Earning a Great Return on Your Stocks

Investors often think of stocks and bonds as completely different animals. And, of course, the two types of securities play very different roles in a portfolio: Investors generally look to bonds to generate income and temper risk, while stocks are meant for long-term growth. But looking at stock valuations through a fixed-income perspective can be a useful way to make sure you're really earning what you should from your stock investments.

For this week's Five-Star Investor, we used Morningstar's  Premium Stock Screener to find companies with cash returns greater than the yield on the 10-year Treasury bond, which stood at about 4.1% at the time of this writing. Cash return looks at a company's free cash flow as a percentage of its total enterprise value, or market capitalization, plus debt. In other words, it measures the return a hypothetical buyer would earn by buying out the entire company (debt and equity) and skimming off the excess cash. About one fourth of the roughly 6,500 companies in Morningstar's equity database passed the first hurdle.

Next, we focused on earnings yield, which looks at a company's earnings divided by the stock price (the inverse of the price/earnings ratio). Like cash returns, earnings yield can be used to compare a stock's return with the yield offered by bonds. To find stocks with earnings yields of at least 4.1%, we first converted that figure back into an equivalent price/earnings ratio of 24.4 and looked for stocks with current price/earnings ratios below that level.

Finally, we wanted to weed out companies with erratic financial performance, so we limited the group to companies with consistent growth in free cash flows over the past three years.

Here are some of the stocks that made the final cut:

 Closure Medical 
Cash Return: 8.43%
Morningstar Rating: 5 Stars
From the  Analyst Report: "Closure Medical's proprietary wound-care technology, marketing collaborations with top-tier pharmaceutical firms, and strong operating cash flow are all indicators of future success for this fast-growing medical-device firm. We'd buy its stock at a moderate margin of safety to our fair value estimate."

 Coca-Cola (KO)
Cash Return: 5.98%
Morningstar Rating: 5 Stars
From the  Analyst Report: "Coca-Cola is currently suffering through what we see as a transitional period in the company's history. We think it will have to traverse a bumpy road in the short to medium term, but as proponents of long-term investments, we would buy the shares at a slight discount to our fair value estimate."

 Gap (GPS)
Cash Return: 12.94%
Morningstar Rating: 5 Stars
From the  Analyst Report: "Gap is in the early stages of recovering from a few dismal years, but we think the new management team's efforts to streamline operations, reverse overexpansion, and pay more attention to customer preferences bode well."

 Fair Isaac (FIC)
Cash Return: 8.85%
Morningstar Rating: 4 Stars
From the  Analyst Report: "Analytics-solutions provider Fair Isaac has a strong competitive position in its core markets, a solid business model, and a history of above-average returns. Although there are risks in management's acquisitive strategy, we believe Fair Isaac would make a good investment, assuming an adequate margin of safety." 

 First Data 
Cash Return: 4.95%
Morningstar Rating: 4 Stars
From the  Analyst Report: "Given its leading market share, sound strategy, huge and recurring cash flow, and straightforward management, we like First Data a lot at the right price."

To run this screen yourself and see all the stocks that passed, click  here. (The stocks mentioned above passed our screen as of Oct. 14. The results of the screen may change due to daily price fluctuations or other factors.) After clicking, you can save the search to use later by clicking the "Save Criteria" button in the bottom right-hand corner of the screen. (Note: You will need to be a Premium Member to view and save the complete screen.)