Practically every day, I bump into someone who, after finding out I'm a portfolio manager, tells me about a recent foray into the likes of Nortel (NYSE:NT) and Sonus Networks (NASDAQ:SONS) -- now that "the stock market is back." The next thing they typically tell me is about their use of "protective stop-losses."

It's getting awfully frothy out there. I'm not making predictions, but I urge the utmost caution and diligence in all investments right now -- be they stocks, bonds, or real estate. Last month's message continues to apply: Be greedy for value. This month, I'll show you one way to do that: Target companies that look fully valued on a price-to-earnings (P/E) basis, but whose underlying business is much more reasonably valued.

What types of companies are these? I'll offer some specific names in a moment, but in general, these are businesses that have some combination of the following: (1) a ton of cash in the kitty; and/or (2) cash profits that are structurally higher than reported net income.

These are the stocks you see with a P/E of somewhere between 20 and 35, and say to yourself, "Nah, too expensive." What you don't see, however, is that the "P" is overstated because the company's excess cash, not just the business itself, accounts for a sizeable portion of the market cap. Similarly, the "E" is understated because reported earnings are lower than cash earnings. Do the math -- smaller "P" divided by bigger "E" -- and you find that the P/E of the underlying business is much lower than initially meets the eye.

Why EV/FCF matters
It's not as complicated as it sounds. The trick is to toss aside the P/E ratio (something regular readers here have long been encouraged to do), and instead utilize the ratio of enterprise value to free cash flow (EV/FCF). This is like trading in a letter opener for a scalpel. Armed with the EV/FCF ratio, you'll be able to uncover the "true P/E" of any given business.

Here are the basic formulas:

Enterprise value = market cap + debt - cash

Free cash flow = after-tax oper. inc. + depreciation/amortization + deferred revenue - capex

The Motley Fool has written a number of excellent articles explaining enterprise value and free cash flow (those two are my personal favorites), so I won't bother rehashing a full tutorial here. But let me briefly give you two reasons why EV and FCF are of tremendous help in gauging a stock's value:

  • Years to Payback: The EV/FCF ratio tells you how many years it will take to get payback on your investment (assuming no growth or decline in free cash flow). Say, for example, you buy a no-growth company with an EV/FCF of 10, and every year it pays its full FCF out to you in the form of a dividend. After 10 years, you'll have received dividends equal to what you originally paid for the stock -- plus you'll still own the stock, of course. So, after 10 years, you'll essentially be playing with house money. (Even if a company doesn't pay a dividend, the free cash flow is still accruing to the benefit of shareholders, and thus the payback logic still holds.)

  • Free Cash Flow Yield: Alternatively, you can flip the EV/FCF on its head and look at FCF/EV. This tells you the yield you're earning on the underlying business. Using the previous example of a company with an EV/FCF of 10 and a full payout, you're getting a 1/10, or 10% yield, on the underlying business. Similarly, if a company's EV/FCF is 15, your yield is 1/15, or 6.7%. From this perspective, you can look at any company's internal free cash flow yield and compare it to bonds and other investment alternatives. (Again, it doesn't technically matter whether a company pays out this cash or uses it in some other value-added way -- as long as it goes to a purpose that's beneficial to shareholders.)

Value behind a high-P/E facade
Enough theory, let's look at some examples. Below are two stocks (both of which my firm currently holds) that I believe offer much more value than their P/Es would otherwise suggest:

Gabelli Asset Management (NYSE:GBL), with $27.6 billion under management, is one of the few mutual fund companies that weren't tainted in scandal this past year. With $1.65 in 2003 EPS and a price of $42.81, the stock has a P/E of 25.9. That doesn't seem like much of a bargain -- until you realize that Gabelli maintains substantial holdings in its own funds. With net cash and investments of $14.80 per share (net of all debt), Gabelli's EV per share is around $28. Turning to free cash flow, Gabelli's earnings are actually a good proxy, and I estimate base earnings power (net of investment income) to be around $1.68 per share. All told, Gabelli's EV/FCF lands at 16.7. Not bad at all compared to 23.4 for the S&P 500, according to Barra.

Handleman (NYSE:HDL) may not be a household name, but you've probably run across its operations if you've ever been inside a Wal-Mart (NYSE:WMT) east of the Mississippi. Handleman's relationship with Wal-Mart dates back to 1972, and it currently manages the music department for about one-third of all U.S. Wal-Mart stores and 100% of its international stores. Handleman incurs heavy amortization charges that mask its true earnings power. The notional P/E is close to 30, but adjusted for $1.09 in net cash per share and with free cash flow potential of $2.46 per share, the EV/FCF is only 8.2.

In closing, I believe Wall Street systematically overlooks businesses like these where you have to dig a little deeper to ferret out the true value of the business. But it's well worth the work. The same companies that defy the P/E mold are frequently the ones that offer shareholders the most bang for the buck.

Guest columnist Matt Richey has been a longtime contributor to The Motley Fool and is a portfolio manager at Centaur Capital Partners LP, a money management firm based in Dallas, Texas. At the time of publication, Centaur Capital held positions in Gabelli and Handleman.