Measuring True Profitability

You are ushered quickly into the room. "There it is," the agent says, pointing toward a dimly lit corner several yards away. "Do you want to buy some or not?"

Squinting, you're able to make out a rather large pile of nuggets. But just how big is the pile? And how much of it is really gold, and how much is just worthless gravel? You move toward it to investigate further, but two burly men in dark suits step in front of you. "No closer!" barks the agent. "It's $150 per pound if you want any."

And so it is with stock investing. We're expected to figure out if $150 per share is a good price to pay for a certain company, yet we can't get close enough to really measure things the way we want. We're kept at arm's length, having to settle for news releases and quarterly earnings reports that barely reveal the inner workings of the business. Perhaps we're certain that if the nugget pile is three feet high, four feet wide, and made up of at least 1% real gold, it would be worth $150 per pound. But we don't know the dimensions and composition with any certainty.

Good investors are constantly searching for metrics that help measure what a company is truly made of. The most important of these, in our way of thinking, is free cash flow. Let's take a brief look at what free cash flow measures and how Tom Gardner has strengthened its measuring abilities by morphing it into structural free cash flow.

Free is good
Most longtime Fools can recite the definition of basic free cash flow (FCF) in their sleep: cash from operations minus capital expenditures. The resulting number is a much better measure of a company's profitability than reported earnings, which are extremely susceptible to manipulation. Creative accounting can alter net income -- and thus earnings per share.

But cash from operations (also called operating cash flow) measures the actual cash that flows into and out of a business, and that's hard to fake. That measure is further improved as we subtract capital expenditures, which is the money a company is spending on buildings and equipment. The resulting free cash flow figure is the cash available for anything management sees fit: to plow back into the business, for example, or to pay out as dividends. FCF gives us a good measure of true profitability (or lack thereof).

If you'd like more details about this important metric, including where to find the necessary numbers in the financial statements, check out Can't Beat Cold Cash.

Getting bare
Tom Gardner has decided to simplify FCF down to the bare, operational essentials for his Hidden Gems service. Here's his formula for what he calls structural free cash flow:

Net income + depreciation + amortization +/- onetime items - capital expenditures

The formula begins with net income and adds non-cash depreciation and amortization charges. It also adjusts for onetime items that aren't part of ongoing operations and subtracts capital expenditures.

"The advantage here," Tom says, "is that you get a clean look at a company's foundational assets and its ability to generate excess cash for owners. I have found structural free cash flow, or owners' earnings, to be an extremely useful tool for finding undervalued companies that'll help you beat the market soundly. It isn't all-powerful, but this tool does help an investor see more clearly into a company's operations."

It's not the easiest thing in the world to figure out what qualifies as a onetime item. But this criterion is essential, and has the positive side effect of requiring deeper research into a company's operations.

It can't hurt to use both of these cash flow metrics in evaluating companies; like Coca-Cola (NYSE: KO  ) and PepsiCo (NYSE: PEP  ) , they're both good.

Proper tools for toiling
As you already know, it takes far more than one good tool to unearth great stocks. So far in this special series, we've talked about the advantages of buying smaller companies, how high levels of insider ownership are beneficial, and, today, the importance of free cash flow and structural free cash flow.

But there's much more in the Hidden Gems tool kit. In future weeks, we'll talk about evaluating management, the benefits of focus, return on equity, and much more. Our goal is to uncover future Dells (Nasdaq: DELL  ) , Wal-Marts (NYSE: WMT  ) , Pfizers (NYSE: PFE  ) , and, yes, even Ciscos (Nasdaq: CSCO  ) and Amazons (Nasdaq: AMZN  ) before they shoot up many times in value.

We hope you enjoy the education.

Tom Gardner has used these principles to generate 48% average returns for Hidden Gems selections since the service started nine months ago (vs. the S&P 500's 8% gain). You are invited to take a no-obligation free trial.

Rex Moore owns no companies mentioned in this column. The Fool has a disclosure policy.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 07, 2012, at 1:36 PM, f80d wrote:

    Can you please take a company, say PM, and from the annual data, calculate the "structured Free Cash Flow." Please point out thr one time item you chose.


    Jim Williams f80d

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