Investors should often remind themselves that businesses derive their values from the cash flows they generate over time. When markets are climbing higher, that fundamental lesson is often forgotten, because rising stock prices tend to cloud sound business judgment. Many interpret a rising share price with excellent stock picking skill, quick to forget that a rising tide lifts all boats. Now is not the time to forget.
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To be sure, the U.S. economy continues to demonstrate improving fundamentals. Housing seems to be on the mend and the unemployment picture is brightening up. Add in a dose of low interest rates and it's easy to see the tailwind being applied to equity prices. However, investors would be wise to exercise caution with each rising market day.
While Amazon's (Nasdaq:AMZN) dominance as the world's largest online retailer is clearly the way of the future, the company's current enterprise value of $75 billion values the business at 44 times EV/EBITDA. While Amazon's future is certainly exciting, shareholders may come to realize a different experience. On the other hand, big boring Wal-Mart (NYSE:WMT), the world's largest traditional retailer, is changing hands at 7.4 times EV/EBITDA. On top of that, the shares yield 2.6%, nothing to sneeze at today. Indeed over the past 12 months, Wal-Mart shares are up about 17% versus a 10% return for Amazon.
Cash (Flow) is King
Companies producing attractive cash flows today are in a better position to insulate themselves from economic uncertainties. Many of these companies are taking a backseat to more exciting names, like Apple (Nasdaq: APPL); Xerox (NYSE:XRX) is a prime example. Trading at about $8.40 a share the company has a market cap of $11.3 billion. With $8.6 billion in debt, the company has an EV of $19 billion. Yet, over the past three years, the company has generated an average of nearly $2 billion in free cash flow each year. That cash flow is real, not a promise of growth.
DirecTV (Nasdaq:DTV) is also a high quality business pouring out cash flow. DTV trades for an EV/EBITDA ratio of less than 7 and is generating $2 billion to $3 billion a year in free cash flow. The company is experiencing rapid growth in areas outside the U.S., where cable penetration is low and demand is strong. Folks still keep the cable running during tough times.
The Bottom Line
Solid cash flow producing companies tend to have solid performing share prices over the course of time. Investors often get caught up with the allure of exciting gains, failing to realize that excitement is the enemy of the value seeking investor. Exciting gains can come with terrific losses; yet, the truly successful investment results come to the businesses with steady production of cash flow.
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At the time of writing, Sham Gad did not own shares in any of the companies mentioned in this article.