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Say Yes to Yield
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In addition to multiple-based measures, you can also use yield-based measures to value stocks. For example, if we invert the P/E and divide a firm's earnings per share by its market price, we get an earnings yield. If a stock sells for $20 per share and has Si in earnings, it has a P/E of 20 ( 2 /Q but an earnings yield of 5 percent Qio). The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment. (The difference Is that earnings generally grow over time, whereas bond payments are fixed.)

In late-2003, for example, I could get a risk-free return from Uncle Sam of about 4.5 percent by buying a 10-year treasury bond. Therefore, I'd want to demand a higher rate of return from my stocks because they're riskier than treasuries. A stock with a P/E of 20 would have an earnings yield of J percent, which is a bit better than treasuries, but not much considering the additional risk I'm taking. A stock "with a P/E of 12, however, would have an earnings yield of 8.3 percent Q4), which is much better than those poky treasuries. Thus, I might be induced to take the additional risk.

The best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it's actually a more useful tool than the P/E.

To calculate a cash return, divide free cash flow by enterprise value. ( Enterprise value Is simply a stock's market capitalization plus its long-term debt minus its cash.) The goal of the cash return is to measure how efficiently the business is using its capital—both equity and debt—to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole shebang, including the debt burden. An investor buying the whole company would not only need to buy all the shares at market value, but also would be taking on the burden of any debt (net of cash) the company has.

Let's use household-products giant Clorox as an example of how to use cash return to find reasonably valued investments. In late 2003, Clorox had a market cap of about $9.8 billion and carried $495 million in long-term debt and $172 million in cash on its balance sheet. Its enterprise value was $9,800 + S495 — $172, or $10.1 billion. That's half of our ratio.

The other half is free cash flow. Figure 9.2 shows Clorox's free cash flow over the past decade; the firm generated about $600 million in free cash flow In 2003. So, our cash return on Clorox will be $600 mfllion/$io,ioo million, or 5.9 percent.

With 10-year treasuries yielding j ust 4.5 percent In late 2003 and corporate bonds yielding a higher (but still relatively paltry) 4.9 percent, that 5.9 percent cash return from Clorox looks pretty good. Throw in the fact that Clorox's free cash flow is likely to grow over time, whereas those bond payments are fixed, and Clorox starts to look like a pretty solid value.

Cash return is a great first step to finding cash cows trading at reasonable prices, but don't use cash return for flnanclals or foreign stocks. As I discuss in Chapter 17, cash flow isn't terribly meaningful for banks and other firms that earn money via their balance sheets. And because definitions of cash flow can vary widely in other countries, a foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally

Figure 9.2 Annual cash flows for Clorox.

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