Companiess 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. Therefore, sometimes the value of cash to a company never looks obvious until a business needs it most. It's only then that one realizes why the balance sheet should always come before the income statement in valuing a business.
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Don't Overpay for Cash
However, just because a company is cash rich doesn't mean it's a good investment. In fact, companies flush with cash can often have rich share prices. Google (Nasdaq:GOOG) is one such name. Google is now a $190 billion company with over $47 billion in cash and short term investments but, shares currently fetch 18 times earnings. It's an excellent business with a dominant position in the tech space but, compare that with Microsoft (Nasdaq:MSFT), a $245 billion company who's shares currently trade for 11 times earnings.
SEE: Value Investing Using The Enterprise Multiple
Cheap Cash Plays
Yet just as the market has enriched the share price of some cash rich stocks, it has also left some potential bargains in the wake. Southwest Airlines Co. (NYSE:LUV) is a $7 billion company with over $3.7 billion in cash and $3.31 billion in debt. Also, shares trade with a forward P/E of 8.63 (fye Dec 31, 2013), and the company has also generated $1.64 billion in operating cash flow in the last year.
Another interesting company is health insurance provider Humana (NYSE:HUM). All insurance companies are required to hold a required level of statutory cash, so you will find most well known insurance companies to have a net cash position, however, Humana has over $11 billion in net cash against a $12.8 billion market cap. The shares trade for 9.7 times current year's earnings and generated $2.75 billion in free cash flow in the last year.
SEE: Free Cash Flow Yield: The Best Fundamental Indicator
The Bottom Line
Cash always looks boring when it builds up and just sits there. Sure there is legitimate concern that cash rich companies can make poor investment decisions with the cash. But identify quality companies with loads of cash, and the upside optionality looks great.
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