Today I’m going to talk about the last of a stock’s 4 vital signs. As I mentioned in Investor Questions Podcast #14: What are the 4 Most Important Numbers to Know About a Stock?, I got the idea of checking a stock’s vital signs from a book called The Checklist Manifesto. That book showed me how useful it can be to regularly check the same few numbers whenever you look at a stock. The idea is for investors to look at stocks the way doctors look at patients. First you check their vital signs. Those same 4 numbers can help you avoid big mistakes. Only after you’ve checked the vital signs do you move on to that patient’s particular problem.
Yesterday I talked about free cash flow margin variation. Today I’m going to talk about a stock’s real free cash flow yield.
When I say “real”, I mean inflation adjusted. Long ago, inflation meant an increase in money. Today, inflation means an increase in prices. Since prices are quoted in money, the idea is the same. We want to throw out changes in the amount of money and focus on the value customers trade for the stuff a business gives them.
The stuff could be goods or services. Sometimes we know the number of “units” sold. Sometimes we don’t. A lot of times we aren’t talking about something general like pounds of copper. Instead we’re talking about dentistry, or advertising, or credit scores, or something like that. Those are special things. One ad campaign is not as good as another. One credit score is not as good as another. If it was, FICO (FICO, Financial) wouldn’t dominate the credit scoring business.
Just knowing how many credit reports FICO scored in a year wouldn’t be enough. If a competing product like Vantage Score was judged to be as good as FICO, each report scored by either would generate less free cash flow, because all credit scores would be less valuable in a competitive business than in a non-competitive business. Right now, FICO scores are a special kind of credit score. They aren’t a commodity. If that changed, prices would change too. Not because of inflation. But because of a change in the real value of FICO’s product as it became a commodity. So you can’t just count up the number of credit scoring transactions to get the real “value”. All that gives you is the volume. The real value comes from multiplying the volume by the price customers pay for the product.
A lot of times we know the costs that went into that product. It’s tempting to assume stuff that costs the same is the same. But it’s not. Take FICO for example. It might cost more to produce a Vantage Score than a FICO score. That doesn’t matter. No one knows what a Vantage Score is. We know what a FICO score is. So the FICO score is more valuable. Not because it costs more, but because it’s worth more in the eyes of the people who buy it.
Pearls are not valuable because men dive for them. Men dive for pearls because they are valuable. Same with credit scores. Same with anything. We can’t just count the number of pearls. Nor can we count men who dive for them. We have to count what buyers are willing to pay for those pearls. The problem is that buyers pay for pearls in cash and cash doesn’t hold its value from one year to the next.
For investors, the number of things a business sells matters. But that’s not the most important number. Procter and Gamble (PG, Financial) and Energizer Holdings (ENR, Financial) own the two big razor blade brands: Gillette and Schick. If you looked at their combined market share by number of blades sold it would be lower than their market share by dollars of blades sold.
That’s not because of inflation. That’s because Gillette blades and Schick blades sell for more than no name blades. If we looked at the number of blades sold from year to year we wouldn’t know the amount of real value those businesses were getting from their customers. That’s the number we want to know. How much value do customers trade for the stuff the business sells them?
And that’s where this idea of real cash flow comes from. We don’t want to adjust for changes in the price of the product the business sells. We just want to adjust for changes in the price of the product the business sells that are caused by changes in the value of money.
So if movie tickets are 4% more expensive this year, but dollars are worth 2% less, we still want to give movies credit for half of that gain. We just want to get rid of the part that was caused by the change in the value of dollars.
It’s not easy to do that. In fact, we can’t do it precisely. Even if all money was in the form of cash in people’s pockets, we couldn’t just add up the growth in those dollar bills. Because the number of people changes. And how rich those people are changes too. Not just in terms of dollars. But in terms of real stuff.
What matters is the change in the amount of money on top of the change in people and their wealth. And even that change won’t show up in prices the moment new dollars appear.
So even though we want to adjust numbers to fix this problem of higher or lower amounts of dollars, we can’t do it by just counting dollars. We have to do it by looking at prices.
And the problem there is that prices don’t move together. The price of video games might rise by 10% while the price of movie tickets rise by just 4%. And that can happen even when most other prices are rising by 2% or 1% or nothing at all.
So there’s no perfect answer to this inflation problem.
And luckily for you – at least if you’re an American investor, or you’re interested in American stocks – none of this matters that much at the moment. Over the last 10 years, inflation has been low in the United States. It’s close to zero right now.
So adjusting a stock’s free cash flow from past years so it reflects real numbers instead of just the effects of inflation, isn’t as important right now as it has been in most decades. But it could be in the future.
Whenever inflation is high this number matters a lot. It will save you from making big mistakes. The same is true if there’s deflation. That means a fall in prices. And it happens from time to time. Deflation happened during the Great Depression. And it could happen again. Adjusting free cash flow from past years to reflect today’s prices will help you fix both problems. It doesn’t matter if the economy saw inflation or deflation during the years you’re looking at. Real prices will always translate past free cash flow numbers into data you can use today.
Again, even though I’m talking about prices, I’m not talking about just one price. I’m talking about economy wide prices. I’m not talking about the price of the product the company is selling. That’s an important number to know. But it’s not the most important number to know when talking about free cash flow. After all, free cash flow comes in the form of cash. And it comes from a combination of what the company gets paid for its product and what it has to put back in the business.
For example: a cruise line’s free cash flow comes from the cash passengers pay for their tickets minus the cash the company pays to run the ships and the cash it pays to buy the ships. Just knowing what happened to the price of tickets isn’t enough. You need to know what happened to the price of the ships too.
For most companies, that’s too hard. There are too many costs to keep track of. It’s better to simply adjust free cash flow based on changes in economy wide prices.
You have a few choices here. You can use the consumer price index. Lots of economists use the CPI.
I’m not an economist. I don’t care what the inflation rate is. I just want some idea of how a specific company’s past free cash flow would look today if everything was the same now as it was then with the one exception of economy wide prices.
That sounds confusing. But, it’s really not. I’m doing what Ben Graham wrote about in “Security Analysis”. He used 10-year average earnings instead of the current year’s earnings, because he thought averages were always more useful than one number alone and because he wanted to smooth out the business cycle. If you look at 10 years, you’re likely to include both lean years and fat years.
So, for me, the GDP deflator works fine. It’s not a basket of things like the consumer price index. It’s just a level of volume. They take a bunch of different groups of the same sort of stuff like food and electronics, measure the price changes in those groups, and then mash them all together based on how much each group makes up of the whole economic pie.
Adjusting a company’s free cash flow using the GDP deflator is like measuring the company’s free cash flow as a slice of the overall economic pie. Actually making that measurement would be tough, because it’s such a small number. But that’s the idea. We’re looking at the company as if it’s on a treadmill. And we’re asking: “How fast would this company’s free cash flow have to grow in dollars to stay in the same spot on that treadmill?”
That’s all we mean by real free cash flow. The yield part comes in when we divide the 10-year average free cash flow per share by the stock price.
As always, we want a stock with a high yield.
I’ll give you an example using Birner Dental Management Services (BDMS, Financial). I talked about this stock in Investor Questions Podcast #10: How Do You Avoid Falling Into a Value Trap? I said then that I liked the stock and I owned the stock. Both those things are still true today. So I’m biased. But it’s a stock I know well. And it’s a stock we’ve talked about before.
Alright. So what is Birner’s 10-year average real free cash flow yield?
Once again, you can do this calculation fastest in Microsoft Excel. If you don’t have Microsoft Excel, you can use a pen, a piece of paper, and a calculator. It’ll just take a little longer. And you won’t be able to update it in the future quite as easily. If you’re like me, you’ll also be more likely to lose a piece of paper than lose an Excel file. But otherwise it’s exactly the same.
Start by labeling 10 rows with the years 2000 through 2009. Leave a blank column for “nominal free cash flow”, that means free cash flow in unadjusted dollars. Then add a column with the GDP deflator for each year. Then add another column for “real free cash flow”. That means free cash flow translated into today’s dollars.
There are a lot of places you can get the GDP deflator. The easiest place is probably a site called “Measuring Worth”. Go there and check the box called “GDP Deflator”, then enter the years 2000 and 2009. It’ll give you all 10 numbers. Type them into Excel. Then go to EDGAR and find Birner’s free cash flow for each year.
To adjust a past year’s free cash flow into today’s dollars you multiply that year’s free cash flow by this year’s deflator divided by that year’s deflator. For example, if the deflator is 109.77 in 2009 and 100 in 2005, you multiply Birner’s 2005 free cash flow by 1.0977 to turn 2005’s free cash flow into today’s dollars.
I know the work is boring. But the data you get out of it isn’t. It puts past years in today’s terms. Once you fill in all the blanks the way I told you to, you’ll see that Birner’s free cash flow is much higher today than it was in 2003, but all of that increase is inflation. In reality, Birner is not taking home a bigger piece of the economic pie than it was 7 years ago. That makes sense, because 2003 was probably a better year than 2009. We’re measuring free cash flow here. And bad economic years tend to be bad free cash flow years. Not always. But usually that’s true. And 2003 was a better year than 2009.
Anyway, after you crunch all the numbers, you see that Birner’s average real free cash flow is $3.6 million. And the company has 1.86 million shares outstanding. You can find this number on Birner’s most recent 10-Q report to the SEC. Take $3.6 million and divide by 1.86 million shares. You get $1.94 a share. That’s Birner’s 10-year average real free cash flow per share. Now look up Birner’s latest stock price. On Friday, the stock price for BDMS was $17.25.
To get the stock’s 10-year average free cash flow yield you take the average real free cash flow per share of $1.94 and divide by the stock price of $17.25. You get 11.25%.
I like to think of that 11.25% as Birner’s earning power. That’s how Graham would think of it if he were around today.
An 11.25% 10-year average free cash flow yield is high. I wouldn’t own the stock if it wasn’t. But that 11.25% doesn’t tell the whole story. The truth is I wouldn’t have bought BDMS unless I thought it was going to do smart things with that cash.
The difference between free cash flow yields and bond yields is that you get to reinvest the bond yield yourself. The free cash flow yield gets invested by the company.
Birner has a long history of using its free cash flow for 3 things. One: it buys more dentist offices. Two: it pays a dividend. And three: it buys back its stock. The dividend and the stock buyback are the most important things to me.
Right now, the dividend yield is 4.64%. Over the last 10 years, Birner has bought back an average of 4.85% of its stock each year. So, really that’s like getting a 9.5% yield paid out to you every year.
And that’s why I like BDMS. Yes, it has a high 10-year average real free cash flow yield. But no. That’s not enough. The clincher for me is the dividend and much more importantly, the stock buyback. If those two things weren’t there, Birner would still be cheap. But I wouldn’t buy it.
You need more than just a high yield. You need a high yield that can grow your wealth over time. A combination of dividends that I get to invest myself and stock buybacks that the company reinvests for me is what makes this cheap stock a better investment than most.
That’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave me a voicemail. That’s 1-800-604-1929. Thanks for listening.
Yesterday I talked about free cash flow margin variation. Today I’m going to talk about a stock’s real free cash flow yield.
When I say “real”, I mean inflation adjusted. Long ago, inflation meant an increase in money. Today, inflation means an increase in prices. Since prices are quoted in money, the idea is the same. We want to throw out changes in the amount of money and focus on the value customers trade for the stuff a business gives them.
The stuff could be goods or services. Sometimes we know the number of “units” sold. Sometimes we don’t. A lot of times we aren’t talking about something general like pounds of copper. Instead we’re talking about dentistry, or advertising, or credit scores, or something like that. Those are special things. One ad campaign is not as good as another. One credit score is not as good as another. If it was, FICO (FICO, Financial) wouldn’t dominate the credit scoring business.
Just knowing how many credit reports FICO scored in a year wouldn’t be enough. If a competing product like Vantage Score was judged to be as good as FICO, each report scored by either would generate less free cash flow, because all credit scores would be less valuable in a competitive business than in a non-competitive business. Right now, FICO scores are a special kind of credit score. They aren’t a commodity. If that changed, prices would change too. Not because of inflation. But because of a change in the real value of FICO’s product as it became a commodity. So you can’t just count up the number of credit scoring transactions to get the real “value”. All that gives you is the volume. The real value comes from multiplying the volume by the price customers pay for the product.
A lot of times we know the costs that went into that product. It’s tempting to assume stuff that costs the same is the same. But it’s not. Take FICO for example. It might cost more to produce a Vantage Score than a FICO score. That doesn’t matter. No one knows what a Vantage Score is. We know what a FICO score is. So the FICO score is more valuable. Not because it costs more, but because it’s worth more in the eyes of the people who buy it.
Pearls are not valuable because men dive for them. Men dive for pearls because they are valuable. Same with credit scores. Same with anything. We can’t just count the number of pearls. Nor can we count men who dive for them. We have to count what buyers are willing to pay for those pearls. The problem is that buyers pay for pearls in cash and cash doesn’t hold its value from one year to the next.
For investors, the number of things a business sells matters. But that’s not the most important number. Procter and Gamble (PG, Financial) and Energizer Holdings (ENR, Financial) own the two big razor blade brands: Gillette and Schick. If you looked at their combined market share by number of blades sold it would be lower than their market share by dollars of blades sold.
That’s not because of inflation. That’s because Gillette blades and Schick blades sell for more than no name blades. If we looked at the number of blades sold from year to year we wouldn’t know the amount of real value those businesses were getting from their customers. That’s the number we want to know. How much value do customers trade for the stuff the business sells them?
And that’s where this idea of real cash flow comes from. We don’t want to adjust for changes in the price of the product the business sells. We just want to adjust for changes in the price of the product the business sells that are caused by changes in the value of money.
So if movie tickets are 4% more expensive this year, but dollars are worth 2% less, we still want to give movies credit for half of that gain. We just want to get rid of the part that was caused by the change in the value of dollars.
It’s not easy to do that. In fact, we can’t do it precisely. Even if all money was in the form of cash in people’s pockets, we couldn’t just add up the growth in those dollar bills. Because the number of people changes. And how rich those people are changes too. Not just in terms of dollars. But in terms of real stuff.
What matters is the change in the amount of money on top of the change in people and their wealth. And even that change won’t show up in prices the moment new dollars appear.
So even though we want to adjust numbers to fix this problem of higher or lower amounts of dollars, we can’t do it by just counting dollars. We have to do it by looking at prices.
And the problem there is that prices don’t move together. The price of video games might rise by 10% while the price of movie tickets rise by just 4%. And that can happen even when most other prices are rising by 2% or 1% or nothing at all.
So there’s no perfect answer to this inflation problem.
And luckily for you – at least if you’re an American investor, or you’re interested in American stocks – none of this matters that much at the moment. Over the last 10 years, inflation has been low in the United States. It’s close to zero right now.
So adjusting a stock’s free cash flow from past years so it reflects real numbers instead of just the effects of inflation, isn’t as important right now as it has been in most decades. But it could be in the future.
Whenever inflation is high this number matters a lot. It will save you from making big mistakes. The same is true if there’s deflation. That means a fall in prices. And it happens from time to time. Deflation happened during the Great Depression. And it could happen again. Adjusting free cash flow from past years to reflect today’s prices will help you fix both problems. It doesn’t matter if the economy saw inflation or deflation during the years you’re looking at. Real prices will always translate past free cash flow numbers into data you can use today.
Again, even though I’m talking about prices, I’m not talking about just one price. I’m talking about economy wide prices. I’m not talking about the price of the product the company is selling. That’s an important number to know. But it’s not the most important number to know when talking about free cash flow. After all, free cash flow comes in the form of cash. And it comes from a combination of what the company gets paid for its product and what it has to put back in the business.
For example: a cruise line’s free cash flow comes from the cash passengers pay for their tickets minus the cash the company pays to run the ships and the cash it pays to buy the ships. Just knowing what happened to the price of tickets isn’t enough. You need to know what happened to the price of the ships too.
For most companies, that’s too hard. There are too many costs to keep track of. It’s better to simply adjust free cash flow based on changes in economy wide prices.
You have a few choices here. You can use the consumer price index. Lots of economists use the CPI.
I’m not an economist. I don’t care what the inflation rate is. I just want some idea of how a specific company’s past free cash flow would look today if everything was the same now as it was then with the one exception of economy wide prices.
That sounds confusing. But, it’s really not. I’m doing what Ben Graham wrote about in “Security Analysis”. He used 10-year average earnings instead of the current year’s earnings, because he thought averages were always more useful than one number alone and because he wanted to smooth out the business cycle. If you look at 10 years, you’re likely to include both lean years and fat years.
So, for me, the GDP deflator works fine. It’s not a basket of things like the consumer price index. It’s just a level of volume. They take a bunch of different groups of the same sort of stuff like food and electronics, measure the price changes in those groups, and then mash them all together based on how much each group makes up of the whole economic pie.
Adjusting a company’s free cash flow using the GDP deflator is like measuring the company’s free cash flow as a slice of the overall economic pie. Actually making that measurement would be tough, because it’s such a small number. But that’s the idea. We’re looking at the company as if it’s on a treadmill. And we’re asking: “How fast would this company’s free cash flow have to grow in dollars to stay in the same spot on that treadmill?”
That’s all we mean by real free cash flow. The yield part comes in when we divide the 10-year average free cash flow per share by the stock price.
As always, we want a stock with a high yield.
I’ll give you an example using Birner Dental Management Services (BDMS, Financial). I talked about this stock in Investor Questions Podcast #10: How Do You Avoid Falling Into a Value Trap? I said then that I liked the stock and I owned the stock. Both those things are still true today. So I’m biased. But it’s a stock I know well. And it’s a stock we’ve talked about before.
Alright. So what is Birner’s 10-year average real free cash flow yield?
Once again, you can do this calculation fastest in Microsoft Excel. If you don’t have Microsoft Excel, you can use a pen, a piece of paper, and a calculator. It’ll just take a little longer. And you won’t be able to update it in the future quite as easily. If you’re like me, you’ll also be more likely to lose a piece of paper than lose an Excel file. But otherwise it’s exactly the same.
Start by labeling 10 rows with the years 2000 through 2009. Leave a blank column for “nominal free cash flow”, that means free cash flow in unadjusted dollars. Then add a column with the GDP deflator for each year. Then add another column for “real free cash flow”. That means free cash flow translated into today’s dollars.
There are a lot of places you can get the GDP deflator. The easiest place is probably a site called “Measuring Worth”. Go there and check the box called “GDP Deflator”, then enter the years 2000 and 2009. It’ll give you all 10 numbers. Type them into Excel. Then go to EDGAR and find Birner’s free cash flow for each year.
To adjust a past year’s free cash flow into today’s dollars you multiply that year’s free cash flow by this year’s deflator divided by that year’s deflator. For example, if the deflator is 109.77 in 2009 and 100 in 2005, you multiply Birner’s 2005 free cash flow by 1.0977 to turn 2005’s free cash flow into today’s dollars.
I know the work is boring. But the data you get out of it isn’t. It puts past years in today’s terms. Once you fill in all the blanks the way I told you to, you’ll see that Birner’s free cash flow is much higher today than it was in 2003, but all of that increase is inflation. In reality, Birner is not taking home a bigger piece of the economic pie than it was 7 years ago. That makes sense, because 2003 was probably a better year than 2009. We’re measuring free cash flow here. And bad economic years tend to be bad free cash flow years. Not always. But usually that’s true. And 2003 was a better year than 2009.
Anyway, after you crunch all the numbers, you see that Birner’s average real free cash flow is $3.6 million. And the company has 1.86 million shares outstanding. You can find this number on Birner’s most recent 10-Q report to the SEC. Take $3.6 million and divide by 1.86 million shares. You get $1.94 a share. That’s Birner’s 10-year average real free cash flow per share. Now look up Birner’s latest stock price. On Friday, the stock price for BDMS was $17.25.
To get the stock’s 10-year average free cash flow yield you take the average real free cash flow per share of $1.94 and divide by the stock price of $17.25. You get 11.25%.
I like to think of that 11.25% as Birner’s earning power. That’s how Graham would think of it if he were around today.
An 11.25% 10-year average free cash flow yield is high. I wouldn’t own the stock if it wasn’t. But that 11.25% doesn’t tell the whole story. The truth is I wouldn’t have bought BDMS unless I thought it was going to do smart things with that cash.
The difference between free cash flow yields and bond yields is that you get to reinvest the bond yield yourself. The free cash flow yield gets invested by the company.
Birner has a long history of using its free cash flow for 3 things. One: it buys more dentist offices. Two: it pays a dividend. And three: it buys back its stock. The dividend and the stock buyback are the most important things to me.
Right now, the dividend yield is 4.64%. Over the last 10 years, Birner has bought back an average of 4.85% of its stock each year. So, really that’s like getting a 9.5% yield paid out to you every year.
And that’s why I like BDMS. Yes, it has a high 10-year average real free cash flow yield. But no. That’s not enough. The clincher for me is the dividend and much more importantly, the stock buyback. If those two things weren’t there, Birner would still be cheap. But I wouldn’t buy it.
You need more than just a high yield. You need a high yield that can grow your wealth over time. A combination of dividends that I get to invest myself and stock buybacks that the company reinvests for me is what makes this cheap stock a better investment than most.
That’s all for today’s show. If you have an investing question you want answered call 1-800-604-1929 and leave me a voicemail. That’s 1-800-604-1929. Thanks for listening.
