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Using Free Cash Flow to Uncover
Profitable Firms |
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Published:
October 22, 2007
Earnings may be the most widely
watched gauge of corporate
performance, but they don't tell the
full story. After all, they
don't represent the actual cash
flowing into corporate coffers.
That's because earnings include a
wide number of non-cash charges such
as depreciation and amortization.
And although accounting rules in the
U.S. are fairly rigid, that doesn't
mean there isn't room to dress-up
earnings. Companies routinely use a
number of perfectly legal accounting
tricks and sleights of hand to
dress-up their earnings results --
most companies like to report
results that at least match Wall
Street's expectations.
However, cash flows offer a useful
way to gauge a company's growth and
profitability while avoiding some of
the pitfalls inherent in earnings
figures, since cash flow results are
far harder to manipulate. And one of the most useful
measures of cash flow is what's
known as free cash flow (FCF).
What is Free Cash Flow and How
Does It Work?
Free cash flow is defined as
follows:
Free Cash Flow = Operating Cash Flow
- Capital Expenditures
To get a better understanding of
this formula, we need to take a
closer look at each of its
components:
Operating Cash Flow -- This
line item, found on every public
company's statement of cash flows,
represents the cash a company
generates from day-to-day
operations. To come up with this
figure, take a firm's net income,
add back any non-cash charges (such
as depreciation), and then adjust
for changes in working capital.
Capital Expenditures (CAPEX)
-- This is the cash a company uses
to purchase or improve upon its
physical assets -- its property,
plant, and equipment.
So, if operating cash flow
represents the actual cash the
business generates and capital
expenditures are the investments the
company must make to operate its
business, free cash flow is
essentially a measure of how much
actual cash is left for the owners
of the business after expenses. In
essence, FCF is a measure of the
"cash profits" available to
shareholders.
Free cash flow represents the
lifeblood of any growing business.
With it, companies are able to
invest in future growth, pay down
debt, complete value-added
acquisitions, repurchase stock and
pay dividends (if done properly, all
of these tend to be
shareholder-friendly activities).
Without a healthy stream of free
cash flow, however, most businesses
tend to run into a host of problems.
These include ballooning debt
burdens, financing troubles, and
cash flow management issues, among
other things
What is "Good" Free Cash Flow,
and How Can I Profit from It?
Obviously, there's no magic number
or dollar figure that represents
good free cash flow. But one useful
comparison tool is the FCF/Sales
ratio, which is found by dividing
total annual free cash flow by
annual sales. The higher the ratio,
the more cash the business generates
per dollar of revenues. Again,
there's no magic number here, but a
FCF/Sales over 15% puts a company in
the top 10% of all U.S. firms.
And this is exactly what Paul Tracy,
editor of the
StreetAuthority Market Advisor,
went on a hunt for in a recent
issue. Paul and his staff used
proprietary screening techniques and
old-fashioned hard work to calculate
FCF/Sales ratios -- not only for the
trailing-twelve-months, but also for
each of the past three fiscal years
-- for legions of companies.
Specifically, they looked for
companies with FCF/Sales greater
than 15%. That means the companies
Paul uncovered are some of the most
profitable firms on the planet and
have plenty of cash to keep growing,
buy back shares, or pay dividends.
To see Paul's list of 12 companies
that made the grade, and to learn
more about the
Market Advisor newsletter,
visit this link. |
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