Before we get started, in case you are tempted to use the title of this article as proof that the top of the market has been reached, keep in mind, if you read my previous articles, I am a bit skeptical of this rally. That said, this analysis I have just done has made me think twice about being too cautious going forward. That is hard for me to say, but the numbers don't lie.
Today I want to take a look at the value of 25 Dow components at the end of 1999 compared to the value of the same 25 Dow components at the end of 2010, and show the reader that even though the Dow has only gained 80 points in those 11 years, the underlying value of the businesses have increased by about 168%.
Let's dig in. First I want to make the case for Free Cash Flow as the way to value a business. If I were to buy the local widget franchise on my street corner for a new family business, I would want to know what the bottom line income I could take out of the business to live on. Looking at free cash flow of a publicly traded stock allows this type of comparison. As Fund Manager of the Decade Bruce Berkowitz said in the 6th Edition of Graham and Dodd's Security Analysis, "Graham and Dodd referred to that excess cash as 'earnings power' or 'owner earnings.' That's the amount of cash an owner can pocket after paying all expenses and making whatever investments are necessary to maintain the business. This free cash flow is the well from which all returns are drawn, whether they are dividends, stock buybacks, or investments capable of enhancing future returns."
Now for an example. Assume the local widget franchise on my street corner is selling for $1,000,000. After paying all my expenses and investing in new capital equipment to maintain the business, pretend I can take home $26,600. Before making the $1,000,000 investment, I would have to decide if a 2.66% return on my money was worth the risk of buying that business. Let's also pretend that back then, if I decide to buy, I only desire to take home $15,000 and leave the remaining $11,600 in the business to expand or buy a competitor, pay down debt, or buy out any partners I may have taken on. I want to look at total owner earnings (free cash flow) rather than just take home pay (dividend yield), as the determing factor for whether I should buy the widget store or not. The $15,000 take home pay is the equivalent of the dividend yield on the Dow back in Dec 1999. The $26,600 is the equivalent of the free cash flow of the 25 stocks we will look at today. This means that these stocks could have paid out all of their free cash flow in the form of dividends (take home pay), giving the owners a 2.66% yield. Not bad when looking at today's low yields from savings accounts, but back then, the yield on a 10 year "risk-free" treasury bond held to maturity would have paid the same investor $65,000 per year for $1 million invested. So investors on Dec 31,1999 that decided to buy these 25 stocks (below) in equal amounts, were willing to take the risks of the stock market in order to earn $26,600, instead of investing in the risk free rate from the government which was $65,000. That equates to 59% less income, for much more risk. Not a good trade off based on those numbers if you ask me. At year end 1999, investors who were buying these stocks, were most likely over paying and not getting a very good risk-reward investment in return.
Fast forward to Dec 31, 2010. These same 25 stocks we will look at below are now showing a free cash flow yield of 7.15%. That is like buying the widget franchise for $1,000,000 today, but getting owner cash flow of $71,500. If I decide to buy today, I can take home the entire cash flow and get a 7.15% return on my money. Let's assume I take home roughly what the Dow was paying at the start of the year, which was about $25,000. That is roughly 60% more take home pay than I would have received in year end 1999. After the 60% increase in take home pay, I am still left with $46,500 that I can use to pay down debt, buy out partners, expand, etc. Did you just see that? The money I have left over after a 60% pay raise is 75% more than the entire amount I could have earned back in 1999 year end, and today's left over cash flow is about 400% more than what was left over back then. A 60% pay raise and 400% more cash left over. That is huge. Even though the price of the Dow has pretty much gone nowhere, by waiting 11 years to buy today, I am getting a much better return on my invested money. So much for the argument that the Dow components have not created any wealth for investors. Dow companies have done a great job creating wealth, the problem lies in the fact that investors over paid by a lot 11 years ago.
The list below shows the 25 stocks I am analyzing with their free cash flow yield in 1999 year end compared to 2010 year end. You will notice I have not included 5 stocks. I did not include Kraft Foods (KFT) because they went public in July 2001 from the old Philip Morris which is now Altria (MO). Altria spun the remaining shares of Kraft off in 2007. I also did not include financial companies due to the fact that their free cash flow yields are astronomically high in 2009. JP Morgan (JPM) shows 67% yields for example. With all of the Wall Street bailouts, it's hard to even know how to value these money suckers anyways. It's best to stick to real businesses whose wealth building is easily measured by cash flow, not government bailouts. We are not including Bank of America (BAC) for the same reason. American Express (AXP) was a bit easier to value, but we did not include them as they are also a financial company, even though their numbers have increased nicely over the testing period. Finally - insurance stocks are a bit different in that it's more important to look at book value when looking at these. The Traveler's Companies was left out for this reason, although they have increased book value roughly 110% during this test.
Also - the current Dow components are not the same Dow stocks in 1999. This fact will throw off the yield numbers above, but for this test, we are assuming each of these 25 stocks could have been bought at 1999 year end. Another assumption we are making is that we are investing equal amounts in each of the stocks, while the Dow itself is price weighted. So the higher a price, the more weighting it gets in the actual Dow. That all said, let's take a look at the current 25 Dow stocks for this analysis, using free Value Line information. Keep in mind some of the 2010 numbers are based on Value Line estimates, so they are rough numbers, not exacts. I got the information here: www3.valueline.com/dow30/index.aspx
|Stock||YE 1999 FCF%||YE 2010 FCF%|
|Equal Weight Total||2.66%||7.15%|
|10 Year Treas. Yld||6.50%||3.83%|
As you can see above, these Dow components make a very strong case for buying stocks based on this one metric. In Dec 1999, if you were able to invest equal amounts into each of the 25 stocks, your owner earnings would have maxed out at 2.66%, which was 3.84% LOWER than the income you could have taken home from the risk free bond. Today, the story is quite different. Assuming you bought each of these stocks in equal amounts at year end 2010, and the companies decided to pay all the owner earnings out in the form of dividends, your income yield could be 7.15%, compared to 3.83% for the risk free income of a 10 year treasury bond. That is a MASSIVE 3.32% (86.6% higher) more income than the bonds, which in my opinion, more than compensates for the potential risks. Would you rather own the local widget franchise that earns the owner $71500 per year, or buy a treasury for ten years and get $38,300 in income? For 86.6% more income, I think the answer is quite obvious.
In conclusion, while stock prices might have been dead money for the past 11 years, it is important to realize that price is not everything. As the market continues to rip higher in the face of daily POMO activity, and as it guns for its old highs, it is also important to remember that the underlying companies are much more valuable today than they were at these prices in 1999.
The Dow closed on Dec 31, 1999 at 11497, and ended 2010 sitting at 11577. It seems to be a lost 11 years for investors, which, if you look at the price, is true. Buying the 25 stocks we looked at using the 2010 year end Dow price of 11577, is the equivalent of buying the Dow in 1999 at 4277. I would guess you would do that if you could go back in time and get the Dow at 4277. Another way to view it, if these stocks were to return to a free cash flow yield like that of 1999 around 2.66%, then the Dow today would have to rise 168% from the year end 2010 number of 11577. That puts the Dow at 31120. I am not saying we get there, but want you to just see the comparison apples to apples. Bottom line, based on 1999 valuations, today's Dow would need to trade at 31120 to be a comparable valuation bubble. Now you can also understand the absurdity of the prices people were paying for stocks back in 1999.
Today, you get over twice the cash flow for your money from these 25 Dow stocks, even though the price has not changed.
This analysis causes the "caution bear" in me to stop and wonder why I keep waiting for the next crash. If nothing else, the case is there that these stocks could easily increase their dividend payout ratios to a level that is higher than the current yield on the 10 year treasury, and still have plenty of cash flow left over to expand the business, pay down debt, or buy back shares.
Disclosure: I am long MO, T, CVX, CSCO, XOM, INTC, JNJ, KFT, MCD, MSFT, PFE, PG, TRV, VZ, WMT, HPQ
Additional disclosure: I have clients that have long positions in every stock mentioned in this article. Also - there is risk to principal in owning treasury bonds. I am saying risk-free inferring to the income they produce, and assuming the reader understands the US government can print the money they need to make payments as our Fed leaders have stated. I am in no way telling the reader that they can own treasuries and not experience risk in the bonds not held to maturity.