Do you ever wonder why investors get so worked up about rising interest rates? Well, the most obvious answer is that higher rates will elevate corporate borrowing costs, which can bite into profits. But there is an even more fundamental reason.
At the end of the day, we only invest in equities because we expect to earn better returns than we would get on a risk-free bank account or U.S. government bond. If Treasuries were yielding 8%, then nobody would buy stocks (and put their principal at risk) unless they thought the market could earn more -- perhaps 10% to 12%.
Fortunately, the bar is set low right now. Current yields on the 10-Year Treasury are at 2.2%, so the market only has to earn maybe 5% to 6% to warrant the increased risk. But the higher we go, the less appealing stocks look versus bonds and other investments.
That's important because it implicitly raises the cost of capital for publicly-traded businesses. And all things equal, the higher the cost of capital, the less a company is worth.
How Risk Is Priced Into Investments
Here's a simplified example:
Suppose that a "club" offered to pay each of its members $105 in precisely one year. Next, assume that you are fairly confident of being able to earn a 5% rate of return over the next twelve months from a safe bank money market or savings account. Based on those assumptions, how much would you pay in order to "join" this club today?
Well, if you invested $100 at the bank, then your money would grow to the same $105 in one year's time. Therefore, it would be a poor financial decision to pay one penny more than $100 -- doing so would provide a return less than the 5% you could get risk-free.
However, it would be profitable to join the club for anything less than $100, as that would offer a higher return than 5%. Would $99 do the trick? Probably not. This club might not have enough cash to fulfill its promise. It might even go bankrupt. So you would want a larger margin of safety to justify the risk.
Thus, the club (or a company) is expected to pay its members (shareholders) pro-rata cash flow of $105 in one year's time. Based on the required rate of return (discount rate) of 5%, the breakeven mark (fair value) for this investment would be $100.
Thus, if memberships were selling for $85, then they would be "trading" at a 15% discount to their fair value -- and probably worth buying.
Of course, in the real world, there is no guarantee that a company can deliver on its cash flow projections. And we have to forecast much further out than just one year. So the riskier the company (and the less predictable the cash flows), the larger the margin of safety.
A Bargain-Finding Short Cut
While this description sounds fairly straightforward, it's actually a complex process that incorporates numerous assumptions regarding growth rates, capital expenditures, weighted average cost of capital (WACC), and many other factors. Such variables are impossible to predict with exact precision, so I err on the side of caution by using deliberately conservative growth rates and other figures.
But if the companies overshoot forecasts, then the upside potential will be even greater.
Fortunately, there is a short cut to identifying companies that might be great bargains. The key input is free cash flow (FCF), so start there. The more cash a business generates, the more it's worth. So we can screen for companies with high FCF as a percentage of market cap -- I like to call it free cash flow yield.
It works just like dividend yield --simply replace dividend distributions with free cash flows. For the purposes of making picks for my premium newsletter, High-Yield Investing, any FCF yield above 12% automatically gets my attention. That means the company could pay out just half what it pockets and still support a yield three times the market average. No scrounging or borrowing to barely meet payments.
This high FCF yield is often the result of a depressed market cap -- which is another way of saying the stock is cheap relative to the cash being produced.
5 Cash-Flow Heavy Companies To Buy Now
I just recently ran an updated screen for high FCF stocks in my newsletter, and here's what came back.
It's important to filter the results of this screen because it doesn't incorporate growth assumptions. And future stock prices are dictated by tomorrow's results, not yesterday's.
Macy's (NYSE: M) qualified for this list, but I'm not including it. While it produced buckets of cash last year, next year is cloudy at best. Department stores are under siege as consumer shopping behaviors change, and the company is struggling with falling sales and weak store traffic. So I'd be careful right now.
But I see real value in DCP Midstream (NYSE: DCP), which owns 60 natural gas processing plants and 64,000 miles of pipelines. DCP is the nation's leading producer of natural gas liquids (NGLs), which has been a tough business lately as prices for products like ethane have crumbled. But management has restructured so that just 20% of the firm's cash flows will be sensitive to commodity prices next year -- 80% will be either hedged or fee-based in nature.
That will greatly smooth out the cash flow stream. DCP is aiming for a 120% coverage ratio on its $0.78 per unit distribution, which provides a lofty yield of 8.5%. And growth projects should keep that payout rising at a 4% to 5% pace over the next few years.
I've got DCP on my watch list as a potential candidate for my High-Yield Investing portfolio. I may dig into the company further and decide to add it at a later date -- but you'll need to be a subscriber to know that.
As for the other stocks on this list, they may prove to be worthy candidates for your own portfolio as well. Remember: stock screens like this are a good starting point for further research -- not hard and fast recommendations. In the meantime, if you're interested in gaining access to all of my High-Yield Investing picks, follow this link.
This article originally appeared on Street Authority.