Never doubt the importance of the cash flow statement. Even though this point is repeated by smart Fools everywhere, investors should still have the words free cash flow tattooed somewhere on their body. (Unless, of course, you're Tom Gardner looking for Hidden Gems; then you'd prefer the words structural free cash flow.) But no matter your preference, the best way to hone your love of this financial number is to check out an example. So today I present you with Internet content monitoring firm (and former Motley Fool Stock Advisor holding) Websense (NASDAQ:WBSN).
A quick glance at the income statement shows that Websense earned $0.73 per diluted share in 2003, modestly up from $0.72 in 2002. Well, that doesn't sound good, especially with the stock trading at almost $34, giving it a price-to-earnings ratio of 44. But the flat earnings are due to the onset of a 38% tax rate for the year, while in 2002 there actually was a tax benefit. To get a clearer picture of growth, look at revenue growth of 34% over 2002, or how earnings before taxes were up a whopping 70%. Not bad.
Now for something even better. Take a quick gander at the aforementioned statement of cash flows and fall in love. It turns out that Websense, which sells subscriptions for its Internet management software, recognizes revenue equally over the months in a subscriber's contract, in accordance with accounting's "matching principle."
But, and this is where it gets good, all the cash from a subscription is paid up-front. That's right: Even if it's a three-year whopper of a sale, it's usually billed quicker than you can say "30 days." That would be like Verizon (NYSE:VZ) trying to bill you for all 24 months of your cell-phone contract before you finished the first month of service. Or Microsoft (NASDAQ:MSFT) charging you $300 on the spot for next year's Internet access. Sounds like a hard sell to me, but that's exactly what Websense has been doing, and boy, does it pump up the cash. While net income was only $0.73 per diluted share in 2003, free cash flow clocked in much higher at $1.91 per share.
This is big news for investors, especially since it's not just a one-shot deal. Free cash flow has been materially higher than net income for the past four years. Look no further than the first-quarter balance sheet to see the pile of cash and short-term investments -- $8.46 per share!
The shares currently trade at a price-to-free cash flow multiple of 17. Subtract the company's cash from the stock price and that multiple drops to 12. Quite nice compared with the P/E of 44 garnered from the income statement.
Whether Websense will slow its rapidly declining sales growth rate and at the same time find a high-return use for its cash are tough questions that will surely dictate the future stock price. But as you're pondering the future and the present values of companies such as this, one thing's for sure: Don't forget to consult that embarrassing tattoo of yours, the one that says "free cash flow."
Fool contributor Matt Thurmond loves your email. Be sure to ask him why he sold half of his position in Websense last year. He will probably say it was to buy another Stock Advisor recommendation that has since doubled: eBay. Aside from Websense, Matt does not own shares of any of the other companies mentioned here. To see his Fool Community profile, click here.
