EMC's Enchanting Expectations

Storage supplier EMC's (NYSE: EMC  ) cup has runneth over in recent times. Sales are up. Earnings are up. The balance sheet is stronger, and today, during the firm's annual meeting with analysts, EMC's executives happily shared the good news that revenues would likely grow by 30% from 2003 to 2004. That translates into $8.1 billion in sales this year, which is expected to deliver $825 million in profits, after a one-time charge of $25 million from the first quarter. That's more than 66% better than last year's $496 million in net income.

Much of this success has been credited to great acquisitions, and a new strategy to help customers manage information wherever it may be. Indeed, EMC's turnaround has been impressive, placing a spotlight on the firm. A huge first quarter has also boosted expectations dramatically, so much so that EMC, despite its strengths, may be one of the worst stocks you could buy. Or could it? Let's have a look at some numbers.

Everything looks great at first blush: An expected 66% rise in earnings this year easily bests EMC's current price-to-earnings ratio of 43. But that hardly tells the whole story. Estimates for EMC's long-term profit growth -- three to five years out -- are closer to 14% annually, resulting in a price-to-earnings-to-growth, or PEG, ratio of better than 1.6, indicating a stock whose current price already factors in the bulk of future growth.

But P/E and PEG ratios aren't perfect. I'd consider them the equivalent of a level and a tape measure in a toolbox full of screwdrivers, hammers, wrenches, and, with enough room, maybe a miter saw. That's probably why our team at Motley Fool Hidden Gems rarely uses these measures, opting instead to look at cash flow in valuing picks. (To learn more, I urge you to read Rex Moore's excellent feature on why cash isn't a cruel measure.)

How does EMC stack up? It's a close call. A quick check today shows the firm trading at roughly 17 times its enterprise value-to-free cash flow. Annualizing results from this year's first quarter would give EMC roughly $1.35 billion in free cash flow for 2004, which is 81% higher than its total from four years ago. That's roughly 16% growth per year -- near enough to the multiple to call EMC fairly valued on a cash flow basis.

Does EMC appear to be a great business? Yes. Can you sleep your way to profits in some great businesses? Of course. But is every great business a great investment? Most assuredly no.

Think valuations are hocus-pocus? Think again. Tom Gardner's rigorous approach to picking winners has already yieldedMotley Fool Hidden Gemssubscribers better than 50% average returns, walloping the market. Subscribe before June 20 to lock in the lowest possible rate.

Fool contributor Tim Beyers thinks he isn't fairly valued on a cash flow basis. C'est la vie. Tim has no ownership interest in any company mentioned, and you can view his Fool profile here.


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