Video Reports

Embed this video

Copy Code

Link to this video

Get LinkEmbedLicenseRecommend (-)Print
Bookmark and Share

By Pat Dorsey, CFA | 09-13-2010 01:01 PM

Dorsey: Cash Returns Look Compelling

The cash return on many equities looks quite attractive compared with Treasury and corporate bond yields, says Morningstar's director of equity research.

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar.

Let's talk about yields. They are fairly low right now, which is causing a lot of people some heartache when they try and get some income from their investments.

Right now the 10-year Treasury is at about 2.8%. Add another percentage point on that, you've got investment grade bonds in the high 3% range, 3.7%, 3.8% take a pick--return levels that are not terribly attractive, if you are an income-seeking investor.

But, of course, we need to always think of investing as "where are the best opportunities?" when you allocate capital; let's look at apples-to-apples and then put the capital where it has the highest prospective return. And so to put things on an apples-to-apples footing, I think it's often useful to treat stocks like bonds and look at their yields and not just the dividend yield. What I want to do is use something called the "cash return," which is basically the free cash flow of a business--that is, the cash that it spits off after accounting for capital expenditure as a percentage of enterprise value. And enterprise value is simply the market cap of the company plus its debt load less any cash.

Enterprise value basically represents what it would cost you to buy the whole business lock, stock and barrel. And so then, cash return, or free cash flow divided by enterprise value, is basically the return you would get if you bought the entire business lock, stock and barrel, and then just were able to take that free cash flow stream as a return to you for that investment that you just made.

Now, of course, free cash flow, cash return, is not the same as a dividend yield. The free cash that a business produces can be used to buy back shares. It can be used to reinvest internally in projects. It can, of course, be used to make value-destroying acquisitions, which is something CEOs love to do, sadly enough.

However, it does put equities on an equal footing with bonds, and I think it's fascinating to note. I did a screen recently; I looked at every domestic company trading in the U.S. with a market cap of over $5 billion--I took out financial companies because free cash flow is calculated a little bit differently for them, so you needed to exclude them from the analysis. And then said, which companies have cash returns better than Treasuries? Better than investment grade bonds? And I will tell what I found:

Read Full Transcript
{0}-{1} of {2} Comments
{0}-{1} of {2} Comment
  • This post has been reported.
  • Comment removed for violation of Terms of Use ({0})
    Please create a username to comment on this article