Buy Quality on the Cheap

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

NutriSystem (Nasdaq: NTRI) and Freeport-McMoRan (NYSE: FCX) are trading with price-to-earnings ratios that hover near or below single-digit territory, while Johnson & Johnson (NYSE: JNJ) and J.C. Penney (NYSE: JCP) clock in with P/Es below their own five-year averages. The likes of ValueClick (Nasdaq: VCLK), Terra Industries (NYSE: TRA), and DryShips (Nasdaq: DRYS), meanwhile, sport stock prices that are at least 20% below their 52-week highs.

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

Buy low! Sell high!
Just kidding, actually. Indeed, that's one piece of investment "advice" I suspect you've heard all too many times, and the only proper response 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
That's the tack that Philip Durell -- the Fool who leads the charge at our Motley Fool Inside Value newsletter -- takes each month as he scoops up two picks from the market's bargain bin for his subscribers. Despite their loads of free cash flow, these companies' shares are currently on sale.

One of Philip's picks is a big-box retailer that churns out billions in free cash flow each year. Another is a home-products retailer with a current P/E well below its five-year average.

Now what?
The next time you think you've found a quality company at a can't-miss price, make sure it shows you the money. Using DCF analysis can help guide you to real cash and real promise -- for a real bargain.

And if you'd like to peek at Philip's full lineup of picks, just click here to take Inside Value for a risk-free spin. Your trial won't cost a thing for 30 days and will 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 is adapted from a Shannon Zimmerman article originally published on Jan. 25, 2007. It has been updated.

Rex Moore is an analyst for Motley Fool Stock Advisor. Of the companies mentioned, he owns shares of Johnson & Johnson. Johnson & Johnson is a Motley Fool Income Investor pick. The Fool has a strict disclosure policy.