The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.
One of these calculations is the forward rate of return pioneered by famous value investor Donald Yacktman, the founder of Yacktman Asset Management (Trades, Portfolio). An estimate of what kind of returns investors might be able to expect to see from an investment, the forward rate of return takes into account the normalized free cash flow yield as well as real growth and inflation.
Forward rate of return
The forward rate of return is a calculation that Yactkman takes into consideration in his investment approach. Unlike the earnings yield, the forward rate of return uses the normalized free cash flow of the past five years and considers growth and inflation.
“When we buy something, we try to look at it as if we were buying a bond,” Yacktman said in an interview with Barron’s published on May 22, 2010. “If a bond [price] declines, its yield goes up. So if a stock declines, its forward rate of return goes up.”
As a measurement of the attractiveness of a stock, the forward rate of return has an advantage over the earnings yield in that it measures growth rather than taking a snapshot of a limited point in time. Looking for a high forward rate of return in potential investments can thus help to weed out companies that are not growing or that are in decline.
The forward rate of return is consistent with Yacktman’s investing principles, which center on high-quality businesses, low purchase prices and shareholder-friendly management. When it comes to the returns that can be expected from an investment, the price paid is just as important as the quality of the business.
Calculation
In a March 2012 interview with GuruFocus, Yacktman described the calculation of the forward rate of return as follows (the S&P 500 was at about 1,400 at the time):
“If the business is stable, this calculation is fairly straightforward. For instance, on the S&P 500 we would normalize earnings. We would then calculate what percentage of those earnings are not reinvested in the underlying businesses and are therefore free. Historically, for the S&P 500, this has been just under 50% of earnings. Currently, we expect the S&P to earn about 70 on a normalized basis, a number which is far below reported earnings due to our adjusting for record high profit margins. $70 X ½ / 1400 gives you a normalized free cash flow yield of approximately 2.5%.
The historical real growth rate of the S&P 500 (companies) is about 1.5%. Assuming an inflation rate of 2.5%, the forward rate of return on an investment in the S&P 500 is about 6.5% today (2.5% free cash flow yield plus 1.5% real growth plus 2.5% inflation).”
When calculating the forward rate of return for stocks, GuruFocus uses the following formula:
“Forward Rate of Return = Normalized Free Cash Flow / Price + 5-Year Ebitda Growth Rate”
For the growth part of the calculation, GuruFocus uses the five-year average growth rate of Ebitda per share, and the growth rate is always capped at 20% in order to keep exceptional results from skewing the data. Normalized free cash flow refers to free cash flow per share averaged over the past five years (keeping it comparable to the growth rate by using the same timeframe). The price refers to the share price as of the end of the same time period measured by the other two components of the calculation.
Uses and pitfalls
The forward rate of return basically tells us what returns a stock is likely to provide if the company behind it continues growing at the same rate it has been growing at in recent years. This is what makes it incredibly useful as a screening criterion when looking for new investment ideas.
GuruFocus users can find Yacktman’s forward rate of return in the “valuation & return” section of each stock summary page:
The forward rate of return can also be selected as a screening criterion in the “valuation” section of the GuruFocus All-in-One screener:
In general, the forward rate of return is considered high if it is in the double-digits range. However, investors should keep in mind that no stock is guaranteed to continue its strong performance in the future. If the company’s growth slows, or if a black swan event occurs, then future returns could be negatively impacted.
The forward rate of return also suffers from an issue that plagues several other valuation metrics: namely, some financial stocks, as well as some small-cap startups with no earnings of their own but plenty of investment dollars for research, can have artificially inflated forward rates of return due to their unique capital structures. That doesn’t mean that these stocks aren’t good investments – it just means that the forward rate of return is not a useful measurement of their potential.
