The Missing Half of the Fraction

April 2, 2013

Dear Investor:

With the Dow now at 14,624, up from 6,500 a few years ago, many say it’s “too high.” But you can’t tell whether a market is too anything by looking at the raw price level, which is what the Dow index represents. This is like saying a NYC apartment at a price of $2 million is too high without knowing basic information like the number of bedrooms or square feet.

A price is totally irrelevant without the other half of the fraction— one which represents the underlying value. For example, an apartment for $2 million might sound expensive when we say the raw number, without any context or specifics. If we’re told it has 4,000 square feet, it doesn’t sound expensive at all. The square footage is the divisor that explains the value:

$2 million =  $500 per square foot

And anyone who knows anything about New York real estate knows it would be snatched up in a New York second. If you could buy that apartment for $2 million and rent it out for the going rate, $50 per square foot, you could get $200,000 in rental income. Assuming annual maintenance expense of $50,000, the net operating income would be $150,000, a yield of 7.5%, a terrific return in a low interest rate world:

$150,000 =  7.5% yield
$2 million

Once again, $2 million tells you nothing until you know the numerator: $150,000. Only by dividing one by the other do you come up with a calculation of value.

It should be no different with stocks, but people act like it is, often saying the Dow is too high or too low without placing it below its appropriate numerator, free cash flow, the amount of actual cash received by the company after all expenses have been paid. The free cash flow is what can be paid out to shareholders in the form of a dividend, reinvested in the business, or used to buy back stock. It constitutes the underlying value of any business.

Whether the Dow is high or not has nothing to do with how far it has come, nor its raw price level. It’s a question only answered by knowing those free cash flows and calculating the underlying yield.

Though the Dow is a price-weighted index, a market capitalization analysis gives a better view of overall yield and value. The Dow’s full market capitalization (total of market value of all 30 stocks in the Dow) is $4,300 billion (or $4.3 trillion). The combined free cash flow across all 30 companies is $280 billion.

The yield calculation is like so:

280 =  6.5%

6.5% is the free cash flow yield. By using a numerator and denominator both, and by putting price in the context of free cash flows, at least we can measure value— something that just can’t be done by looking at price alone.

The free cash flow yield has dropped to 6.5% from 9% a year ago, reflecting a rise in the price level. A 6.5% yield still reflects good value but stocks are no longer dirt cheap, and attention to sectors is more important than ever. Domestic stocks now look less valuable than their foreign cousins, especially stocks in Europe which still sport free cash flow yields above 8%. Japanese stocks look more attractive on a price-to-book level than any market sector. Finally, emerging markets, especially other Asian stocks, are starting to look truly cheap for the first time in many years. We are adding selectively to foreign holdings and taking profits in some overextended sectors.