In this article I will explore the interconnected relationship between investment multiples, the yield on that investment, and the rate of return investors should expect. My overarching view is that even though investment multiples are much more commonly used in the financial world, I would urge investors to instead do their thinking in terms of yield. Yields are more simple and explicit than using multiples, and using yields allows easier comparison across investments. I end the article by recommending investors use free cash flow yield in their decision making.

The Problem With Multiples

The most well known example of an investment multiple is the price to earnings ratio (P/E). If you listen to the financial media you might hear that some stock is trading at a 20 P/E while another is trading at a 30 P/E. If you are dealing with private companies the preferred multiple might be based on Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). You might hear that some private business was just bought for 8 times EBITDA or something similar.

The problem with using multiples is that on their surface they seem to explicitly tell us very little about the underlying investment opportunity. Multiples are not intuitive for most investors. If I buy a stock at a P/E of 20, what exactly have I done? How is this different from buying at a P/E of 10 or 30? Investors might know that the average stock trades for around 15 times earnings, but why is this? It all seems like an arbitrary system.

The reality is that even most professional investors have not thought about what they are actually doing when they purchase an investment at a specified multiple. Most investors don’t know why they are using that multiple other than the fact that it has worked in the past and that multiple is more or less what people in the industry are currently paying for investments.

Converting Multiples to Yields

We can take any multiple and turn it into a yield by simply taking the inverse of that multiple. In other words we simply flip the equation. Let’s look at the P/E ratio to see how we turn the price to earnings ratio into an “earnings yield.”

Let’s say a share of stock was currently selling for $50 a share. For this example let’s say the company earns $2.50 per share. To find the P/E, we would take 50 ÷ 2.50 = 20. A stock with earnings of $2.50 that is currently selling for $50 has a P/E of 20.

A stock with a P/E of 20 means we must pay 20 dollars to get 1 dollar of earnings. Therefore what is our yield? We get 1 dollar in earnings per 20 dollars of investment. 1 ÷ 20 = 5%. So a stock that trades at a 20 P/E is offering us a 5% earnings yield. We could have also divided the earnings per share of $2.50 by the stock price of $50 to get the same 5% earnings yield.

Suppose instead that an investment we were looking at was trading at a P/E of 10. We would follow the same process again to find the earnings yield. We simply take the inverse of the P/E ratio.

By turning a P/E into an earnings yield that is in percentage terms investors are likely to think more clearly about what they are doing. It forces investors to think about the initial rate of return that a specified multiple is offering. If you buy a stock for a P/E of 10 it means that for every 10 dollars you pay you get 1 dollar back in earnings. By purchasing this investment you will receive 1 dollar of earnings for every 10 you put up for a 10% yield on your investment. If instead we had to pay a 20 P/E our earnings yield would drop to 5%. ( 1/20 = 5%).

Below you can see the corresponding earnings yield associated with various P/E ratios. As you can see the P/E ratio and your earnings yield are directly inversely related. The more you have to pay for each dollar of earnings, the lower the yield on the investment.

 

Comparing Across Asset Classes

The problem for investors is that in some industries the convention is to use yields and in other industries the convention is to use multiples. I would suggest always converting to yields because I think they are more intuitive because it explicitly states the per unit return (yield) we are going to receive for the price paid.

For example we can compare the earnings yield of a stock to the yield on a government bond, to the yield on a corporate bond, to the yield from a bank CD, or t0 the capitalization rate on a real estate opportunity.

In the real estate industry the convention is to use something called capitalization rates. The capitalization rate is really just a yield by a different name. It is equivalent to the concept of the earnings yield except it uses NOI instead of earnings.

 

Notice how the capitalization rate could just as easily be stated as an “NOI multiple” if we so chose. This just simply isn’t the convention however.

 

In real estate we say we paid a 5% cap, but we could equivalently say we paid 20 times NOI.

In the bond market we say we bought the 10 year treasury at 2.5%, but we could equivalently say we bought the treasury for 40 times earnings.

In the stock market we say we paid 15 times earnings, but we could equivalently say we bought it at a 6.66% earnings yield.

As you can see we can switch back and forth between multiples and yields which are just equivalent ways of saying the same thing. I prefer yields because I believe it is most logical to speak in percentage terms regarding what you receive against what you pay for.

Below is a fairly up to date picture of what investment opportunities currently exist. Below the yield is the equivalent multiple. You can use this to make decisions in an absolute sense: for example, is a 2.4% annual yield sufficient to make you purchase the ten year bond. It also allows you to compare asset classes relatively to each other: for example is the 2.7% spread between the earnings yield of stocks and the 10 year bond sufficient to compensate you for the additional risk you assume by investing in equities versus a risk free instrument such as the 10 year.

 

The Historical Equity Rate of Return

We have established that it seems like a logical idea to determine the current yield of an investment. I have also stated that I think it seems easier to think it terms of yield rather than in multiples even though they are equivalent ways of expressing the same thing.

Even though the current yield of an investment is an incredibly important consideration, it is not the complete picture. The total return of an investment can be broken down into two components: 1) the current yield of the investment and 2) the value of any future growth.

Return from Investment = Current Yield + Value from Future Growth

I had mentioned earlier that equities as a group have tended to trade at a P/E ratio around 15. You may also know that over the last 75 years or so the average annualized return for equities has been around 8-10% depending on the time period. How are these two pieces of information linked? Well, they link so perfectly that no other result would make sense. Using the above formula we can plug in the current yield associated with a 15 P/E. We can use GDP growth for the second term to estimate the value created from growth for equities as a group. Some will grow faster and others slower but as a group they will grow with GDP.

Return for Equities = Earnings Yield + GDP Growth

The average P/E has been 15 which corresponds to an earnings yield of 6.66% (1/15). GDP Growth has been in the area of 2-3% annually.

Return for Equities = 6.66% Earnings Yield + 2-3% GDP Growth = 8.66%-9.66% annually.

8-10% returns is exactly what we have observed in practice. When you think about it the result fits together perfectly. Most people have never made this connection because they have never considered what a 15 P/E actually corresponds to. When we convert the P/E to Earnings Yield things become much more straightforward.

Forward Rates of Return

Recall that “Price to Earnings” and “Earnings Yield” are direct inverses of each other. Therefore the higher the P/E ratio, the lower the Earnings Yield. The lower the P/E ratio, the higher the Earnings Yield. For example a P/E of 25 provides an earnings yield of 4% while a P/E of 10 provides an earnings yield of 10%. All else being equal, an investment with a P/E of only 10 will outperform that same investment with a P/E of 25 because of the much higher earnings yield corresponding to a P/E of 10. In short, the more you have to pay for each dollar of earnings the lower your rate of return will be. Buying $1 of earnings for $10 is superior to buying that same $1 for $25.

The higher the P/E we pay the more we are relying on the future to be overtly kind to us. If we sacrifice current yield with a higher Price to Earnings today, we need the value from future growth to be disproportionally large to offset the initial deficiency. What has been found in practice is that as a group, high P/E stocks (low earnings yield) fail to materialize the promised future value creation and therefore dramatically underperform low P/E stocks (high earnings yield).

Below is information presented by economist Robert Shiller illustrating the relationship between P/E and rates of return. Notice the clear trend from the upper left to the lower right. As the P/E increases, the observed rate of return decreases. We get to the point that at certain high P/E’s, we should actually expect the rate of return on our investment to be negative. The link between valuation and return is difficult to argue with. Buying things cheaply (high earnings yield) makes a big difference.

 

Put simply, buying things cheaply (Low P/E, High Earnings Yield) drastically outperforms buying things that are expensive (High P/E, Low Earnings Yield). This should seem obvious, but many people do not make the connection that High P/E stocks leads to low forward rates of return. This is likely because to them the P/E is just some number because they have never made the connection that the P/E corresponds to the current Earnings Yield.

The Commodity Multiple

I think it helps as a reference to figure out what P/E ratio a purely commodity business should be valued at. Then from that base rate we can determine if the business we are assessing deserves a higher valuation than a commodity multiple.

When I am talking about a commodity business I am not talking solely about those explicitly in the business of selling actual physical commodities. When I am speaking about a commodity business in this context I am talking about any business that lacks a durable competitive advantage. I would say that pertains to around 90% of the businesses you will ever come across. It is not meant to be derogatory, it is simply reality. Establishing a durable competitive advantage that routinely fights off the effects of competition for a decade or more is achieved by only a small number of companies. Therefore most companies are commodity companies in the sense that I am using the term.

Without an economic moat to protect the business, returns on invested capital will be driven down to the costs of capital by the effects of competition. In most industries, excess profits will immediately invite additional supply which will drive returns back down to the cost of capital. This means each dollar of earnings should simply be capitalized at the cost of capital. This means that investors will be compensated solely with their required rate of return. Nothing more, nothing less.

What P/E results if we capitalize a dollar of earnings at the cost of capital? Depends of the cost of capital. I think it is safe to assume that generally the cost of capital for a large publicly traded corporation should be in the range of 8-10%.

 

So a commodity business should trade in a P/E range of 10-12 depending on its cost of capital. This P/E is applied to the “normalized earnings” of the business. Depending on where we are in the economic cycle a business may be over or under earning in regard to its “normal” mid-cycle year. But given information on the normalized earnings of a commodity business we should only be will to pay 10-12 times earnings.

Only if we can say that a business has a durable competitive advantage should we pay a multiple of earnings that is higher than this. For the vast majority of businesses a dollar of earnings should simply be capitalized at the cost of capital. This allows investors to only achieve returns that reflect the cost of capital. Businesses with economic moats on the other hand will reward their investors with “excess” returns and therefore deserve a higher P/E than the 10-12 commodity multiple.

Free Cash Flow Yield

Although we have been talking extensively about the P/E ratio and the equivalent earnings yield, there is a different yield that I focus on. Rather than base my analysis on accounting earnings, I prefer to look at free cash flow. Free Cash Flow is the ultimate reflection of what belongs to the shareholder at the end of the year. Therefore in analyzing an investment opportunity I focus on the free cash flow yield rather than the earnings yield.

Earnings may overstate what is available for shareholders because earnings does not take into account capital expenditures that the business must make. Alternatively earnings may understate what is available for shareholder because the earnings figure has deducted certain expenses such as depreciation which in fact do not require cash to go out the door. Cash is the ultimate thing that matters in the valuation of a business. You can’t buy things with earnings, you have to pay cash.

Therefore I look at how much free cash flow I am getting in relation to how much I am paying. This is called the free cash flow yield.

I choose to focus on this yield at the level of the entire business but it would be equivalent if you chose to do it on a per share basis. I envision what would happen if I purchased the entire business and had access to its entire cash flow. If I purchased all of the equity of the business (Market Capitalization) how much free cash flow would I be getting in return?

In short, I am trying to buy as much free cash flow for as little as possible. I am looking for high free cash flow yields or equivalently a low free cash flow multiple. I typically target a free cash flow yield of at least 10% which corresponds to paying less than a 10X multiple of free cash flow. These are pretty demanding standards as only a small number of investments offer these kinds of free cash flow yields.

Let’s look at few examples from the current market environment. The following companies are all in the technology industry. Compared to other areas of the market many of these yields are fairly attractive, but I believe investors should be strict in their investment criteria regardless of what others are doing. I typically begin getting interested in taking a closer look at an opportunity as the free cash flow yield approaches 10% and above.

As an example, let’s look at Cisco Systems. If I purchased the entire equity of the company it would cost me $170B. In return for that $170B, the business is currently producing $12.9B of annual free cash flow. Therefore if I owned the entire company my free cash flow yield would be 12.9 ÷ 170 = 7.5%. A 7.5% free cash flow yield isn’t bad, but it simply isn’t cheap enough for me yet; I usually require slightly higher free cash flow yields. With 12.9B in free cash flow, I would start become very interested if price declines in the market brought the market capitalization down to the area of 130B rather than 170B.

Out of these investments the one that would catch my eye would be Juniper. If I bought the entire business today it would cost me 9.6B. As the now owner of Juniper, I would have access to the current free cash flow generation of 1.2B. This equates to an attractive yield of 12.5%.

Now, investors shouldn’t go out and mindlessly buy any stock with a high free cash flow yield. We should still go through all of the normal analysis such as assessing whether the business has a durable competitive advantage, looking at the capital allocation decisions of management, calculating the returns the company is getting on its capital, assessing the opportunity for future growth, etc. However, if all of your analysis indicates that we are looking at a strong business, a double digit free cash flow yield indicates an attractive valuation.

Summary

• Investors should consider thinking in terms of yield rather than multiples because it more explicitly illustrates what you get (yield) against what you have to pay.
• P/E and Earnings Yield are inverses of each other. For example, a stock with a P/E of 15 equates to an earnings yield of 6.66%.
• By converting to yield, we can more easily compare to other asset classes that are most likely to be quoted in terms of yield rather than multiples.
• Buying things cheaply (Low P/E, High Earnings Yield) drastically outperforms buying things that are expensive (High P/E, Low Earnings Yield).
• The more you have to pay for each dollar of earnings the lower or rate of return will be. Buying $1 of earnings for $10 is superior to buying that same $1 for $25.
• The commodity multiple is in the range of 10-12.
• Investors should focus on free cash flow yield because free cash flow is the best measure of the money available for distribution to the shareholders.
• You should try to buy as much free cash flow for as little as possible. In other words, you should seek out high free cash flow yields.