In the 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 apart 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, Applied Materials (Nasdaq: AMAT).

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

 

2011*

2010

2009

2008

2007

Normalized Net Income $1.5 billion $1.5 billion $29 million $0.6 billion $1.5 billion

Source: S&P Capital IQ. *12 months ended Oct. 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 $2.2 billion $1.6 billion $0.7 billion $0.8 billion $1.9 billion

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

Now we know how much cash Applied Materials 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 Applied Materials has returned to shareholders in recent years:

 

2011*

2010

2009

2008

2007

Dividends $397
million		 $361
million		 $321
million		 $322
million		 $319 million
Share Repurchases $468
million		 $500
million		 -- $923
million		 $1.8
billion
Total Returned to Shareholders $865
million		 $861
million		 $321
million		 $1.2
billion		 $2.1
billion

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

As you can see, the company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

 

2011*

2010

2009

2008

2007

Shares Outstanding (millions) 1,319 1,335 1,336 1,344 1,401

Source: S&P Capital IQ. *12 months ended Oct. 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 Applied Materials fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Sure enough, Applied Materials repurchased a lot of stock in 2007 when shares were high, and pulled back entirely as shares came tumbling down. Whether this was a prudent way to save cash as it looked like the economy was about to implode, or a classic example of buying high and panicking low, is up for debate. In general, it doesn't appear management has been the most astute buyer of its own stock.

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

Source: S&P Capital IQ.

Over the last five years, Applied Materials shares returned -20%, which drops to -28% without dividends -- not a bad boost to top off otherwise poor returns.

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, you, the shareholder, own the company. Are you happy with the way management has used Applied Materials' cash? Sound off in the comment section below.