Friday, July 2, 2010

The Origins of “LACFY”

I was fortunate enough to discover Benjamin Graham’s The Intelligent Investor prior to the global downturn in 2008 (Graham’s comparison of earnings yield to risk-free yields proved to be an invaluable and protective tool.)

However, it wasn’t until 2008 that I read Graham and Dodd’s 1934 classic, Security Analysis – the book that opened my eyes on how to invest in a business-like fashion. In particular, the following paragraph -- tucked nondescriptly in the back-third of the book -- changed the way I would invest forever:

It is an almost unbelievable fact that Wall Street never asks, “How much is the business selling for?” Yet this should be the first question in considering a stock purchase. If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking…Let the stock buyer, if he lays any claim to intelligence, a least be able to tell himself, first, how much he is actually paying for the business, and secondly, what he is actually getting for is money in terms of tangible resources.

In the chapter from which this paragraph was taken, Graham was extolling the utility of book value (a metric that has lost some meaning in a brand-driven society…not to mention, a corporate society that relies on distortive share repurchases). But from Graham and Dodd’s suggestion, I saw something bigger – a formula that would provide the true ownership yield of a company with respect to modern accounting standards. After much deliberation, I conceived the following formula:

Liability-Adjusted Cash Flow Yield

10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

And so, LACFY was born.

Of course, the formula isn't perfect -- it won't protect you from overvaluing a company with a large cash hoard overseas or an artificially-low tax rate (two accounting anomalies that often run hand-in-hand). Nor will it give you a fair valuation for a fledgling company with dramatic earnings growth (although, you can always modify the numerator to a best-guess cash flow figure).

But for established companies with a long earnings record, liability-adjusted cash flow yield shows a "more complete picture" than a company's earnings yield alone (the inverse of the price/earnings ratio).

A Corollary Formula, "Inspired" by the Crash

When the financial crisis came to a boil in 2009, I noticed a funny thing -- companies that paid a dividend yielding more than their LACFY were cutting their dividends with greater regularity than those that did not (notable examples include General Electric and Pfizer). It made perfect sense; debt-laden companies had little recourse if they could not support their dividend with free cash flow and/or couldn't roll-over debt in a drying credit market.

Based on this observation, I created a corollary pass/fail formula:

Dividend Acid Test

Pass = Dividend yield less than LACFY
Fail = Dividend yield greater than LACFY

Again, no formula is perfect -- but for any income investor that salivated at BP's yield following the Macondo disaster -- the ultimate dividend cut would have seemed a foregone conclusion.

Practical Use for Fixed-Income Investors

I fear that today's manipulated bond market will leave many retired investors in the uncomfortable position of watching their real-return eroded by inflation (we've kicked the can for a long time, but the day of reckoning will come upon us 'gradually and then suddenly,' as Hemingway would say).

In my opinion (please note that this should not be construed as personal investment advice), retirees would be wise to allocate a portion of their investments to conservatively financed dividend-paying stocks that meet the following criteria:

LACFY is greater than Dividend Yield is greater than 10-Year Treasury Yield

This will provide the investor with a high level of current income, and hopefully, better protection against a rise in interest rates.

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