If you've sat through many job interviews, you've probably at some point been asked that most dreaded of all questions, "Do you have any weaknesses that might impact your ability to perform this job?" Fun stuff, that one. Nothing like telling a prospective employer why not to hire you. And c'mon, there's no use trying to spin some sort of my-weaknesses-are-strengths line like, "Well, sir, my one struggle is becoming so wrapped up in my work that I sometimes neglect my health." Uh-huh.

But with the exception of job interviews, I actually like this question. To state the profoundly obvious, being aware of one's weaknesses is essential for overcoming them. This is nowhere more true than the realm of investing in individual stocks. Either you become aware of your weaknesses and respond accordingly, or you get your financial clock cleaned. It's no wonder the market has been called "The Great Humbler" and "The Great Humiliator."

For me personally, the major weakness I've identified as an investor is my tendency to jump to conclusions. When I see a company that on the surface meets my investment criteria (strong cash flow, clean balance sheet, understandable business, reasonable P/E, etc.), my compulsion is to buy first and ask questions later. But I've discovered time and again that what I don't know most definitely can hurt me. And usually what I don't know -- and need to know -- is there to be found in a company's 10-K and 10-Q (which can be accessed through Fool Quotes & Data).

I bumped into just such a scenario recently when I was doing some follow-up research on one of the companies I spotlighted in my Small-Cap Value Radar series (Part 1, Part 2, Part 3, Part 4). As you'll recall, each of the companies in that series had a lot to like, including consistent cash flow from operations, a cash-rich balance sheet, and a low valuation. But some had more to like than others, and one of the names I mentioned as looking especially promising was Arden Group (Nasdaq: ARDNA), a Los Angeles-area chain of upscale grocery stores.

As I wrote on October 22:

The company's grocery business has shown nice growth over the years. Since 1995, annual sales have increased from $243 million to $392 million, or 8.3% annually. Also, management has diligently used its cash flow to repurchase shares almost every year, resulting in a decline in average shares outstanding from 5.2 million in 1995 to 3.4 million in 2001. As such, sales per share have actually grown at a 16.3% pace, or almost twice as fast as overall sales. Also impressive is the company's return on invested capital of around 25%. At a current price of $55.60, the stock is priced at 9.9 times free cash flow and 13.2 times earnings. In addition, the company has $14.48 in net cash per share. When you back out the cash, the business is priced at only 7.4 times free cash flow.

Darn it if that's not enough to make me want to pull the trigger. We're talking about a grocery store, one of the most stable and defensive of all businesses. No matter how bad the economy gets, you know people aren't going to give up on buying bread and milk. At an enterprise value-to-free cash flow (EV/FCF) ratio of only 7.4, how could this not be a profitable investment?

Well, after reading its 10-K and 10-Q, I discovered three reasons why the company wasn't as cheap as it looked on the surface:

1. Current capital expenditures understate the company's ongoing capital requirements
Back in October, when I originally calculated Arden's free cash flow (FCF), I was looking at capital expenditures (capex) for the 12 months through June 2002, which amounted to $7.5 million. What I failed to take into account is the fact that over the past five years, Arden's annual capex have tended to be a good bit higher. The following numbers are from page 6 of the company's most recent 10-K:

             Capex ($M)
1997             7.9  
1998             4.2  
1999            19.6   
2000             9.9  
2001            10.1
Average         10.3

This table shows that Arden's annual capex, while lumpy, are typically going to be higher than the $7.5 million I measured for the 12 months through June 2002. And if capex are normally higher, then FCF is normally going to be lower (because FCF equals cash from operations minus capex). This is all to say that I originally overestimated Arden's ongoing FCF capability.

Another sign that Arden's current capex understate the true ongoing capital costs of the business is that its capital expenditures are currently running below the company's depreciation charges. Let me explain this one. Depreciation is the estimated annual cost of upgrading all of the company's current plant and equipment. Capital expenditures, on the other hand, are the actual cost of purchasing plant and equipment.

For a growing business, capex will usually be higher than depreciation (because more equipment is being purchased than just that necessary to maintain the existing base of equipment); while for a mature business, capex and depreciation should be roughly equal (because equipment is being purchased only as necessary to maintain the existing stock of equipment). Rarely, however, will you see capex running below depreciation, at least not on average over a period of several years.

So, for Arden, as a modestly growing company, one would expect capex to be at least equal to, if not greater than, depreciation. But through June 2002, trailing-12-month depreciation was $8.2 million versus $7.5 million in capex. That's probably not sustainable. In situations like this, I substitute depreciation for capex in my calculation of FCF in order to get a more conservative estimate of ongoing FCF capability. Through June 2002, this more conservative estimate of FCF amounted to $18.0 million versus $18.7 million by my original estimate. Also, if you back out interest income, the adjusted level of FCF is further reduced to $16.3 million.

If I'd used this final number ($16.3 million) in my original EV/FCF calculation back in October, the EV/FCF ratio would've been 11.5. That's not a high multiple, but it's not nearly as cheap as my original calculation of 7.4.

2. Recently re-instated pension contributions will negatively affect future earnings
In the latest 10-Q, Arden reported a new pension expense that began in May 2002 and is expected to continue indefinitely. This, of course, poses negative consequences for future earnings. As of May, the company received notice that it is required to make payments into a multi-employer pension plan because of the union membership of its employees. These payments had been suspended in late 1999 because of the stock market's strong returns, but due to the bear market over the past several years, the payments have now been reinstated.

Arden estimates that it will have to pay $817,000 per quarter, or more than $3.2 million per year, to meet these obligations. For a company with $16.3 million in conservatively estimated free cash flow, you can see that this imposes a pretty significant obligation.

3. Recently increased insurance costs will negatively impact future earnings
If the pension thing weren't bad enough, Arden also reported in the latest 10-Q that as of October it faces dramatically higher workers' comp insurance premiums. This comes not as any fault of the company, but rather because of newly passed California legislation that seeks to reform the state's workers' compensation system. Arden's higher premiums will result in an incremental expense of $1.9 million annually.

Putting it all together
So we see that not only is Arden's FCF capability lower than I originally estimated due to capex issues, but also the company is in the process of absorbing two new significant expenses that will not fully reveal themselves in the financials until the coming year. Where, then, does this put Arden's valuation?

To answer that question, I worked up a model of Arden's income statement for the coming year. On the top line, I assumed 3% sales growth, and then from there I maintained its current margins but added the new expenses described above. The result was net operating profit after-tax (NOPAT) for 2003 of $12.3 million ($3.65 per share), which I expect will be roughly flat with this year's profit. By the way, for a company like Arden, I believe NOPAT is roughly equivalent to the company's ongoing FCF.

From a valuation perspective, this means Arden, at a recent $60, is trading for about 12.1 times expected 2003 NOPAT, plus $15.91 per share in cash. That's not expensive compared to companies in the S&P 500 (at an average P/FCF of 23.7), but it's still a good bit more pricey than what I originally estimated. It's also roughly in line with other grocers of similar caliber. It may be modestly undervalued, but not by nearly as much as I originally would've thought. Case in point for the value in not jumping to conclusions.

A winner found
On a final note, while Arden turned out to be lacking in investment merit, further research on one of the other companies in my small-cap value series did prove fruitful in finding what I believe to be a gem of a stock. That company is featured in our current edition of The Motley Fool Select, where Fool analysts profile their best investment ideas every month.

Matt Richey is a senior investment analyst for The Motley Fool. At time of publication, he had no position in any of the companies mentioned in this article. For his best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.