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Hedge fund manager, long/short equity, value
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In order to help me determine the value of a purchase, I use something I call the Total Return Yield [TRY]. It simply tells me what I am getting in return from the company for my purchase price. For me, it is a gauge of value; the higher the rate, the more I am getting for each dollar I invest. I do not know if this is used under another name by anyone else, but it is working for me.

Currently, the common measurement of this metric is what is called the Earnings Yield [EY]. It is simple to determine, and is just the reverse of the PE ratio. Rather than dividing the price by the earnings, to get the EY we divide the earning by the price. That tells us the return in earnings for each dollar we invest. An example: We purchase a stock for \$10 that earns \$1 a year. The PE ration is 10 (\$10 /\$1), that means we are paying ten times the earnings per share for each share. The EY is 10% (\$1/ \$10). It tell us that for each dollar we pay, this stock will return 10% to us in earnings. This is a good gauge, but I feel totally inadequate. Why?

In a word, dividends. Let's look closer. What are dividends? They are monies paid from retained earnings (money in the bank) to shareholders. Isn't this a return to us? What the company is essentially saying is, "our business requires "x" dollars to function and grow, but our earnings are large enough where we have "x plus" in the bank, so here you go - as an owner, take some." Again, we have to look at the purchase of a share of stock as a purchase of the whole company. If we bought the whole company, we would receive all the money in the bank (retained earnings). All dividends are is a partial payment of that to us for buying part of the company. When I figure my Total Return Yield [TRY], I take the EPS (earnings per share) and add the dividends per share to it then divide by shares outstanding.

The argument from accountants will be that dividends are paid from earnings that do not need to be reinvested in the company, so to count them again is in essence "double counting" them, which will artificially inflate my return. That argument is technically correct by accounting standards, but not correct for our uses. (Let's not get stuck on that point, gang, these are the same people who did not classify stock options to as an expense to the company. Yeah... employee compensation was not an expense?).

Here is why I claim it is incorrect to make their assumption: If we were buying the whole company and going to value it, part of our valuation would include a value of the money in the bank (retained earnings). So if we are to believe the accountants argument, because we are only buying a portion of the company, we should not value the return of that money in the bank (dividends) to us? The way retained earnings (money in the bank) are treated for accounting purposes does not quantify what years earnings they represent.

Why does this matter? Let's assume I buy stock in a company that earns \$1 a share and pays me a \$1 dividend. The next year I own it, earnings drop to \$0 for whatever reason, but they still pay me my \$1 dividend. Where did the \$ come from? Prior years' earnings. The point here is that when you buy a stock that pays a dividend, you are also buying a claim to unused portions of prior years' earnings that are paid to you in the form of that dividend. We must include that value in our return. This process does admittedly favor dividend paying stock so we need to look closely at that:

There are only three reasons a company will not pay a dividend, and two are bad: