveraged return on tangible net assets of 12% - that's pretty much a wash. I can't say that money is better off with the company than it is with you. And I think – absent tax concerns – it would make perfect sense to hope the company paid that cash out to you.
At a 20% unleveraged return on tangible net assets I'd feel differently. The evidence points to the company having a better chance to earn more on the capital inside the business than you'd be able to earn if it paid you a dividend.
Still, beware of averages. Sometimes the average past return on capital is a good gauge.
For a lot of companies this is nowhere near true. As an example, restaurant chains almost always follows this pattern:
· Great concept attracts attention, builds momentum
· Demand is greater than supply – you can't build these restaurants fast enough
· Returns on invested capital are mind bogglingly wonderful
· Chain continues to expand
· ROC starts to decline
· Chain expands even faster
· ROC declines even faster
· Chain gets too big
· ROC becomes mediocre
· And worse
Now, if you think about the fact that where I say "ROC" I mean the average return on all the company's invested capital – remember, it was once super terrific and then it ends up quite mediocre – for that to happen, the company must have been getting really bad retu! rns on it! s additional investment for a long time.
At the margins, returns were probably really bad for a really long time.
Actually, this can pretty much be proven by the rare examples of chains that hold back growth earlier in their development. If they find something else to do with the capital – like buy back stock, pay dividends, etc. – the ROC of a restaurant can stay high for a long time.
This isn't the only issue. Competition is the biggest issue. But over expansion comes up too. And it demonstrates the difference between what we're earning on the extra money we add today and what we've tended to earn over time.
This is one reason I'm not usually that excited to own a restaurant, retail store, etc. It is usually much easier for them to overexpand and start investing at much low ROIs than I expected. Just like growth investors say it isn't a company's growth before you bought it that matters it's the growth after you buy it – an ROI investor is looking for future return on capital added to the business.
This can be hard to calculate. But if you know ROI will stay above what you could achieve yourself with the same amount of money – you should use a P/E type measure (or EV/EBIT or EV/EBITDA – it depends on the accounting) to price a stock. You should not use free cash flow.
There is a spectrum of businesses.
If you line up businesses by their ability to get a good yield on their own capital, the company's should be valued like this:
· Reliably above average returns on investment – value on an earnings basis
· Consistent companies with a mixed or impossible to evaluate ROI situation – value on a free cash flow basis
· Inconsistent companies with an unreliable or poor ROI situation – value on a tangible book value basis
Or to put it another way:
· Good, reliable companies are snowballs
· Mixed, reliable companies are waterfalls
· Unreliable, bad companies are rocks
A snowbal! l is wort! h what it can grow to as it travels down the hill. A waterfall is worth the rate of its flow. A rock is worth its weight. The rock is static. The waterfall is constant. The snowball is dynamic.
Remember the idea of earnings – assets equivalence. Too many investors stick themselves entirely in one camp or another. Now, there's nothing wrong with just being an earnings investor in terms of your own process. And there's nothing wrong with just being an asset investor in terms of your own process.
But there's something wrong with thinking the other guy is wrong for looking at the other side of the equation. You are entitled to a specialization. You are not entitled to opine on the other guy's chosen field.
Assets produce earnings. Earnings become assets. The process repeats.
This is critical. And people don't pay enough attention to it. When I say there is a difference between a low price-to-book stock with a lot of retained earnings and a busted IPO with no retained earnings with a low price-to-book I'm saying that while the assets are the same in both cases – in one case those assets were formed from past earnings and in the other they were not. There is a history of earnings at one company. And no history at the other.
Would you rather buy a clearly finite pool of water or a pool of water you once knew was being fed by a spring. Maybe the spring isn't feeding it anymore. Both might dry up. But you have a history of past renewal in one case – and no history in the other.
Asset and earnings equivalence matters with earnings and free cash flow too. Free cash flow is about – to use another nature analogy – cutting down a lot of timber. Maybe more timber than will allow you to maintain a steady state of yield each year forever.
If you own timberland you get to choose:
· Cut down more trees than you can replace
· Cut down the same number of trees you can replace
· Cut down fewer trees than you can replace
Is your p! roperty w! orth more when you cut down more trees than you replace?
Is it worth less when you cut down less trees than you can replace?
Or is it always worth the number of trees you can cut and replace plus or minus the smartness or dumbness of your decision to prefer more trees tomorrow to fewer dollars today?
It's the last one.
So ask yourself:
· What is the sustainable rate of cash removable from the business?
· What is the valued added or subtracted from the business by the resource use decisions of management?
I mentioned that I recently bought Dun & Bradstreet (DNB).
Why?
Basically, it comes down to 3 things:
1. Reliability
2. What is the sustainable rate of cash removable from the business?
3. What is the value added or subtracted from the business by the resource use decisions of management?
My answers are:
1. Very high
2. Acceptable
3. Not negative
I think DNB is highly reliable.
I think normal free cash flow – what the company will cut from its economic forest – is acceptable. Not the best returns in the history of stock market investing. But good when you look at other options available now and decent when you look at the history of what stocks have yielded in the past.
I've said it's about 10%. (That's a leveraged number. DNB has debt.)
If I spend $1 buying DNB stock in the market, they can cut about 10 cents and still be able to cut another 10 cents next year and next year and next year for as far out as I can see.
And then I think the value added or subtracted from the business by resource use decisions of management is not negative.
This is based on past behavior. I think a dollar that stays with DNB is roughly the same as a dollar paid out to me. This has to do with how quickly they will use the dollar, whether they will buy back stock, whether they will pay dividends, whether they will make acquisitions, how much I have to pay in taxes on what t! hey distr! ibute to me, etc.
But, basically the result of this is that when you look at DNB's business – its moat – and its free cash flow yield and its resource management (capital allocation) I think it's pretty darn close to a 10% perpetual bond. And I'd buy a 10% perpetual. So, I'd buy DNB stock.
Everything I am talking about with DNB is really just setting up that point. I think it's like a 10% perpetual bond.
But I want to make something very, very clear. Although I value DNB on a free cash flow basis – this is only because I think they:
· Should cut down as many trees as they can replace
· Will cut down as many trees as they can replace
I have nothing against a company that wants to grow its forest. If I was an investor in:
· Copart (CPRT)
· Boston Beer (SAM)
· DreamWorks (DWA)
I would want them to grow the forest. I would want them to cut down fewer trees than they can replace each year. I want Copart to own more salvage years. I want Boston Beer to sell more barrels. I want DreamWorks to make more movies (and other things).
I don't really want DNB to do that. I would love for DNB to grow their economic forest. Each of their trees is worth a lot more than anybody else's.
But I don't really think they can. I think they are seriously constrained in the amount of additional capital they can use. Actually, I think they are probably operating most efficiently when the net tangible investment by owners is less than zero. I don't think top line growth beyond 4% a year in the U.S. would necessarily be desirable – because I'm not sure it's realistically achievable in a manner consistent with what their business is and should be about in America.
Now, maybe they will figure out other uses for their products I haven't thought of. But absent that, I would expect that the best growth for DNB would be under 4% in the U.S. So, whatever capital they need to achieve that growth they should keep. And wh! atever ca! pital they don't need, they should pay out.
If they go a full year of earning what they tend to earn that's already way too much capital. So, they should buy back stock and pay dividends every year. Which they do.
So, at DNB free cash flow is a fine measure of what an investor will tend to get out of the stock.
What about at DreamWorks?
I would strongly prefer DreamWorks finds a way to use its earnings in the business. This is a slightly non-intuitive answer because DreamWorks is not earning eye popping ROIs right now.
There are a few reasons why I'd still like them to retain their earnings. One, this is a business that scales beautifully.
The ultimate size of DWA's operations in any year is seriously constrained – in theaters – because of movie schedules and the size of DWA's films.
There is a definite limit to how big DreamWorks can get doing the exact same thing. But until they reach that point, getting bigger has some nice benefits.
DreamWorks really can't more than double their film output over time no matter how big they get without straying from their focus. You can't release more than 4 of the kinds of films they release each year and expect really wonderful results over time. You'd have to diversify.
But DWA keeps ownership of their films. This is key. The more films they make, the bigger the library gets. Sadly, they do not have the same arrangement with their TV series. If they did have that arrangement – and it's totally understandable why they can't – they could already be in a position where you could fill a whole cable channel with their own content. That would be very valuable. So, you can see why at someplace like DWA I would not want them to focus on free cash flow. I would want them to focus on owner earnings.
This is the number that really matters. Not free cash flow. And not earnings. But owner earnings.
It's different for different companies.
At DWA, I'd calculate owner earnin! gs for th! is past year as 99 cents a share. Which is extraordinarily close to their reported EPS of $1.02 a share.
As I mentioned when I talked about DWA, I consider DWA's owner earnings to be:
Operating Income
+ Film Amortization
- 0.5 times the production budget of the films released this year and last year
= Pre-Tax Owner Earnings
X 0.65
= After-Tax Owner Earnings
There are no one size fits all calculations for earnings yield. When you are screening, you may use EBITDA/EV, EV/EBIT, E/P, etc.
But when you are looking at a specific company like DreamWorks what matters is not using a number – like a GAAP number – that is comparable to how other companies report. What matters is accurately representing the economic reality of the business for a 100% owner.
In the case of DreamWorks, I think a 100% owner would view the business as having earned about $83 million (after-tax) in 2011. That happens to be very close to what DreamWorks reported using GAAP. It doesn't always work that way.
But owner earnings is always the number that matters. What you are getting out of the investment.
It doesn't mean you literally have to be getting money out of an investment through dividends. You know that.
It also doesn't mean the company has to be generating free cash flow. It could be reinvesting everything in the business. That's fine.
As long as $1 reinvested in the business will be worth $1 – then it's okay for them to reinvest the money (report earnings, but not free cash flow) through added receivables, inventory, property, etc.
You always want to be thinking about earnings and free cash flow in terms of the actual value of the money. It's easy to value free cash flow – although it can be tricky at companies that simply pile up cash for a decade – it's hard to value earnings.
As a rule, I'd say start by not assuming earnings, free cash flow, etc. ever have value beyond what is reported. But assume t! hat retai! ned earnings at a subpar business are actually worth less than their stated amount. While retained earnings at an above average business are worth every penny.
So, at a great business with favorable long-term prospects you can treat earnings as if it's free cash flow.
At a lesser business, you can't.
I would never assume that $1 of retained earnings at GTSI (GTSI) was worth $1. It's not.
So it would be hard to buy GTSI on an earnings basis. I didn't. I bought it for the Ben Graham: Net-Net Newsletter's model portfolio simply based on its cash, receivables, and stake in another company. Those 3 things meant the company's liquidation value was higher than the price I paid for the stock.
But at a company where earnings are reinvested well over time – it's fine to look at the earnings yield.
I should point out that this is a different issue than reported earnings vs. owner earnings. For example, Carnival (CCL) reports earnings that are high relative to owner earnings because of the way it accounts for depreciation. Basically, it owns long-lived tangible assets in a world with inflation so it does not depreciate these assets enough over their lives to account for the higher nominal replacement cost of the asset in the future. It's a common problem for railroads, etc. But it doesn't have to do with return on investment. It has to do with accounting.
Remember, depreciation is the spreading out of a past cost of some asset over the same time period as the benefits provided by that asset. I've seen people say depreciation is a provision for replacing the asset. That's not right. It's incredibly important that you never make the mistake of thinking depreciation is a provision for the future. No. It's the spreading out of the past. It has nothing to do with the future. And during times of high inflation depreciation will have no resemblance to the annual provision that would be needed to replace a company's assets.
This is an important! concept.! Sometimes earnings and free cash flow diverge for timing issues. We aren't talking about that here. We're talking about actual reinvestment in the business. What matters in those situations is the value of retained earnings.
And what determines the value of retained earnings?
How much you earn on the earnings you retain.
If you can earn 10% a year on the additional earnings you retain, that's definitely enough to make those retained earnings worth as much as an equal amount of free cash flow. So, if you're looking at a company that earns a 10% unleveraged return on net tangible assets – earnings yield may be a perfectly appropriate gauge of the business.
That's because additional inventory, receivables, stores, etc. should be worth as much as additional cash.
But only at a business that is earning its keep. At a bad business – cash is worth much, much more than inventory, receivables, property etc.
In those cases, you shouldn't use earnings yield. You should look at free cash flow. And you should look at asset value.
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