For most individual investors, analyzing the financial statements of the companies in which they own stock is no easy task. While the numbers reported on a corporate income statement are relatively straightforward, all too often the meaning behind them is not. Accrual accounting being what it is, seemingly simple items such as earnings per share can often prove difficult for investors to value appropriately.

IN PICTURES: 7 Tools Of The Trade

Earnings Aren't Always Reliable
In fact, a company's reported earnings rarely represent the amount of cash it managed to bank in a given year. This is because there are myriad ways that accounting events can affect a company's accounting income while having no impact on the actual cash transactions a company makes during a reporting period.

Non-cash charges such as the amortization of goodwill or intangible assets can reduce a company's reported earnings significantly, turning what would have been a good-looking earnings number into an apparent failure. On the other hand, sales generated by accounts receivable contribute to reported earnings just as cash sales do, but they won't pay a company's cash expenses, such as payroll. Too much reliance on accounts receivable could put a company in a difficult situation, even while its reported earnings appear just fine.

Cash Is King
This is where prudent comparison of a company's income statement with its cash flow statement serves an individual investor well. After backing out all the non-cash, non-recurring and otherwise impertinent items that are baked into reported earnings, the cash flow statement reveals the true cash-generating ability (or inability) of a company to investors. (For related reading, check out Fundamental Analysis: The Cash Flow Statement and The Essentials Of Cash Flow.)

As such, stocks that generate cash flows significantly greater than their reported earnings can potentially end up undervalued by the market. As well, stocks that are consistently able to produce large amounts of operating cash flow are arguably safer than those that don't, as having plenty of cash coming in the door each quarter makes it that much less likely that a company will run into trouble paying its bills.

With that in mind, here are five stocks generating significant amounts of operating cash flow, yet are trading at relatively cheap valuations on a price-to-cash-flow basis.

Company Market Cap Operating Cash Flow (TTM) Trailing Price/Cash Flow
The Chubb Corporation (NYSE: CB) $16.8 B $2.3 B 7.2
Lockheed Martin (NYSE: LMT) $26.5 B $3.7 B 7.2
Rent-A-Center (Nasdaq: RCII) $1.3 B $208.1 M 6.5
Dean Foods (NYSE: DF) $1.8 B $553.4 M 3.3
Tyson Foods (NYSE: TSN) $6.3 B $1.5 B 4.3
Data as of market close, August 20, 2010.

Dean Foods

Dean Foods provides an example of a company that has consistently hauled in larger amounts of cash flow than it has booked in reported earnings. In its most recently completed full fiscal year (ended December 31, 2009), the company reported a net income of $240.3 million. However, during this same period of time, it actually brought in $658.7 million worth of operating cash flow.

Even after subtracting its capital expenditures of $268.2 million from its operating cash flow, Dean Foods still managed to generate $390.5 million in free cash flow for its shareholders. This represents a significant positive difference from its net income, and a similar type of disparity existed in its previous fiscal year as well. From the individual investor's perspective, this is definitely a positive attribute that lends strength to the bullish case for Dean Foods.

Rent-A-Center's financial statements provide an even stronger example of a company bringing in significantly more cash than its reported earnings would indicate. For example, in its three most-recently completed fiscal years, Rent-A-Center earned $167.9, $139.6 and $76.3 million, while its operating cash flows for each of those same years were $330.1, $384.7 and $240.4 million, respectively.

Why does the company consistently bring home more cash than reported income? Because each year it has been able to reduce its taxable earnings with more than $500,000 million worth of depreciation, which is a non-cash charge. However, its capital expenditures have averaged well under $100,000 per year, and thus its non-cash depreciation amounts each year have essentially acted as a tax shield, because the company has been able to claim the depreciation expense but has not needed to replace the depreciated assets with comparable capital expenditures - at least, not yet.

The Bottom Line
As the examples of Dean Foods and Rent-A-Center illustrate, there is a lot of context behind a company's annual earnings that is not readily apparent from its earnings-per-share number alone. In some cases, companies are consistently able to generate significantly more cash flow than reported earnings, and although it does not look great on an income statement, it can be a boon to stockholders.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  2. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  3. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  4. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  8. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  9. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  10. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!