Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, September 4, 2011

Rate of Return on Equity Perpetuity: Dividend Yield and Free Cash Flow Yield

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and the Equity Perpetuity Theory

If we start to think of stocks as perpetuities (i.e. if we intend to be passively enriched as the "equity" perpetuity unendingly pays us flat dough—regardless what the market is schizophrenically doing) then we might as well identify which "equity" annual payments we’d be considering and discounting. Once we identify these, we'll discover that the rate of return on our equity perpetuity is nothing more than two familiar, often used (but also often misunderstood) measures: the dividend yield and free cash flow yield.

Return Measures of the Equity Perpetuity. When we conservatively assume a stock is a perpetuity and try to derive a rate of return, we're mathematically bound to eventually use the Dividend Yield and Free Cash Flow Yield.
If we choose cash dividend payments, then we’re effectively using the dividend yield. If a stock has recently paid out dividends of Php100 and we assume that it’s gonna issue dividends year after year (since it’s been doing that for years already) and we also assume these will be flat, then we'd have to discount Php100 at a rate we'd want to achieve (i.e. 15%). Using this conservative frame of mind, the stock, obviously, has got to be worth Php666.67 (Php100/15%). On a flipside, if the same stock’s trading at Php500 and we bought it at that price level, then perpetuity-wise (i.e. assuming flat payments forever), our rate of return shall conservatively be 20% (imagine: that is regardless whether the market shuts down or commits suicide—you’re just relying on the fundamental dividend-paying capacity of the underlying business). The dividend yield shall be that equity perpetuity yield from a dividend-conscious perspective. Isn't the Dividend Yield more meaningful if taken from a flat-dividend-paying perpetuity standpoint?

But what if we want the business-conscious perspective (since we don’t wanna rely on dividends because that’s being aloof or it’s skin deep), or what if the business isn’t giving out dividends but is actually good at making money? Then we look deeper into the business and measure it through that tangible evidence of its underlying cash-generating capacity which is the free cash flow. Free cash flow shall be our assumed fixed annual payments for the equity perpetuity, that is the business. When we divide free cash flow by the stock price, we’re effectively getting the free cash flow yield. Isn't the Free Cash Flow Yield more meaningful and solid if taken from a flat free-cash-flow-generating-perpetuity standpoint?

In conclusion, having a perpetuity mind frame (i.e. looking at stocks as "equity" perpetuities) shall be a good tool when quickly evaluating stocks (although I would personally advice not to exclusively or solely rely on it). It’s a conservative measure because while we assume infinite inflows, we’re still projecting flat earnings anyway. If we use dividends as our substitute for the equity perpetuity’s annual payments in trying to measure a prospective rate of return, then we’re effectively using the dividend yield. Past dividend-skin-deep, however, if we use free cash flow (which personally is a better substitute to have a more business-rounded evaluation) then we’re effectively getting the free cash flow yield.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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