The EASIEST Way To Value A Stock
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Howard Marks once said that there’s only one intelligent form of investing, and that is “figuring out what something's worth and seeing if you can buy it at or below that price. It's all about value."
Warren Buffett has echoed this sentiment with his famous saying: “Price is what you pay. Value is what you get.”
The point is, identifying good value is crucial, and it’s one of the most challenging aspects of being an investor, especially considering the numerous ways you can value a stock.
First off, you can perform a Discounted Cash Flow (DCF) calculation. This method is detailed and thorough but difficult to accurately forecast because it relies heavily on future cash flow predictions.
Another approach is the Dividend Discount Model (DDM), which is useful for valuing companies with stable, predictable dividend payouts. However, its applications are limited to such companies.
You can also consider Relative Valuation, which uses metrics like the P/E Ratio, P/FCF Ratio, P/Book Ratio, etc. This method is simple and easy to apply but is influenced by market conditions and peer performance, which may not always reflect the subject company's true intrinsic value.
In my opinion, none of these methods are as simple and straightforward as looking at a company’s Free Cash Flow Yield.
The Free Cash Flow Yield is calculated by dividing the company’s free cash flow by its market value. You can also divide the free cash flow per share by the stock’s current share price for the same result.
At any rate, I wasn’t familiar with the Free Cash Flow Yield as a method for valuation until recently when I read Investing for Growth by Terry Smith, who has been referred to as the “British Warren Buffett.”
Investing For Growth by Terry Smith
In his own words, this is how he uses the Free Cash Flow Yield to value a stock:
“We seek to buy our portfolio companies when their free cash flow (FCF) yield (the free cash flow they generate divided by their market value) is at or above the yield we would expect to get on long-term government bonds in the same currency. Please note: not the current yield on bonds, which in most cases has been depressed by governments buying their own bonds, but the yield we think might apply if this were to stop and all bonds had to be sold to third-party investors. Our starting guess for the yield that might then be required is 1% over the expected rate of inflation. If we can buy shares with FCF yields higher than that and which will grow, unlike the coupon on the bonds, we should have captured some value.”
In summary, he aims to buy companies when the Free Cash Flow Yield is at least 1% above the expected rate of inflation. This reflects the notion that investors typically demand a premium above inflation to compensate for risk and to ensure a real return on their investment (this is what’s referred to as a risk premium).
Now putting all of this to use, with the expected rate of inflation currently at 2.45%, you would look to buy a company if its FCF yield is at least 3.45% or above. According to Seeking Alpha, there are several companies in my portfolio right now that meet this threshold:
EPD: 7.13%
PG: 4.07%
SBUX: 4.46%
SNA: 6.95%
WSM: 7.35%
Fortunately, Seeking Alpha makes it extremely easy to find the Free Cash Flow Yield of any stock. When you search for a stock on their website, go to the “Dividends” tab, and then go to the “Dividend Yield” sub-menu. You'll find the Free Cash Flow Yield listed at the bottom.
With that said, now I want to hear from you: Which stocks in your portfolio have the highest free cash flow yield? Reply to this email, or write to me here and let me know.
And a big thank you to all of the readers who responded to last week's newsletter! You can read some of the responses down below in the "Hot Takes" section. 👇
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I use Seeking Alpha every single day, and have done so for years now. It's my go-to website for everything related to stock research, and it's been essential in helping me become a better investor.
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If nothing else, it's at least worth checking out the 7-Day FREE Trial.
IN MY PORTFOLIO 📈
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ICYMI 🎥
A BRUTALLY HONEST Review of My Subscribers' Dividend Portfolios
In this video, we'll take a look at three different dividend portfolios, and I’ll give my honest thoughts on the good, the bad, and the ugly of each one.
CAREFULLY CURATED 🔍
📺 A Tribute To Charlie Munger - I can't believe I'm just now getting around to watching this, but this was Berkshire's tribute to Charlie Munger at the most recent shareholder meeting. You will definitely laugh, you might cry, and in some instances, you may even do both at the same time.
🎧 A Masterclass From The Indian Warren Buffett - Mohnish Pabrai is sometimes called the "Indian Warren Buffett" for having turned $1M into over $1B+ with investing. In this episode of My First Million, he talks about how entrepreneurs can become great investors, how to avoid devastating mistakes, and essential lessons learned from Warren Buffett and Charlie Munger.
📚 The Next Great Dividend Growth Stocks - For the most part, technology companies and growth stocks typically do not take the cash they generate and use it to pay dividends to shareholders. Instead, that cash is reinvested in the business to fuel additional growth or do share buybacks. Now, with Alphabet, Meta, and Salesforce paying dividends, what does this mean for investors, and how does this change the dividend investing landscape as a whole?
SINCE YOU ASKED 💬
"Why invest in stocks when you can keep your money in a money market fund?"
- @alelzaghir5674 | YouTube
This is a great question, and with interest rates on the rise, it's one I'm hearing more often.
Right now, a money market fund can be a solid place to park your cash. For instance, one of Charles Schwab's money market funds, SWVXX, is yielding around 5%, which is awesome! However, like anything else, money market funds have their pros and cons, especially when compared to investing in stocks.
The biggest advantage is that you don't risk losing your principal, meaning your initial investment will stay safe and you won't have to worry about losing money. On the downside, you won't benefit from potential share price appreciation in the same way that you would with stocks.
Additionally, while the high-quality dividend-payers (the kind that you'd want to invest in) tend to increase their dividends over time, you can't count on the same from a money market fund, especially if interest rates start to decline.
Overall, if you're saving money for some short-term use (a vacation, down payment for a house, etc.), a money market fund or a high-yield savings account would be a great place to park it. However, if you're saving for retirement or some other long-term goal, investing in stocks that grow and appreciate over time might be a better way to go.
Have a question? Ask me here to see it featured in an upcoming newsletter.
HOT TAKES 🔥
Last week, I asked readers which stocks came to mind when they thought of dependable dividend payers. Here are some of the responses:
Gerald said: I'll give you a list of SWANs I hold in my portfolio — AVGO, ITW, HSY, GD, QCOM, EPRT, CMCSA, KO, NNN. Good consistent payers with wide motes and long histories.
Alpar said: Dependable dividend paying companies are those that are too big to fall, have been around for decades and their products will be needed 10, 20 and 50 years from now. To mention just a few: KO, PEP, SBUX, CVX, XOM, HD, LMT, RTX, BAC, MSFT, JNJ, and TXN. I have a position in all of them.
Mark said: I guess my list of names has stayed the same over the years. I'm sure it's no surprise when I say that WMT, PG, KO, DOW, ET, KR, PFE, MO, T, and HRL have been with me my entire journey. Others that I have grown to enjoy include SBUX, EPD, KHC, O, MAIN, WSM, and BMY. Now that I have penned this response, it occurs to me that a portfolio holding just those positions could be a great way to go!
Matt said: I think the most dependable dividend paying companies that come to mind are stocks I have in my portfolio like PG, O, WMT, and XOM. With all the uncertainty in many facets in our day to day lives including the market, the best thing to have is a sound, timeless strategy like dividend investing that brings balance, order, and consistency that everyone desires.
LAST WORD 👋
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