Earnings Yield on Cost
Measure wealth by the cash a business grows relative to your purchase price
- Difficulty
- Moderate
- Time to result
- ~ongoing to results
- Steps
- 6
- Confidence
- 97%
Earnings yield on cost evaluates an investment as if the investor bought the entire business. Begin with sustainable cash earnings after spending enough to maintain the company's productive capacity, then compare those earnings with the original purchase price. The initial ratio establishes the starting yield. The crucial question is whether the business can increase that cash generation over ten, twenty, or thirty years. If earnings rise substantially, the yield on the investor's original cost rises with them and the asset becomes more valuable regardless of temporary market quotations. This owner-oriented perspective resembles evaluating an apartment building by its rental cash flow. Daily price fluctuations become secondary because long-term returns are expected to come from the cash the business produces rather than predictions about a future valuation multiple.
Origin
Extracted from Masters in Business through Chris Davis's apartment-building analogy and his explanation of how Davis Advisors measures generational wealth creation.
Core principles
- 01Buy businesses rather than price symbols
- 02Anchor returns to the price originally paid
- 03Measure sustainable cash after necessary reinvestment
- 04Let long-term earnings growth drive wealth
- 05Treat market quotations as offers, not appraisals
How to run it
- 1
Think like a whole owner
Evaluate the company as an operating business you could own outright, not as a ticker whose price changes daily.
Pro tip Describe plainly how the company converts invested capital into cash.
Watch out Do not let price charts substitute for business analysis.
- 2
Normalize cash earnings
Estimate cash available after the reinvestment required to keep customers, assets, and operations healthy.
Pro tip Separate maintenance spending from discretionary growth investment.
Watch out Reported net income may not represent owner cash.
- 3
Calculate the starting yield
Divide normalized cash earnings by the proposed purchase price to establish the earnings yield on cost.
Pro tip Use conservative normalized figures rather than a peak year's result.
Watch out A high starting yield may reflect a deteriorating business.
- 4
Project long-term compounding
Assess how retained earnings, competitive advantages, and reinvestment opportunities could expand future cash generation.
Pro tip Focus on ten-year economics rather than next quarter's estimate.
Watch out Do not assume growth creates value unless reinvested capital earns an adequate return.
- 5
Track earnings against cost
Periodically compare current sustainable earnings with the original purchase price and the initial thesis.
Pro tip Monitor business progress even when the stock price is volatile.
Watch out Do not mistake multiple expansion for operating wealth creation.
- 6
Treat quotations as optional offers
Use market prices to buy or sell when advantageous, but do not let an irrational quote redefine the economics of the asset.
Pro tip Ask whether you would accept the same offer for a privately owned building.
Watch out Liquidity can provoke unnecessary action.
In the wild
An investor buys an apartment building for ten million dollars and evaluates the cash left after maintaining the roof, furnaces, and tenant experience. If the property's annual cash generation later rises materially, the investor has created wealth even if a buyer temporarily offers less than the purchase price.
→ Operating cash growth, not the latest outside offer, determines the owner's economic progress.
Common mistakes
Watching the quote instead of the business
Daily prices can create anxiety and activity even when underlying cash generation remains healthy.
Ignoring maintenance spending
Cash is not distributable owner earnings if it must be reinvested to preserve the business.
Relying on future multiple expansion
The framework expects returns to come primarily from business earnings, not a prediction that someone will pay a higher multiple.
Is it for you?
Best for
It is best for patient owners evaluating durable businesses with understandable cash economics.
Not ideal for
It is not ideal for short-term trading or businesses whose sustainable cash generation cannot be estimated.
From the transcript
“we think a lot about earnings yield on cost as sort of the way to build wealth and measure that wealth creation over time.”
“We look for the returns to be driven by the cash the business produces over a long period of time”
“Will the earnings that business produces over time build wealth not over three years or five years, but over ten, twenty thirty years.”
From the episode
Christopher Davis Discusses Smart Value Investing