Yield Investing: Dividend, Earnings And FCF

There are numerous ways to value investments, and many investors prefer a specific valuation method. For some it may be the often used price-to-earnings multiple. For others it may be revenue growth, and still others may look at price momentum. Yield investing is one way to value a stock by comparing the current price to various factors that produce income from an investment. There are many ways to measure yield - three common ones are dividend yield, earnings yield and free cash flow yield.

Dividend Yield
Dividend yield is calculated by dividing the annual dividend per share by the price per share or the annual dividend by the market cap. A high dividend yield could reflect stocks that are undervalued and will provide a higher return. To determine if a dividend yield is high, it is often compared to the market yield. For example, the average dividend yield for the S&P 500 over the the last six decades leading up to 2013 is 3.4%. Using this as a benchmark, any yield above this mark is attractive. Rising dividend yield can be the result of two occurrences: a falling stock price or a rising dividend payout, the latter being preferable. Another use of dividend yield is to compare it to the yield on 10-year treasuries. If an investment's dividend yield is greater than the treasury yield, then that investment is attractive given that the risk profile is not too high.

Earnings Yield
Earnings yield is the last 12 months of earnings per share divided by the current price per share. The earnings yield measures how much return an investment in a company earned over the past 12 months. Earnings yield is the inverse of the popular price/earnings ratio. Like the dividend yield, the higher the earning yields, the more attractive the investment. Earnings yield is extremely useful for comparing various markets. For example, if the current 10-year treasury yield is 3.5% and the earnings yield for S&P 500 is 5%, then the stock market is undervalued on an earnings basis compared to the bond market. Company shares trading at an earnings yield greater than 5% will be considered undervalued compared to the market. The criticism of using the earnings yield, like the P/E ratio, is that earnings are easily manipulated. And because of the potential for creative accounting to impact earnings, some investors prefer to use free cash flow as a truer measure.

Free Cash Flow Yield
Free Cash Flow (FCF) yield is the annualized FCF per share divided by the current share price. FCF yield is popular with investors who believe the true measure of a company's operating strength is sought by following the cash. FCF is the cash left over after paying all the operating expenses and capital expenditures, or operating cash flow minus capital expenditures. Determining how much cash a company generated, after paying its operating expenses and other ongoing costs to keep itself operating, and comparing that to the price per share provides the company's true value. The higher the FCF yield, the more attractive the investment. The FCF yield points to the fact that investors would like to pay as little as possible for as much earnings as possible. Similar to earnings yield, the FCF yield can be used to compare companies across the same or different industries.

Which 'Yield' Makes Sense?
Are there advantages to using one yield measure over another? That depends on the investor. No one measure is the "holy grail." Each has its critics and proponents. Dividend yield is perhaps the most frequently used yield measure. It is also the one that is left to the company's discretion, because dividends can be increased, decreased or suspended by the company at any time, although companies try not to reduce dividends because it is a negative signal. Therefore, dividend yield is not the best yield measure when looking to value a company, but it can indicate a company's general trajectory.

Investors will often compare dividend yield to the yield on 10- year treasuries (a riskless asset) as a proxy for stock market attractiveness. Secondly, the yield level or percentage change can give investors foresight into company management's expectations of future cash flows and growth prospects. Lastly, dividend yield can be used in conjunction with other measures. For example, FCF provides insight into the cash generated after expenses. If the FCF is low and the dividend yield is high, this indicates a mismatch in the investment's valuation using both metrics and should raise a red flag for the analyst or investor. In contrast, if the FCF is high and the dividend yield is low, the company could be signaling a future acquisition or other growth investment that could be a positive catalyst for the stock.

FCF yield and earnings yield are two measures that can be used to value a company and compare it to other investments over time. These yields look at valuation in two ways, the former using cash flow and the latter using earnings. Although proponents and critics argue about which measure is a better indicator of "true earnings," both can be used to find strong companies. Take the following example:

	Earnings Yield	FCF Yield
Stock A	5%	4%
Stock B	10%	5%

In this example, Stock B has a higher earnings and FCF yield than A, which says that the stock appears undervalued on both measures. Also, one can notice that the earnings yield has a larger spread than the FCF yield, which should make the investor look deeper into the financials to see where the cash is going or what makes the company's earnings much higher.

In another example:

	Earnings Yield	FCF Yield
Stock A	5%	4%
Stock B	10%	1%

In this example, Stock B has a higher earnings yield but a lower FCF yield, which can lead to two conclusions. The first is that earnings are being propped up by non-cash items like depreciation. The second conclusion is that FCF is being reduced by large capital expenditures.

Using the two yields in conjunction with each other provides a clearer picture of the company's valuation than either measure alone. Although earnings and FCF yields look backward, using these measures together with dividend yield may provide some forward-looking insight into the management's expectations of future earnings.

The Bottom Line
Dividend, earnings and FCF yields are applicable measures on their own, although their limitations are noteworthy. Understanding the inputs that go into each calculation better prepares the investor for the measure's usefulness. But used together, these yield measures can paint a clear picture of a strong or weak potential investment.