I was fortunate enough to discover Benjamin Graham’s The Intelligent Investor before the global downturn in 2008. Graham’s suggestion to compare the earnings yield (of stocks) to the risk-free yield (of government bonds) proved to be an invaluable and protective tool.

However, it wasn’t until after the crash that I read Graham and Dodd’s 1934 classic, Security Analysis; it was the book that taught me how to invest in a business-like fashion. The following paragraph, tucked nondescriptly in the back-third of the book, changed the way I would invest forever:

It is an almost unbelievable fact that Wall Street never asks, “How much is the business selling for?” Yet this should be the first question in considering a stock purchase. If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking…Let the stock buyer, if he lays any claim to intelligence, a least be able to tell himself, first, how much he is actually paying for the business…

From Graham and Dodd’s suggestion, I saw something bigger: a formula that would provide the true ownership yield of a company with respect to modern accounting standards. After much deliberation, I conceived the following formula:

Liability-Adjusted Cash Flow Yield

10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

And so, “LACFY” was born.

Of course, the formula isn't perfect. It won't protect an investor from overvaluing a company with a large cash hoard overseas or an artificially-low tax rate (these two accounting anomalies often run hand-in-hand). Nor will it provide a fair valuation for a fledgling company with dramatic earnings growth (although, one can always modify the numerator to a best-guess cash flow figure).

But, for established companies with a long earnings record, liability-adjusted cash flow yield shows a more complete picture than the earnings yield alone (i.e. the inverse of the price/earnings ratio).

A Corollary Formula, "Inspired" by the Crash

When the financial crisis came to a boil in 2009, I noticed a funny thing. The companies that were cutting dividends (e.g. General Electric and Pfizer) had a dividend yield that exceeded the company’s liability-adjusted cash flow yield. It made perfect sense. These debt-laden companies had little recourse if they could not support their dividend with free cash flow and/or couldn't roll-over debt in a drying credit market. Based on this observation, I created a corollary pass/fail formula:

Dividend Acid Test

Pass = Dividend yield less than LACFY

Fail = Dividend yield greater than LACFY

Again, no formula is perfect. But, for any income investor who salivated at BP's yield following the Macondo disaster, the forthcoming dividend cut would have seemed a foregone conclusion.

Practical Use for Fixed-Income Investors

I fear that today's ultra-low yield bond market will leave many retired investors in the uncomfortable position of watching their real-return eroded by inflation. In my opinion (please note, this should not be construed as personal investment advice), retirees would be wise to allocate a portion of their investments to conservatively financed dividend-paying stocks that meet the following criteria:

LACFY is greater than Dividend Yield is greater than 10-Year Treasury Yield

This will provide the investor with a higher level of current income, and hopefully, better protection against a rise in interest rates.