Calculate Shareholder Yields and Owners' Earnings
David J. Waldron
Contributing editor and author of Quality Value Investing | Helping readers achieve their career and financial goals since 2013 | Join 1200+ Subscribers of the QVI Newsletter on LinkedIn and Substack
Summary:
Welcome to the fourth segment of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises (working title and subtitle). I am writing the book on LinkedIn as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript over the next 24 months.
Book Segment #4?uncovers proprietary due diligence?that averages the total shareholder yields on earnings, free cash flow, and dividends to measure how a targeted stock compares to the prevailing yield on the intermediate Treasury benchmark note.?In other words, what is the equity bond rate of the common shares?
This segment also explores dividend yield-on-cost, an ideal alternative to forward high-yield dividend investing, and how to take a snapshot of a company’s shareholders’ rewards or owners’ earnings.
Quantifying a Stock’s Equity Bond Rate
When researching a stock for inclusion in a portfolio, consider the returns to shareholders a leading barometer of the worthiness of owning a slice of the business.
As quality-driven shareholders, we deserve a compounding return or yield from each leg of the earnings vertical beyond just dividends.?When valuing the intrinsic value of a stock price, view the shareholder yields of a stock as the equivalent of its equity bond rate.
QVI’s proprietary equity bond rate modeling tells us whether a stock is worthy of the assumed higher-risk profile compared to the perceived safer intermediate-term government issue.?In this segment, we will average the earnings, free cash flow, and dividend yields and compare them to the Ten-Year Treasury rate in determining the equity bond rate of the individual stock.
Intermediate Treasury notes are debt obligations issued by the United States government with a maturity of 10 years upon initial issuance. The prevailing yield is the fixed interest payment to the bondholder divided by the closing price of the note.
A?simple definition of the equity bond rate is how the company and its underlying stock returns compare to government-issued bonds. Dividend yields are typically investors’ primary comparable. Still, two other metrics, earnings yield and free cash flow yield, should be considered to quantify the actual return to shareholders.
Common shares that outperform the Treasury signal a stock with shareholder return opportunity. When underperforming the government benchmark, shares might be unworthy equity candidates for investors seeking intrinsic value.
Implement the following checklist methodology to confirm that a targeted stock’s shareholder yields exceed the bond rate. Then, despite being out of favor on Wall Street, seek publicly traded companies generating multiple, Treasury-beating shareholder yields.
Earnings Yield
The earnings yield is the annualized trailing earnings per share or EPS divided by the stock’s closing share price.
It indicates how much a company earns each year per common share relative to the stock price. Earnings per share, or EPS, represents the portion of the operation’s profits allocated to each outstanding share of common stock.?A higher earnings yield suggests more robust earnings per shareholder dollar invested.
Earnings yield is the inverse of the price-to-earnings ratio (P/E) and is measured in a more usable percentage format than the P/E multiple. It provides a yield profile similar to that of a bond rate. EPS represents the portion of profits allocated to each outstanding share of common stock.
When comparing stocks to prevailing bond rates, the earnings yield is more accurate than the dividend yield. This is because boards raise and lower dividend payouts at will. Besides, non-dividend-paying stocks also generate earnings yields.
Look for stocks with earnings yields of at least 100 basis points—one percentage point—above the Treasury yield. Targeting earnings yields above 6 percent is the inverse equivalent of price-to-earnings ratios below 17 times.
The higher the earnings yield and, thus, the lower the P/E ratio, the more unfavorable the stock appears to the market. Nevertheless, as quality value investors, enduring enterprises with high earnings yields grab our attention for further research.
During the historic bull market of the 2010 decade, stocks were favored over treasuries. Nevertheless, earnings yield becomes a reliable barometer of whether to favor common stocks over government bonds in any market cycle.
Free Cash Flow Yield
Free cash flow yield shows how much a business generates in free cash flow each year per common share relative to the stock price. Hence, free cash flow yield is trailing free cash flow per share divided by the closing stock price.
Free cash flow per share is the cash available after operating expenses and capital expenditures divided by shares outstanding at the end of the most recent fiscal period.?The calculation includes income after taxes minus preferred dividends plus depreciation, depletion, and amortization expense net of capital expenditures.
Free cash flow represents a company’s bottom line more than net profit. It allows?senior management to enhance shareholder value by pursuing capital deployment opportunities such as research and development, mergers and acquisitions, dividend payments, share repurchases, and debt reduction.
Some investors trust free cash flow over earnings because of the controversy surrounding earnings calculations by GAAP or non-GAAP — the acronym for generally accepted accounting principles. Analyzing both returns provides more information about a company and the underlying stock and, thus, is to our advantage.
Nonetheless, keep in mind that free cash flow represents a byproduct of earnings. Therefore, quality value investors screen for a free cash flow yield above 7 percent, an ideal target signaling an inverse price-to-free cash flow multiple of fewer than 15 times.
Cash Flow Margin and Cash On-Hand Per Share
Earnings quality can also be measured by cash flow margin or operating cash flow divided by trailing sales.
Operating cash flow is income after taxes minus preferred dividends and other distributions plus depreciation, depletion, and amortization expenses. Quality value investors consider the cash flow margin a flash indicator of senior executives’ vertical cash flow management. They favor cash flow margins above 10 percent.
Cash per share, or the amount on hand plus any short-term and liquid long-term investments on the balance sheet divided by common shares outstanding, has been newsworthy in recent years, especially from the cash is king crowd.
By subtracting cash per share from the stock price, investors get a more definitive representation of the enterprise’s intrinsic value, net of cash and investments.
Indeed, an insignificant spread between the two prices presents an attractive investment opportunity. In addition, the cash hoard provides senior management with hedges during economic downturns, interest-free financing for strategic acquisitions, and redistribution of capital to shareholders via stock buybacks or increased dividends.
Dividend Yield
The?dividend yield indicates how much a company paid out in dividends for the previous twelve months relative to the current share price.
Target companies with a forward dividend yield or the annual dividend rate divided by the current stock price exceeding 2 percent and below 6 percent.
Nevertheless, consider buying the dividend-paying stocks of quality companies trading at attractive prices if the historical yields are below 2 percent. Select non-dividend-paying stocks of quality enterprises are also worthy of inclusion.
The dividend rate is the dollar sum of dividends paid over the prior fiscal year.
In contrast to dividend growth or income investors, quality value investors seek dividends to keep paid in the short term while waiting for the investment thesis and capital appreciation to play out over time. And, unlike growth investors, they deemphasize historical and projected dividend payouts.
Thus, stocks with payout ratios or the percentage of net income allocated to dividends exceeding 60 percent should be avoided.?Payout ratios below 60% generally indicate a safe, well-covered dividend with room for rate increases. The payout ratio is dividends paid divided by after-tax earnings.
The full-service version of the QVI Newsletter is available on my website, https://davidjwaldron.substack.com/
Learn more:
An Alternative High-Yield Dividend Model
This book segment introduces an alternative yield methodology toward outperforming Treasury rates without the limitations of the dividend growth strategy—such as overweighting dividend history—or the outsized risks of forward high-yield dividend investing.
Unless retired with limited investable assets, buy-and-hold quality value investors should avoid forward high-yield dividends and, as an alternative, rely on the yield on a share-cost basis. The dividend-yield-on-the-cost basis is the annualized dividend payout rate divided by the cost basis of the common shares held in a portfolio.
领英推荐
The yield-on-the-cost basis is an ideal recourse to forward high-yield dividend investing.?Measure a stock holding’s yield-on-cost instead of chasing current dividend payouts.?
Nonetheless, it requires a patient buy-and-hold strategy.?For example, as of the market close on March 18, 2024, the yield-on-cost of each of the top dividend-paying holdings of the QVI Real-Time Stock Picks was far superior to the current forward yield.
Table Key
Average the Sum of Total Shareholder Yields
To create a snapshot of the researched stock’s performance against the benchmark Ten-Year Treasury note’s most recently published prevailing rate,?average the trailing earnings, free cash flow, and dividend percentage yields per share.
Formula to determine a shareholder yield rating:
Earnings yield % + free cash flow yield % + dividend yield % divided by three = average shareholder yield. Compare to prevailing yield % on Treasury benchmark.
Equities are arguably riskier than US bonds. Thus, securities that reward shareholders at lower yields than the government benchmark question the relative safety of the stock versus the bond.
Remember that earnings and free cash flow yields are inverses of valuation multiples and suggest whether a stock is over, under, or fairly valued relative to earnings per share and free cash flow. Valuation or intrinsic value is addressed in a later book segment.
The resulting shareholder yields rating, or equity bond rate, is bullish if well above the Treasury rate, neutral if in the same range, or bearish if below the rate based on the stock’s average total yields.
The QVI Real-Time Stock Picks consider shareholder yields or the equity bond rate of a publicly traded stock as a leading barometer of the worthiness of buying a slice of the business.
Owners’ Earnings
In a further test of shareholder value, consider calculating?owners’ earnings to indicate?the bottom line rate of return.
Owners’ earnings estimate the trailing growth per share, which captures the actual dollar value a company has produced and is potentially available to spend or invest as operating free cash flow. Combined with the forward dividend yield, it gives investors a snapshot of how the company historically rewards its shareholders.
Measuring the sum of the trailing current wealth of five-year?EPS growth annualized plus the forward dividend yield is one way to determine owners’ earnings:
Five-year annualized trailing EPS growth % + forward dividend yield % = owners' earnings %.
New reader? Subscribe to Quality Value Investing on LinkedIn. It’s free.
The Intrinsic Value of Shareholder Yields
Quality value investors quantify shareholder yields beyond the more conventional dividend payout.
Earnings per share are controversial because of company executives’ creative financial engineering. Free cash flow, or the net cash available after capital expenditures and other asset costs, is a more precise measurement of net earnings after income taxes and capital investment.
Nevertheless, earnings and cash flow yields are the foremost valuation tools for measuring the market sentiment of a business based on its bottom line’s relationship to the stock price.
Most high-yield and some dividend-growth investors gravitate to dividend yields alone that far exceed the Treasury rate. On the contrary, quality value investors are cautious with dividends susceptible to erratic stock price fluctuations, unexpected rate decreases, or unsustainable payout ratios.
The dividend payout from an expensive stock equates to a dividend purchased or held at a high cost. Value and price prevail in every area of investing. Thus, practice the more balanced approach of quality-driven, value-based, buy-and-hold total-return investing.
When investing in the stocks of non-dividend-paying companies, earnings and free cash flow yields are telling valuation alternatives. Nonetheless, as shareholders, we deserve a compounding return or yield from each leg of the earnings vertical, dividends included.
If shareholder yields are underperforming the government bond benchmark, consider the company unworthy of taking an ownership slice because of the higher equity risk. Quality value investors might deem a stock unattractive when shareholder yields are inferior to those of a Treasury bond or note backed by the US government’s alleged full faith and credit.
Calculating owners’ earnings provides an additional test for quality value investor checklists to measure the current wealth of the comapny in the paradigm of shareholder yields.
One example is this segment’s proprietary approach to measuring the equity bond rate. Readers should also consider what they are attempting to uncover to foster confidence that a targeted common stock has the potential to be more valuable than a conventional government bond over a long-term holding period.
In contrast to fixed-income investors, dedicated quality value stock investors avoid lending money to companies as bondholders. Some gentlemen and gentlewomen prefer bonds, although thoughtful, alpha-seeking investors favor the equity bond rate multiple of shareholder yields, including dividend yields-on-cost and owners’ earnings.
All QVI on Substack subscribers (free and premium) can download my international-selling book, Build Wealth with Common Stocks, for free.
Learn more:
Thank you for reading?this edition of the Quality Value Investing newsletter, a reader-supported publication. Please consider subscribing to receive new posts and support my work. It’s free on LinkedIn.
If you found value in this post, you can hit Like or add a Comment below,?as it is helpful.
Also, this post is public, so you can share?it with your network.
About the Author
David J. Waldron is the founder and contributing editor of Quality Value Investing, and author of the international-selling book Build Wealth with Common Stocks. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. He previously enjoyed a 25-year career as a post-secondary education administrator. David received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed?The Practice of Management Program?at Brown University.
Disclosure: I/we have beneficial long positions in the common shares of MMM, MSFT, and UNP in our family portfolio. I wrote this book segment myself, and it expresses my own opinions. I am not receiving compensation for it other than from Substack paid subscriptions. I have no business relationship with any company whose stock is mentioned in this post.
Additional Disclosure: David J. Waldron’s Quality Value Investing newsletter posts, book segments, course modules, research reports, and real-time stock picks are for informational purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs nor intended for portfolio construction beyond his family portfolio, which is presented solely for educational purposes. David is an individual investor and author, not an investment adviser. Readers should always engage in independent research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or specialized attorney before making any investment, income tax, or estate planning decisions.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.