The thought of doubling your money in the stock market sounds good, doesn't it? Achieving this goal isn't all that hard if you can hold onto your investments for a long enough period of time. Even at a relatively low annualized growth rate of 4%, an investment would increase by 100% in value in around 18 years.
If you want to double your money over a shorter time frame, though, it's not as easy. You'll need to carefully evaluate numerous stocks to select the ones with the best chances of delivering strong returns. While there are several factors you'll need to consider, one especially stands out. Want a stock that can double? Focus on free cash flow.
Image source: Getty Images.
What exactly is free cash flow?
Cash flow is simply the cash that flows in and out of a business. Every company on the market has cash flow. But not all of them generate free cash flow. Free cash flow is the amount of cash that's left over after a company covers its operating costs and makes any capital expenditures. These capital expenditures include all money spent on buildings, land, and equipment.
Some financial websites show the free cash flow generated by a company over the last 12 months. You can also calculate the metric by looking at the company's cash flow statement. All you have to do is subtract capital expenditures (sometimes shown as something similar to "purchases of property and equipment") from net cash provided by operating activities (which could also be listed as something similar to "cash provided by operations").
Free cash flow is important because it tells you how truly profitable a company is -- even more clearly than its net earnings metric does. That's because the net earnings figure includes items such as amortization (spreading the cost of assets over time) and depreciation (the reduction in the value of assets over time), inventory valuation changes, and stock-based compensation. Such non-cash items can be manipulated to make a business look more profitable than it actually is.
Using free cash flow to evaluate stocks
Ideally, you'll want to invest primarily in companies that generate positive free cash flow. However, there are some cases where companies have negative free cash flow on a temporary basis, but are positioned to quickly return to delivering strong positive free cash flow.
Amazon (AMZN -3.42%) is a good example. The bad parts of the company's latest quarterly update included a free cash flow number of negative $9 billion. The reason for that dismal number was that Amazon invested heavily in capital spending. But the company is now reducing its capital expenditures, so it should swing back to producing significant positive free cash flow in the near future.
A better scenario is when a company is growing its free cash flow robustly. MercadoLibre (MELI -1.24%) stands out as a business of this type. Free cash flow for the Latin American e-commerce and fintech company has skyrocketed by nearly 570% over the last year.
Free cash flow can also help you determine which stocks are valued attractively. Just look at the stock's price-to-free-cash-flow metric. The inverse of this number is called free-cash-flow yield. A low price-to-free-cash-flow ratio and high free-cash-flow yield can mean that a stock is cheap -- as long as the company's free cash flow isn't expected to decline in the future.
If you want an example, check out Occidental Petroleum (OXY -0.36%). The oil and natural gas stock trades at around 4.9 times free cash flow, giving it a free cash flow yield of close to 20%. By comparison, the biggest oil stock -- ExxonMobil -- trades at roughly 8.3 times free cash flow with a free cash flow yield of around 12%. It's not surprising that famous value investor Warren Buffett has been aggressively buying shares of Occidental.
Stocks most likely to double
The stocks that are most likely to double combine the best of all worlds. They generate positive free cash flows. Their free cash flows continue to grow quickly, reflecting businesses that are becoming more profitable. And they trade at attractive free cash flow yields compared to peers, indicating that the market hasn't yet recognized their full potential.
Admittedly, such stocks can be hard to find. However, they do exist.
Keep in mind, though, that great free cash flow numbers don't guarantee that a stock will double. Other factors will come into play, including how the overall market performs, competitive dynamics, and sheer luck. But generally speaking, the stronger a stock's free cash flow growth is and the more attractive its free cash flow yield is, the better its prospects for solid long-term gains are.
