Buy Quality on the Cheap

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

ExxonMobil (NYSE: XOM  ) is trading at an earnings multiple well below its five-year average. Wal-Mart (NYSE: WMT  ) and PepsiCo (NYSE: PEP  ) are trading at discounts to their recent historical levels, too, and the likes of Wells Fargo (NYSE: WFC  ) , Cisco (Nasdaq: CSCO  ) , Chevron (NYSE: CVX  ) , and Apple (Nasdaq: AAPL  ) 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 and, for the 10 years that ended with August, has cranked out an annualized gain of more than 23%. Another of our companies, a go-go small-cap contender, is a reliable cash-generator, one that has 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 this October, 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. Apple is a Motley Fool Stock Advisor recommendation. Wal-Mart is an Inside Value choice. The Fool has a strict disclosure policy.

Read/Post Comments (4) | Recommend This Article (7)

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 October 12, 2008, at 10:37 AM, goatsnuff wrote:

    OK, Time to think about some buying. What do you think.

    1- Pepsi or Coke

    2- J&J or P&G

    3- Exxon or Chevron

    4- Intel or Microsoft

    5- IBM or AAPL

    6- MRK or PFE

  • Report this Comment On October 12, 2008, at 1:13 PM, sliderulemoose wrote:

    1. Buy Pepsi - Coke is in atransition period now. ( I own Coke, I wish I owned Pepsi)

    2. J&J AND P&G (I own PG, but I am seeling some to roll the money into bonds)

    3 Exxon ( I own Exxon)

    4 Microsoft. There is no competition for the software. Hrdware is a chancy business

    5. Neither

    6. Neither. Too many risks because what Washington may try to force down big pharmas throat. Big Pharma may just move to another country that is friendlier to industry.

  • Report this Comment On October 20, 2008, at 5:57 PM, weakmine wrote:

    If Lowes is doing so good how come they are laying people off. the reason I know this is they layed me off and several others.

  • Report this Comment On October 27, 2008, at 1:00 PM, bricks79 wrote:

    Don't be fooled by the negative comments on Big Pharma and fear of the Democrats. Historically, the Dems have been good for stocks. Healthcare is a growth industry and stocks like Phizer have a lot of cash, a high dividend and are valued as if they are going out of business. Don't forget, there are many former Democrats as lobbyists in Washington. Long MRK, PZE, IYH.

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