How to Quickly Assess a Likely Long-term Rate of Return Given a Stock’s Current Price

Foresight? In stocks, hindsight is clearer and easier. While we know by hindsight what the excellent business is capable of performing, we downplay our prospects of it, and content ourselves with the more likely, easily achievable, conservative scenario.

This is Part 1 of a Series.

I’m starting to be more inclined towards fast but very conservative approaches in rate of return and intrinsic value appraisals. Because no matter how detailed, elaborate, or complex our models are, if the assumptions, programming, or the projections themselves are too optimistic and aggressive, then the likelihood of achieving these forecasts would be thinner. And the same thing goes with achieving superior returns.

What we simply want to do is downplay our prospects, minimize our expectations, and be happy and content ourselves with the safe, very achievable, conservative scenario, and pay a reasonable price for that—all these despite knowing by hindsight that the business is much more capable and can offer more!

Squeezing the Rationale Behind the Price/Earnings Ratio... or at least its Twin, the Earnings Yield

I’m not really a fan of the Price/Earnings (P/E) Ratio.Why would you want to divide the stock price by its earnings, anyway? Have we even really thought what kind of information we'll get from that? Or are we using it just because everyone else is. Let’s be honest.

P/E Ratio & Earnings Yield. The P/E Ratio personally doesn't appeal to my reason. Its reciprocal, the Earnings Yield, however, seems to be more logical. It's very reminiscent of the rate of return of a perpetuity annuity!

Well, I’ve been thinking about it... And the immediate, most seemingly logical explanation I can muster (to justify its use) is this: It essentially computes the breakeven period (in years) it would take to recover that stock price you’d be paying assuming the company continues to flatly produce the same earnings. Doesn’t it make sense from this stand point? But why would you want to know that, anyway?

The only way I can think of to make sense of the P/E ratio is by taking its reciprocal—that is, instead of dividing the stock price by its earnings, we do the opposite—divide earnings by the stock price. Thus, we get the Earnings Yield, P/E’s reciprocal twin. I have to admit I had my initial reservations on using this ratio. But after going through several valuation techniques and further pondering on the DCF approach/analysis, the simplistic rationale behind the earnings yield suddenly lit up!

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.

I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?

A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE

• Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
• Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
• Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).

The Corporate Cash Hoard Theory

This is Part 1 of a Series.

Ultimately, the industrialists, the rich, or the wealthy want to see a certain build-up of cash profits (i.e. free cash flow) in their businesses. This is despite all the demand of large cash outlays to maintain their respective core business operations. They try to achieve and maintain this liquid financial state so they can pay themselves (e.g. dividends, share buybacks) or further reinvest those free cash in other cash-generating assets (e.g. acquisitions of whole businesses, non-core business investments). Like a small seed growing into a large fruitful tree, small humble businesses, producing hoards of cash, turn themselves into large holding companies owning several other businesses. These subsidiary businesses, which eventually produce even more cash themselves, enable the corporate group to acquire even more businesses, compounding wealth at an accelerating speed.

Uncle Scrooge McDuck's Cash Hoard. While the word "hoard" or "hoarding" evokes images of wealth and riches in the forms of gold coins, jewelries, and other valuable/rare items, in the real world of business, these are in the forms of cash, investments in real estates, ownership of businesses/stocks, bonds, and other liquid, marketable assets or other cash-generating assets.

This hoarding nature of excellent, money-making companies can be attributed to their unwaning generation of free cash flow which has accumulated in the midst of the enterprise. Its accumulation, thus, would indicate a business well positioned to propel itself, as it utilize those hoarded free cash to exploit shareholder value-enhancing opportunities.

I will be discussing a self-contemplated financial concept I shall be referring to as “Corporate Cash Hoard” or simply, “cash hoard”, “free cash hoard”, or “free cash equity”. It is a theory which picks up from where the idea of free cash flow left. It is not intended to replace your usual standard accounting/finance balance sheet framework (particularly familiar accounts such as current assets, non-current assets, current liabilities, non-current liabilities); what it intends to offer is a cash-bias perspective on the overall “free cash” financial standing of a firm.

Before you continue reading, I’d suggest you read through my Cash is King blog series. That’s gonna help provide some basic understanding and, hopefully, useful insights on how to visually observe how a business internally generates its cash profits.

The concept of the corporate cash hoard is founded on the idea that: With free cash flow being continuously produced by a cash-generating business, it’s got to be accumulating somewhere in the balance sheet. The question is, where have all those free cash flow gone? Thus, although I would refer to it as “cash hoard”, this shouldn’t be confused with the cash & cash equivalents asset account under the balance sheet. Continue to Part 2: So Where Have All Those Free Cash Flow Gone?

The Money Machine Making Free Cash Flow

This is Part 4 of a Series. Go to Part 3: Showing You the Money and the Natures of Cash Flow

Save the Investing and Financing portions of Cash Flow, Operating Cash Flow just lacks that discerning appeal innate to the Income Statement. You've got certain adjustments which are really confusing, and immediately churned out at the bottom is a net figure; you can hardly decipher where and how cash was made and paid! What we want to see is how the business makes it money...

Seeing the Money Machine in Action. The Direct Method of Cash Flow Statement cleanly illustrates where and how money is paid and made in the business. 

Now imagine an Operating Cash Flow statement which can tell you, spot on, the cash receipts coming in, and cash disbursements going out, in an organized way similar to the kind of intuition you get when you look at the Income Statement. This is the Direct Method of Cash Flow Statement.

So you’re telling me there is such a thing called Direct Method of Cash Flow Statement? Yes. Then why hasn’t this been used in the first place? I’m not so sure myself (I'm curious, too, so you may comment below or message me if you know why). Companies and regulating government agencies seem to prefer the Indirect Method of Cash Flow Statement because of how it readily reconciles with the Income Statement’s Net Income. After all, because of the reconciling adjustments, it actually holds information you need to convert it into a Direct Method. Its proforma just needs a slight overhaul and reorganization to be easily understood. And that’s just exactly what we’re gonna do and demonstrate.