The Sweet Smell of Money

Are Warren Buffett and Bill Miller just lucky?

They'll tell us some luck was involved in their phenomenal investment success. But luck favors the prepared. Do you want to know the secret to their success? They understand that the value of a company is the sum of its future cash flows, discounted to the present.

If you and I want to become better investors, we should use the the discounted cash flow equation to analyze how companies create value. After all, over the long haul, stock prices rise in concert with increasing value.

Show me the money
There are many definitions for free cash flow -- a favorite Foolish method for discovering a stock's true value -- but we'll use the following to make the illustrations clear:

EBIT * (1 - Tax Rate) - (CAPEX - Depreciation) - Change in Working Capital

To increase the amount of free cash flow to the firm, a company can:

• Increase its operating earnings (EBIT)
• Decrease its tax rate
• Decrease its CAPEX
• Increase its depreciation charges
• Decrease its working capital requirements.

Some of these measures aren't always wise or practical. There's a limit to how low a company's tax rate can go, depreciation is an accounting choice, and reducing capital expenditures can limit future prospects. Imagine what would happen if General Motors (NYSE:GM) stopped investing in its factories, or if Comcast (NASDAQ:CMCSA) stopped maintaining and upgrading its network.

So we'll focus on how decreasing working capital requirements and increasing operating earnings can bolster free cash flow and create value.

Working capital
Working capital is the cash needed to manage day-to-day operations. The change in working capital is defined from the balance sheet as:

(Current Assets - Cash) - (Current Liabilities - Short-Term Debt)

Managing working capital requires managers and employees to roll up their sleeves. It's not glamorous, but it can be powerful.

Dell (NASDAQ:DELL) is the poster child for great working capital management. Thanks to its just-in-time assembly process, it receives cash from customers 40 days before it pays suppliers!

Information technology software player Symantec (NASDAQ:SYMC) increases free cash flow by decreasing working capital requirements every year. Granted, it's a bit easier for a company that sells software to manage inventory. Still, the company must manage its receivables and payables.

From the table above, you can see that the market rewarded Symantec for its efforts and boosted Dell to a lesser extent.

Operating earnings
Most companies need to invest in working capital to generate cash. As a result, some cash flows out. But that's OK, as long as they can fund those investments with operating earnings. Here are two examples of companies with a strong track record of increasing margins.

Florida Rock, a cement company, and Stericycle, a medical-waste disposal company, are not fast growers in sexy industries. On average, both have grown sales between 10% and 15% per year. I think you'll agree that increasing margins, not sales growth, drove their stock price appreciation.

Three steps to success
When searching for great companies, look for:

1. Good working capital management
2. Increasing margins
3. Relatively low capital investment requirements.

Business research and education company Corporate Executive Board (NASDAQ:EXBD) puts all three steps together. As you can see from its chart, investors have been richly rewarded by its extraordinary business performance.

Value creation through free cash flow generation is the hallmark of a Philip Durell recommendation in the Motley Fool Inside Value newsletter. Now that you know an important piece of the value investor's secret to success, come get your free, no-strings-attached 30-day guest pass to see how Philip beats the market.

Remember: Informed investors beat the market!

Fool editor David Meier does not own shares in any of the companies mentioned. Corporate Executive Board is a Motley Fool Stock Advisor recommendation, while Dell has been selected by both Stock Advisor and Inside Value. The Motley Fool has a disclosure policy.