The stock market is rising and rising because of today's low interest rates -- or maybe I should say no-interest rates. That's the definitive statement being made today.
After all, if we woke up tomorrow to find that our savings accounts were paying 5%, a lot of people would leave stocks quickly in order to earn a 5% risk-free rate of return. If 5% were the going rate on savings, what would it take for investors to stick with equities? Investors would have to believe that they could earn a much higher rate of return from stocks, relative to the added risk. In finance, the term is equity risk premium.
Whether investors would want a 10%, 12% or 15% return on stocks would depend on the individual investor's risk appetite. That's why today, amid effectively zero-percent interest rates at banks and 10-year U.S. Treasury notes paying less than 2%, it's not hard to see why equities are attractive. And while I don't believe we will see banks paying 5% on savings anytime soon, we are clearly getting closer and closer to the day when the Federal Reserve will begin inching rates back up. When that day comes, I wouldn't be so quick to abandon stocks, provided you have invested cautiously and paid a sensible price for your underlying assets.
To illustrate my point, I like to look at a ratio that's easy to calculate but which is not part of today's commonly used financial ratio lexicon. It's the cash-flow yield, which compares the company's market cap with its cash-flow generation, expressed as a percentage. Consider it an extension of a company's earnings yield, which is the price-to-earnings ratio inverted.
If a company's market cap is $1 billion and that company's annual earnings are $80 million, the P/E ratio is 12.50. The earnings yield is the reciprocal, or earnings-to-price, which is 8%. An earnings yield is how you can express your investment -- not stock price -- rate of return.
Expressed this way, it's easy to see why interest rates matter a lot to the attractiveness of stocks. The choice is a 2% return on a 10-year note or an 8% yield from a company that could grow over time. Cash flow yield simply substitutes operating cash flow for earnings. I like it because cash, not earnings, is what a company uses to pay dividends and to make other investments that can create to even more cash-flow growth.
Let's look at why Dell (DELL) management is under fire for agreeing to a buyout that shareholders deem way too low. Dell has a current market cap of $25 billion. For the year ended Jan 31, 2013, Dell generated $3.2 billion in cash from operations, or a cash-flow yield of 13%. However, Dell doesn't require all the cash it generates, so the cash piles up on the balance sheet: $12.5 billion to be exact. Measured against its debt, Dell has net cash position of about $4 billion, for an enterprise value of $21 billion. Dell's true cash-flow yield is closer 15%. Is it any surprise that private-equity investors -- who can probably borrow at less than 6% -- are salivating at taking Dell private?
Another high-quality company I've mentioned, Gentex (GNTX), has a cash-flow yield of 8%, or 10% on an enterprise value basis. Apple (AAPL) has a cash-flow yield of 12%, but when you strip out the excess cash, the yield jumps to 14%. What you find when you look across a wide sample of equities today is a cash yield that far exceeds today's "risk-free" interest rates.
Wal-Mart (WMT), an economy unto itself, it has a market cap of $241 billion, and it generated $24 billion in cash flow, for a yield of 10%. A good portion of that cash is used for maintenance capital expense, while some is used to pay a 2.4% dividend. But what is truly the less risky asset, Wal-Mart stock or a 10-year Treasury? Perhaps equities are more attractive than they appear to be.