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
MEDNAX (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!