9 lessons for investors: How farmers yield higher returns

Applied to DNP, ADYEY, INMD, DUR, BABA

This image is doing the rounds on X by different accounts:

Think like a farmer

My grandparents were farmers. And my parents had to work on the land before and after their day job!

Although you could extract a lot of wisdom from the above picture, my goal is not to go into detail about each of them. This has been done before.

And the master frequently references farming as a proxy for great investing.

Here’s a great video where Buffett draws a comparison.

A small extract from his wisdom:

• When you buy a farm, you buy it based on the yield it might produce, not on what price anyone else is trying to offer

• You think about the future potential of the farm

• Now you get this idiot neighbor, who is a manic depressive, might smoke some pod from time to time, and offers prices that are just all over the place

• The guy is there not to instruct you, but to serve you. You do not need him.

There is one thing I learned from my grandparents

➡️In the end, a farmer is interested in one thing: the yield

A farmer will diversify by planting different crops and looking at prices to decide what dollar yield he can extract from a certain area of land.

In investing, most discussions are around P/E ratios or EPS growth. I rarely see a discussion purely based on yields. Yields are the inversion of the ratios more commonly used.

Let’s dive into 9 different yields, and see how we can use them to understand a business and compare companies.

Consider the following definitions:

We’ll apply these yields to 5 different companies:

• Dino Polska (Ticker DNP.WA) ➡️write-up

• Adyen (Ticker: ADYEY) ➡️write-up

• Inmode (Ticker: INMD) ➡️30-page pdf

• Duratec Ltd (Ticker: DUR) ➡️write-up MMMT Wealth

• Alibaba (Ticker: BABA) ➡️write-up

Which of these 5 companies will reign supreme?

Here’s the overview of the first 6 yields:

Let’s start the yield analysis

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1. Earnings Before Taxes Yield

Warren Buffett favors this yield. Investing is all about opportunity costs. The earnings before taxes yield allows Warren to compare it to a 10-year treasury bond. 

The idea is this: If there is no more growth, and the company behaves like a bond, does it yield more than a treasury bond?

The current US 10-year treasury sits at 4.5%

From the table, we see that Dino Polska and Adyen have a yield lower than the 10-year treasury. Is this a problem? No, but it’s a first interesting piece of information.

Let’s continue the yield analysis.

2. Earnings yield

This is the P/E multiple upside down. How much am I getting from the land?

Earnings yield = Net Income/Market Cap

But there are problems with the earnings yield:

1. It’s based on profits, not cash

2. Profits can swing, and there can be one-off items

3. Profits may not take into account capitalized costs

Duratec and Inmode provide the highest earnings yields. But will they hold up taking into account these 3 caveats?

3. Owner’s earnings yield

Let’s go beyond profits, and look at cash. 

We take the cash from operations and subtract:

   Stock-Based Compensation

   Non-Controlling Interests (if any)

   Maintenance Capex or Depreciation Costs

To arrive at the owner's earnings. Divide by the market cap.

This yield is an improvement as it starts with cash and considers capex in addition to opex.

➡️How much can I extract from the business without impacting its operations?

Most owners’ earnings yields in the table are close to the earnings yield except for Alibaba and Duratec.

Why?

For Alibaba, there is a big difference between its income from Operations (10B) and Cash Flow from Operations (25B) which increases the owner’s earnings. For Duratec, it is the other way around. One of the reasons is their change in working capital. Baba runs a negative working capital.

4. Normalized earnings yield

When using earnings, one should also aim to remove all non-recurrent items. The easiest way is to use some sort of average margin and multiply this by the current revenue. That’s what we did. The best way is to go through the income statements line by line.

Normalized earnings yield =

(6-year average owner earnings margin x current revenue)/market cap

This tells us that Adyen, Duratec, and Alibaba all had higher margins in the past as the current calculated normalized yield is a lot higher. 

5. Free Cash flow Yield

Now let’s deduct ALL net CAPEX (including the growth capex). What is left over is excess cash generated by the business. It does not need this cash to grow, or to maintain it.

FCF Yield = FCF / Market Cap

FCF = OCF - Net CAPEX

For Dino and Duratec, we see a drop in yield when compared to the Owner’s earnings yield. The reason is that Dino and Duratec use a lot of growth capex to grow their business. The other companies have a free cash flow yield similar to the owner’s earnings yield.

Some businesses need very little growth capex to sustain growth. This might signal a MOAT. Companies like Dino and Duratec reinvest big parts of their cash flow to grow. (at a high ROIC). They compound.

But a high free cash flow yield on itself is worthless. Capital allocation is the bridge from the company to the investor.

How can we as investors get hold of some of that cash?

6. Shareholders Yield

If the company has excess cash, it can decide to:

1. Do nothing

2. Pay a dividend

3. Buy its own shares

4. Pay down debt to strengthen the balance sheet

The first part is what happened at Inmode. The company generated loads of excess cash in the past. It had few reinvestment opportunities. But it did nothing. Shareholders have not been rewarded. Luckily, they have since decided to launch a buyback program.

Net Payout Yield = Dividend Yield + Buyback Yield

Paying down debt = Debt Paydown Yield

• Duratec has the highest shareholder yield of 6%. It has a dividend yield of about 3% and has paid down part of its debt for again about 3%.

• Dino has paid down some of their debt, it does not pay dividends or buy back stock.

• Alibaba has been buying back shares and paying a dividend.

But when we look at the table once more:

We look at yields from the past. Although they are helpful, they are not a guarantee for the future. So we will add 3 more yields to the mix:

1. Forward earnings yield

2. Forward free cash flow yield

3. Total Shareholder’s return yield

Let’s look at the first 2

7. Forward earnings yield

The data is provided by finchat.io and the forward EPS and free cash flow are calculated as the mean of all analyst consensus estimates.

Here’s the evolution of the forward earnings yield for the 5 companies:

8. Forward Free Cash Flow yield

And when we add this to the table before, we get this:

When looking just at the color of the table, Inmode, Duratec, and Alibaba seem best positioned based on forward yields.

One important thing to mention from the Finchat formula list. The Forward FCF yield is based on the total enterprise value. This also explains why the Forward Yield for Inmode increases to 13.6% as Inmode has a lot of cash on its balance sheet.

But something is missing. Based on this table, can we conclude Inmode to be the best investment? We know Inmode is struggling with growth.

It’s time for the final yield and arguably the most important one.

9. Total Shareholder return yield

From Mauboussin and Morgan Stanley, we know what Total Shareholder Return looks like:

• Your return is a combination of price appreciation and dividend (reinvestment)

• Price appreciation is a consequence of EPS growth and multiple expansion/contraction

• EPS growth is a consequence of net income growth and share count (buybacks or share issuance)

• The PE multiple depends on a combination of ROIIC and earnings growth. When both improve, the multiple should expand. ➡️see our article on the PE-multiple

You can use these drivers of total shareholder returns and put them into a formula as we have seen in the Polen Capital Heat map.

You can download the Excel from our Tools section.

The formula is as follows:

Expected return yearly yield = 
    Eps growth + 
    1/period(final P/E-current P/E)/current P/E + 
    dividend yield + 
    buyback yield

This is a forward-looking yield, so you’ll need to:

• Estimate how earnings will grow in the coming years

• Determine if the P/E-multiple will contract or expand

• Add the expected dividend and buyback yield for the future

Instead of exactly calculating what the expected return would be, we assign a probability rating to see if the company passes the hurdle rate. We use the following simple scale:

Let’s apply the formula and heat map to the 5 different companies:

Dino Polska

• EPS has grown at a rate above 30% over the past 5 years. Although Dino will continue to roll out its strategy, we do not expect to keep growing its EPS. We’ll estimate a 15% to 20% EPS growth rate over the coming 5 years.

• Will the multiple expand or contract? The multiple is a function of ROIIC and growth. We know growth has slowed a bit. But ROIIC will remain similar to before as Dino keeps on investing. So we should factor in a multiple compression

• Dino has no dividends or buybacks, it will not issue any in the next 5 years

The expected return heat map becomes:

➡️To reach a 10% hurdle rate, for a final multiple of 20, Dino needs to grow EPS at 15%. Based on the past, and considering all the new store openings, we consider the probability high.

Adyen

• Adyen’s growth has slowed down. Its last EPS growth was 22%. Its middle-term outlook is around 20% growth. 

• There are no buybacks or dividends with Adyen 

➡️Let’s assume Adyen’s multiple gets compressed. If Adyen trades at a multiple of 30 in 5 years, it needs more than 15% growth in EPS to be able to deliver a 10% yearly return. That seems reasonable. We consider the probability to be: Medium

Inmode

• Inmode is currently struggling to find growth. The consensus forecast is an EPS decline of -5% over the next 2 years

• It has launched the intent of a buyback program of about 10% of shares outstanding. Because I do not know if they will continue to buy back in the future, I’ve put the buyback yield at 2%.  

➡️To pass the current hurdle rate of 10%, without multiple expansions, it will need to grow at 7% EPS each year over the next 5 years. If EPS does not grow in the coming years, it would need a multiple expansion towards 13. Inmode has the ROIC, but it may not have the growth to justify such a multiple. We consider the probability: low

Duratec

• Net Income has grown fast over the past 3 years, with a 50%+ CAGR

• ROIC has been increasing since 2021

➡️To reach a 10% hurdle, Duratec only needs to grow EPS at 6% if we consider the PE-multiple to stay flat over the coming 5 years. We consider the probability very high.

Alibaba

• After a steep decline, Baba is growing its EPS once more at a rate of 15%

• Its ROIC is stable at around 8-9%

• Since ROIC is pretty low, there might be an impact on the multiple in the future if it does not improve

➡️To reach a hurdle of 10%, and consider a slight multiple contraction to a PE of 16, it needs an EPS growth rate of 10% which might be doable based on the most recent data. We assign a medium probability.

The final table with all 9 yields then becomes:

It’s important to look at the past and the future. Based on the entire table, Duratec seems to be the most attractive investment as it ticks all the boxes except that it’s not as capital-light as some of the other companies.

As we discussed in our deep dive on Inmode, to go beyond a 10% yearly return, it needs to extend its buyback program and grow its EPS even at low single-digit percentages. If it buys back its shares at a 10% clip each year, then there’s no problem in reaching the hurdle.

Summary

This article showed a 9-step yield analysis. 

We went from earnings before tax yield towards free cash flow yield to understand the past of the company.

We used expected shareholder returns in a heat map to look at what the future might bring based on what we know of the companies.

Instead of calculating the expected return directly, we asked what the company needs to do to pass a 10% hurdle rate. We assigned a probability to each company.

Based on the information we have, Duratec seems to be the best pick. Although I have read the write-ups by Sohra Peak Capital on Duratec, I did not do a deep-dive analysis of the company. I do not hold a position at this time.

What do you think of this yield analysis and way of comparing companies?

I hope it provides some value and as always,

May the markets be with you!

Kevin