The maths is relatively straightforward, and any half-decent calculator will do the sums for you.
Bond yields can then be readily compared with the yield on other investment instruments, or on bonds of different types and maturities.
In theory, equities should be valued in just the same way. But unfortunately the maths is nothing like as easy. Not only are the future dividends much more difficult to forecast, but there is no easy way to determine what the lifespan of the company will be, or the final capital value of its shares.
Bonds, by contrast, have both a fixed interest rate (the coupon) and a pre-determined repayment date.
Much effort has been devoted over the years to constructing discounted dividend or cash-flow models for the valuation of equities, but the assumptions that have to be made are usually so heroic as to make the exercise of little practical value.
For everyday purposes, most investors are still forced back on shorthand measures such as the price/earnings ratio and dividend yield.
Both have serious flaws as analytical tools. Earnings, in particular, are a notoriously unreliable basis for valuing shares.
Research has consistently shown that there is no discernible correlation between the earnings that companies report under accounting rules and their share price performance.
The market has long since rumbled that company earnings can be manipulated with ease. Dividend yields, at least, are based on something more concrete, an actual cash payment, but they too give only a small part of the story about what a company is worth.
It is encouraging therefore to find reaching London a new attempt to crack the conundrum of equity valuation. It comes from Holt Value Associates, a Chicago-based firm of financial consultants whose guiding light, Bart Madden, has been refining his cash flow valuation model for many years. The firm has started marketing it to professional fund mangers in the City this year, and found several takers.
Mr Madden's valuation "mousetrap" is undoubtedly a step up on earlier discounted cash flow models in this field.
The basic analytical tool Holt uses is "cash-flow return on investment". The analysis is complicated, but suffice it to say that it essentially focuses on how good managers of a company are at generating a real (inflation- adjusted) return on the capital that shareholders and lenders have given them to invest.
To avoid accounting distortions, it looks at the net cash receipts that a company generates, not at its earnings.
One key feature of the model is that, in projecting future cash flows, it takes on board the notion - well supported by empirical evidence - that companies which achieve above-average returns on capital do not do so indefinitely.
Over time, as competitors come in, or managements run out of inspiration, even the highest flyers see their returns fall back towards their long- term average.
Holt calculates that the average real return (on its definition) achieved by British industry is about 6.5 per cent, and has been consistently about that level for several decades. An exceptional company, a Microsoft or a Glaxo, may manage a 15 per cent real return for 10 years, or longer, but eventually they too will start to run out of steam.
Any company that fails to generate a real return of more than 6.5 per cent is destroying, not creating, wealth for its shareholders.
How does this help judge the market now? Bells and whistles are all very well, but results are after all what count. Holt provides monthly buy lists to its clients, and also calculates target prices for the companies. These are based on management's past performance and what it sees as the company's future potential for generating value for shareholders.
But, unfortunately, it is still too early to judge the results. Chris Faber, Holt's man in Loncon, admits that the methodology works better for industrial companies than for financial ones. Whatever its value as a stockpicker, the programme is a powerful analytical tool that provides a useful reality check on what the market is saying about a company's prospects.
One thing that the Holt methodology shows clearly is how much value the market is assigning to a company's existing assets and how much to its future (still to be made) investments. In a number of cases, the second value is close to zero; and sometimes even negative. When that happens, it tells you that a company may have had a good run in the past, but the market lacks faith in its ability to invest future capital profitably.
In such cases, the best thing the management can do is to start shrinking the company, by selling assets or returning capital to the shareholders. (Managers, for some strange reason, never seem to warm to that idea much). A quick spin through Holt's database last week threw up some interesting examples. Something like 60 per cent of the current value of Reuters, for example, according to Holt, can be attributed to the value of its existing assets, while 40 per cent is down to the present value of the capital investments it has yet to make. By contrast, British Gas is one of several companies whose existing assets account for 100 per cent or more of its present valuation. In other words, the market has little confidence in its future growth prospects (which you probably knew already).
When I asked Chris Faber to come up with some current buy suggestions, he listed the following. For aggressive investors with a tolerance of greater risk: BET, Farnell Electronics, Powerscreen and Reuters. For more defensive investors, BP, Grand Met, Burmah and Unigate. All have been trading below their indicated values on the Holt system. The risk in the former groups comes from the fact that they generate exceptionally high returns on capital, which are therefore vulnerable to erosion by competitors. Faber particularly likes Bass, the brewer. The bad news for those who go on about the need to encourage more investment in British industry is that too many companies in this country are still investing capital in projects whose returns do not cover the cost of that capital. As many shareholders know to their cost, there is nothing magic about capital investment per se. It can just as easily be wasted as made to earn a return. (Banks are particulary good at throwing it away on dodgy prospects).
That is one reason capital allowances, such as those proposed by the Shadow Chancellor Gordon Brown last week, sound great, but rarely do much good in the long run.Reuse content