In their quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear open a company's cash flow statement to see how much money is truly being earned, and, more importantly, what management is doing with that cash.

Step on up, CVS Caremark (NYSE: CVS).

The first step in analyzing cash flow is to look at net income. CVS Caremark's net income over the last five years has been impressive:

 

2011*

2010

2009

2008

2007

Normalized Net Income $3.5 billion $3.5 billion $3.7 billion $3.5 billion $2.9 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flow, or the true amount of cash a company has left over for its investors after doing business:

 

2011*

2010

2009

2008

2007

Free Cash Flow $5.0 billion $2.8 billion $1.5 billion $1.8 billion $1.4 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now we know how much cash CVS Caremark is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can either be stashed in the bank, used to invest in other companies, or to pay off debt.

Here's how much CVS Caremark has returned to shareholders in recent years:

 

2011*

2010

2009

2008

2007

Dividends $0.6 billion $0.5 billion $0.4 billion $0.4 billion $0.3 billion
Share Repurchases $2.6 billion $1.5 billion $2.5 billion -- $5.4 billion
Total Returned To Shareholders $3.2 billion $2.0 billion $2.9 billion $0.4 billion $5.7 billion

Source: S&P Capital IQ. *12 months ended Sept. 30.      

As you can see, the company has repurchased a decent amount of its own stock. But combined with share issuances (in part to finance acquisitions), shares outstanding have been fairly flat:  

 

2011*

2010

2009

2008

2007

Shares Outstanding (millions) 1,354 1,367 1,434 1,434 1,328

Source: S&P Capital IQ. *12 months ended Sept. 30.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does CVS Caremark fall into this trap? Let's take a look:

Source: S&P Capital IQ. 

There doesn't seem to be much method to the madness with CVS' share repurchases. There was indeed a pullback in buybacks in 2008 when shares were cheap, but the rest of the buyback behavior doesn't show signs of management getting excited when shares are expensive or panicking when they sink. In general, management has done a fair job with repurchases.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Over the last five years, CVS Caremark shares returned 34%, which drops to 28% without dividends -- a small boost to top off otherwise decent share performance.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember that you, the shareholder, own the company. Are you happy with the way management has used CVS Caremark's cash? Sound off in the comment section below.