Investors seeking to evaluate whether a stock is a viable investment should be looking to ensure it generates a consistent rate of return, regardless of whether that is made up of capital growth or dividends, as well as a track record of free cash flow, according to an Australian global equity manager.
Talaria co-chief investment officer Chad Padowitz suggested given the ongoing success of segments of the market, such as technology stocks, investors should base their valuations on a steady rate of return that offsets market risks.
“We think it’s appropriate to look for an 8 per cent discount rate or, to put it another way, we want to see 8 per cent a year return right now. That’s the number we think is an appropriate rate of return for taking equity market risk,” Padowitz told smstrusteenews.
“It’s broadly consistent with the long-term delivery of what fairly priced equities should deliver. If you think of interest rates and inflation probably being less than half that number, it’s an appropriate equity risk premium as well.
“How do you earn 8 per cent? Well there are two ways and the first is the company gives you an 8 per cent dividend yield.
“Alternately it gives a lower amount and reinvests retained earnings, and it grows at a certain rate to get 8 per cent, so it has 5 per cent earnings yield, but the growth rate of the company is 3 or 4 per cent.”
He pointed out actual earnings were more certain than growth, which may not be achieved or may even be negative, and that was a consideration in regards to some of the Magnificent Seven technology stocks, which he noted were paying earnings around 3 per cent alongside a 5 per cent growth rate.
“That sort of ratio of earnings to growth tends to be a very tough ratio to maintain as markets don’t tend to keep price-to-earnings ratios at around the 30 to 40 times for that long.
“If you are expecting return of 15 per cent a year, you’re almost guaranteed to be disappointed over time and if you want a lower number than eight, you might ask yourself why you’re investing in an asset class that has some level of risk as well.”
Padowitz added while returns were an important consideration, indicators of free cash flow were critical as well.
“Some companies tell you they make ‘X dollars’, but you find there’s non-recurring items, restructuring costs there or bad acquisitions that destroy capital,” he said.
“So if a company over the last 10 years says they earned ‘X dollars’ of net income, one way to check on that is how much free cash flow was actually generated as it is a time-tested proof point that takes away accounting tricks and the bad allocation of capital.”