Cash Return

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Cash Return

The best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E ratio. You can calculate cash return by adding free cash flow (cash from operations minus capital expenditures) to net interest expense (interest expense minus interest income), and then dividing the sum by enterprise value (market cap plus long-term debt, minus cash). We add back interest expense to free cash flow so that capital structure doesn’t impact cash return.

The value of cash return

The goal of the cash return metric is to measure how efficiently the business is using its capital—both equity and debt—to generate free cash flow. In other words, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy out the entire business.

An example for illustration

Let’s use software giant ABC Network Systems as an example of how to use cash return to find reasonably valued investments. Recently, ABC had a market cap of about $90.9 billion and carried $16.3 billion in long-term debt and $9.8 billion in cash on its balance sheet. Its enterprise value was $90.9 + $16.3 - $9.8, or $97.4 billion. That gives us the first part of our ratio. The other half is free cash flow, adjusted for interest expense. In that year, ABC generated about $11 billion in adjusted free cash flow. Thus, our cash return on ABC will be $11 billion/$97.4 billion, or about 11%.

With 10-year Treasuries yielding just 1.7% at the time and corporate bonds yielding a higher (but still paltry) 2.7% in that year, that 11% cash return for ABC looks pretty good. Throw in the fact that ABC’s free cash flow is likely to grow over time, whereas those bond payments are fixed, and ABC starts to look like a pretty solid value.

Cash return is a great first step to finding cash cows trading at reasonable prices, but avoid using cash return for financials or foreign stocks. Cash flow is not terribly meaningful for banks and other firms that earn money via their balance sheets. And because definitions of cash flow can vary widely in other countries, a foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally.