Chapter 4: Calculate Shareholder Yields
Book Serialization | Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises
Welcome to Chapter 4 of the draft manuscript serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises.
I am writing the book on Substack Finance as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real time.
Chapter 4 discusses the concept of shareholder yields and how to use it to analyze the worthiness of owning a stock.
Chapter 4
Calculate Shareholder Yields
Quality-driven value investors quantify shareholder yields beyond the more conventional dividend payout.
In this chapter, we’ll uncover proprietary due diligence that averages the total shareholder yields 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?
It explains the different components of shareholder value, including earnings yield, free cash flow yield, and dividend yield.
The chapter emphasizes the importance of comparing shareholder returns to the prevailing yield on the Ten-Year Treasury benchmark note to determine the equity bond rate of a stock.
In addition, the chapter uncovers the alpha-seeking research methodologies of dividend yield-on-cost, an ideal alternative to forward high-yield dividend investing, and owners’ earnings or how to take a snapshot of a company’s shareholder rewards.
Quantifying a Stock’s Equity Bond Rate
When researching a stock for inclusion in a portfolio, consider the return to shareholders as 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 estimating the intrinsic value of a stock price, view the shareholder yields of a stock as the equivalent of its equity bond rate.
My 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 chapter, we will average the earnings, free cash flow, and dividend yields and compare the sum 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 an investor’s 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 outperforming the Treasury signal a stock with higher shareholder return opportunity. When underperforming the government benchmark, shares might be unworthy equity candidates for investors seeking a more attractive intrinsic value with a wide margin of safety.
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 represents the portion of an 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 or P/E, measured in a more usable percentage format than the P/E multiple. It provides a yield profile similar to that of a bond rate.
When comparing stocks to prevailing bond rates, the earnings yield is more accurate than the dividend yield. This is because boards of directors raise and lower dividend payouts at will. Besides, non-dividend-paying stocks also generate earnings yields.
Look for stocks with earnings yields above 6 percent or 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 2010s decade, investors favored stocks over treasuries. In contrast, 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 as GAAP or non-GAAP — the acronym for Generally Accepted Accounting Principles. Analyzing both earnings and free cash flow 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
Investors can also measure earnings quality with 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. We 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, a nominal 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, quality-driven investors should avoid stocks with payout ratios or the percentage of net income allocated to dividends exceeding 60 percent. Payout ratios below 60 percent generally indicate a safe, well-covered dividend with room for rate increases. The payout ratio is dividends paid divided by after-tax earnings.
An Alternative High-Yield Dividend Model
This chapter 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.
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 rational, disciplined, and patient buy-and-hold strategy. For example, as of the market close on September 5, 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
Ticker = Stock Symbol — Union Pacific Corporation UNP 0.00%↑, DICK’S Sporting Goods, Inc. DKS 0.00%↑, Microsoft Corporation MSFT 0.00%↑, Williams-Sonoma, Inc. WSM 0.00%↑, and The Coca-Cola Company KO 0.00%↑.
Price = Closing Price — Closing share price on September 5, 2024.
Rate = Dividend Rate — Trailing one-year annualized dividend payout.
Basis = Cost Basis — The purchase cost of each common share of the company in QVI Real-Time Stock Picks adjusted for splits and dividends.
Yield = Forward Yield — Dividend rate divided by closing share price.
Y-O-C = Yield-On-Cost — Dividend rate annualized divided by the cost basis per share.
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:
Sum of earnings yield % + free cash flow yield % + dividend yield %, divided by three = average shareholder yield. Compare to prevailing yield % on Treasury benchmark.
Equities are arguably deemed 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 estimating a share price’s present value, is addressed in Chapter 5.
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 reveal the bottom-line rate of return for stockholders.
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 dividend rate growth for the same period, it gives investors a snapshot of how the company historically rewards its shareholders.
Measuring the sum of the trailing current wealth of five-year annualized EPS growth plus the dividend rate growth is one way to determine owners’ earnings.
Formula to determine an owners’ earnings rate of return:
Sum of five-year annualized trailing EPS growth % + dividend rate growth % = return on owners' earnings.
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.
Nevertheless, earnings and free 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 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 a quality-driven value investor’s checklist to measure the company’s current wealth and present value in the context of the shareholder yield paradigm.
Averaging shareholder yields, calculating owners’ earnings, and tracking dividend yields-on-cost provide three proprietary approaches to measuring the equity bond rate of a stock price. Readers should also consider what they are attempting to uncover to elicit 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 and value-driven equity 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.
Achieving stock market alpha equates to picking the value shares of high-quality companies that outperform the market benchmark and the sovereign government bond’s alleged safety and security.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.
About the Author
David J. Waldron is the contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. His work has been featured on Seeking Alpha, TalkMarkets, ValueWalk, MSN Money, Yahoo Finance, QAV (Australia’s #1 Value Investing Podcast), Money Life with Chuck Jaffe, LifeBlood with George Grombacher, The Acquirer’s Multiple, Capital Employed, Amazon, Barnes & Noble, Apple Books, the BookLife Prize, and Publisher’s Weekly. David previously enjoyed a 25-year career as a postsecondary education executive. He 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.
