Buy Quality on the Cheap

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A quick check of the market's sale rack finds the following:

IBM (NYSE: IBM) is trading at an earnings multiple well below its five-year average. Coca-Cola (NYSE: KO) and Hewlett-Packard (NYSE: HPQ) are trading at discounts to their recent historical levels, too, and the likes of Berkshire Hathaway (NYSE: BRK-B), Pfizer (NYSE: PFE), General Electric (NYSE: GE), and Merck (NYSE: MRK) are not even within shouting distance of their 52-week highs.

Which can only mean one thing, right? It's time to ...

Buy low! Sell high!
Just kidding, actually. I'm sure that's one piece of investment "advice" you've heard all too many times, and the only proper response to it is, "Well, duh." The real question, of course, is how to know whether you're buying low and selling high. Discounted cash flow (DCF) analysis is one compelling way to answer that question.

Show you the money
Rather than focusing myopically on earnings (which are easily fudged) or on some kind of short-term market catalyst (which may never materialize), DCF analysis requires companies to show you the money -- literally.

By zeroing in on a company's free cash flow (cash from operations less capital expenditures), making conservative assumptions about future earnings growth, and applying a discount rate (the return you require given the business's risk), you'll be in a good position to determine whether a company is trading above or below its intrinsic value -- and within your margin of investing safety.

Follow the Fool
Gauging a company's cash flow history relative to its current price and forward-looking prospects is the tack I've taken for the stocks that appear in the Fool's new Ready-Made Millionaire service. One of our selections, for instance, is a medical-equipment manufacturer that delivered more than $840 million of FCF during its last fiscal year. For the 10 years that ended with August, it's cranked out an annualized gain of more than 23%. Another of our companies, a go-go small-cap contender, is a reliable cash-generator. It's racked up an annualized return of more than 24% over that same 10-year period.

Now what?
Coincidence? We think not. Indeed, the next time you think you've found a quality company at a can't-miss price, make sure it shows you the money. And if you'd like to peek at our full Ready-Made lineup when we reopen to new members, click here to learn more about the service and to snag a special report dubbed The 11-Minute Millionaire. The report is completely free, and it'll come in mighty handy, I suspect, as you go about the very important business of generating a little free cash flow of your own.

This article was originally published on Jan. 25, 2007. It has been updated.

Shannon Zimmerman runs point on Ready-Made Millionaire and doesn't own shares of any of the companies mentioned. Pfizer is a Motley Fool Income Investor pick. Pfizer, Coca-Cola, and Berkshire Hathaway are Inside Value picks. Berkshire Hathaway is a Stock Advisor recommendation. The Fool owns shares of Pfizer and Berkshire Hathaway. The Fool has a strict disclosure policy.