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Why Choice Hotels International's Earnings Are Outstanding

Seth Jayson
July 30, 2012

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are often less trustworthy than cash flow, as they're more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so to see whether it bears any relationship to the net income in the headlines. That's what we do with this series. Today, we're checking in on Choice Hotels International (NYSE: CHH  ) , whose recent revenue and earnings are plotted below.

Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, Choice Hotels International generated $128.5 million cash while it booked net income of $118.9 million. That means it turned 19.4% of its revenue into FCF. That sounds pretty impressive.

All cash is not equal
Unfortunately, the cash flow statement isn't immune to nonsense, either. That's why it pays to take a close look at the components of cash flow from operations to make sure the cash flows are of high quality. What does that mean? To me, it means