While earnings are typically the focus of analysts when projecting a company's growth, the free cash flow metric is arguably more useful and reliable. Earnings are an accounting number and as such, can be manipulated to meet or exceed expectations. Free cash flow, as a measure of the actual cash that comes in and goes out of a business is a much more reliable figure.

TUTORIAL: Investing Concepts

Loving Free Cash
Simply defined, free cash flow is a company's net income plus depreciation and amortization less any dividends paid and other capital expenditures. In more simplistic terms, free cash flow is merely cash flow from operations less capital expenditures.

Ultimately, free cash flow is the concrete cash that a company generates in a given period. It's the cash left over after a company pays its bills and other expenses to run the business. So it would stand to reason that a company that generates a high level of free cash flow relative to its valuation and competitors should be looked at very favorably. Indeed in his seminal work, "The Theory of Investment Value" written over 70 years ago, John Burr Williams stated that the value of any company is merely the sum of all the cash that can be taken out of the business discounted at an appropriate rate. (For more, see Free Cash Flow Yield: The Best Fundamental Indicator.)

Free Cash Flow Monsters
(NYSE:MD) provides physician management services to hospital based pediatric units. The company operates in over 33 states and Puerto Rico. The company has a market cap of $3.2 billion and no net debt. Shares trade for 16 times earnings. Over the past three years, free cash flow has averaged over $200 million a year. To be sure, MEDNAX is susceptible to Medicaid reimbursement levels, an inherent risk of any medical service provider. (For more, see 4 Companies With High Free Cash Flow Yield.)

Industrial company Wabtec (NYSE:WAB) looks a lot more expensive than it may actually be. This provider of equipment to the rail industry trades at 26 times earnings. Yet 2010 free cash flow of $156 million is approximately 18 times the company's enterprise value of $2.9 billion. With the rail industry growing again, the demand for Wabtec's products should remain solid going forward.

Technology stocks often generate healthy levels of free cash flow due to their light capital-expenditure levels. But that doesn't mean all tech stocks pass the test. For example, online jewelry retailer Blue Nile (Nasdaq:NILE) currently has an enterprise value of $640 million while free cash flow in 2010 was $40 million. That values the company at 16 times EV/FCF, significantly less than the company's P/E ratio of 57. Still, Blue Nile may not be as attractive as it looks. The economy is still recovering and selling high ticket items may not be a reliable bet to make over the next couple of years.

Selling medicine, on the other hand, is a good business. And pharmaceutical company Forest Labs (NYSE:FRX) looks incredibly compelling for the patient investor. FRX has an EV of just over $5 billion and annual free cash flow of nearly $1 billion. The big risk for FRX is that their blockbuster drug Lexapro goes off patent in 2012 and currently accounts for 60% of the company's revenues. The company recently announced its intent to acquire Clinical Data (Nasdaq:CLDA) for $30 a share, or $1 billion, in cash. Even after the acquisition, that will leave FRX with over $2 billion in cash on the balance sheet. FRX has a strong pipeline of new drugs as well. All those options coupled with the healthy cash generation form a recipe for favorable upside potential.

Count the Cash
At the end of the day, it's all about cash flow. Earnings are indeed critical but if they can't be connected to the balance sheet, then they are less likely to create any long-term value. (For more, see Free Cash Flow: Free, But Not Always Easy.)

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

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares FTSE RAFI US 1000

    Find out about the PowerShares FTSE RAFI U.S. 1000 ETF, and explore detailed analysis of the fund that invests in undervalued stocks.
  2. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  3. Stock Analysis

    Fortinet: A Great Play on Cybersecurity

    Discover how a healthy product mix, large-business deal growth and the boom of the cybersecurity industry are all driving Fortinet profits.
  4. Stock Analysis

    2 Catalysts Driving Intrexon to All-Time Highs

    Examine some of the main reasons for Intrexon stock tripling in price between 2014 and 2015, and consider the company's future prospects.
  5. 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.
  6. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  7. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  8. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  9. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  10. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
  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 formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  3. 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 >>
  4. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  5. 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 >>
  6. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... 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!