You've probably heard it said that cash is king. In the old days, before the era of plastic, cash gave you staying power. Even today, I don't know of anyone who has ever turned down a cash payment.
In investing, cash is the foundation that allows businesses to grow and stock value to increase. After 9/11 and Hurricane Katrina, for example, some insurance companies were teetering on the verge of insolvency. But giants such as Berkshire Hathaway
Cash is real
Consider this analogy. One person may make $300,000 a year while another makes $100,000 a year, but if the first person spends half a million a year while the second lives on just $75,000 annually, the person with the lower income will be sitting pretty if any disruption in earnings occurs.
The same goes for businesses. If a company has unsustainable capital expenditures or isn't generating cash, it will suffer during weak business cycles. And all businesses at some point will suffer from a decline in industry demand. Just ask the homebuilders.
I am very interested in the cash-generating abilities of any company that I am looking to invest in. Yes, profits are important and are the source of cash, but I like to focus on how those earnings are made. Looking at the cash flow statement is the way to do just that.
One of the most fundamental tenets of investing is that a company is worth only the sum of its future cash flows discounted back to the present. More importantly, cash cannot be manipulated as readily as company earnings can. Management teams can massage earnings. Sales can be increased by offering very generous credit terms to customers, thereby leading to more "profits." Yet no cash was created -- only an increase in accounts receivable. Inventory management -- or mismanagement -- can often lead to an artificial boost in earnings, too.
Cash, on the other hand, can be counted. You can go the bank and determine how much cash you have on hand. Earnings can be decorated, but that's not so easy to do with cash.
When looking at a business, you want to pay attention to free cash flow, which is the cash a business generates after its capital expenditures. The rule-of-thumb calculation is:
FCF = cash flow from operations - capital expenditures
Some investors tweak the equation a bit, but this calculation will give you a general idea of the cash a business has left after paying all of the bills and funding plant operations.
This metric is important because companies generating lots of free cash flow are better equipped to ride out market slumps relative to the overall market. Having cash on hand also gives a business the option to pay out a special dividend, as Microsoft
Worth a closer look
Yet when business picked up in late 2004 and into 2005, FreightCar brought home gobs of cash. Free cash flow came in at $4 million in 2004, $45 million in 2005, and $125 million in 2006. All this cash for a company that Mr. Market now sells you for less than $700 million, or about 5 times 2006 free cash flow.
Where has all the cash gone? FreightCar has about $185 million on the balance sheet and no debt, or roughly $15 in cash per share. Since it trades at about $55 a share, you are paying $40 for a business that earned $10 a share in 2006 and is set to earn $3 a share for the first half of 2007.
To be sure, 2006 was a peak year for the coal-car business, and FreightCar has specifically said that the next couple of years will be much more subdued. However, the company's rock-solid balance sheet and cash position are a good example of what we're talking about today: A lot of compelling outcomes are possible, any of which could generate some cold, hard cash for investors who are willing to be patient.
If you're looking for more companies with solid balance sheets, and enough cash to rival Fort Knox, head on over to Motley Fool Stock Advisor and take a free 30-day trial. Fool co-founders David and Tom Gardner run point on Stock Advisor and thus far have posted returns on their picks of more than 75% -- that's 35% better than the market has done.
Fool contributor Sham Gad runs the Gad Partners Fund, a value-centric investment partnership similar to the 1950s Buffett Partnerships. He owns positions in both Berkshire Hathaway and FreightCar America. Microsoft is an Inside Value pick. Berkshire Hathaway is a selection of Stock Advisor and Inside Value. You can reach him at email@example.com. The Fool has a crystal-clear disclosure policy.