Here's why China Agritech (Nasdaq: CAGC) may be cheaper -- or pricier -- than you think.

In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures.

This is the primary metric we use to mark corporate progress. Earnings, or net income, are also the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.

Unfortunately, "earnings" figures don't always give you the full picture.

Let me explain
Reported earnings are an accounting construction that may or may not accurately reflect a company's true earnings power. Free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, oftentimes more accurate, metric that can help you identify cheap stocks.

Better still, it's one that other investors frequently overlook. That means investors like us who peek at free cash flow can gain a significant advantage in the market.

There are a number of reasons why net income may understate a company's true profitability. If accounting bores you, that's fine -- just skip to the end of the bullets.

  • Companies usually depreciate large capital investments over a number of years, and sometimes that depreciation charge to net income is larger than the amount it actually needs to spend on maintaining its assets.
  • One-time non-cash charges such as asset writedowns show up as losses on the income statement even if they're not indicative of true earnings strength.
  • Income statements tend to match sales with their costs. But depending on a company's business model and efficiency, cash can be collected quarters or even years in advance of costs.
  • However, free cash flow can sometimes understate earnings for fast-growing companies that need to invest a lot of capital in their business.

Considering this overlooked-but-critical metric can give you an advantage over other investors.

How China Agritech stacks up
If China Agritech tends to generate more free cash flow than net income, there's a good chance earnings-per-share figures understate its profitability and overstate its price tag. Conversely, if China Agritech consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares China Agritech's historical net income to free cash flow. (I omitted various gains and charges that could include things such as tax deferrals, restructurings, and benefits related to stock options.)


Source: Capital IQ, a division of Standard & Poor's, and author's calculations. LTM = last 12 months.

As you can see, China Agritech actually has a tendency to produce less free cash flow than net income.

This means that the standard price-to-earnings multiple investors use to judge companies may understate its price tag.

Company

Price-to-Earnings Ratio

Price-to-Free-Cash-Flow Ratio

China Agritech

14.3

N/A

China Green Agriculture (NYSE: CGA)

11.9

32.3

Yongye (Nasdaq: YONG)

14.3

N/A

As you can see, it's pretty common for start-up Chinese fertilizer producers to generate substantially less free cash flow than net income. The culprit in China Agritech's case is mostly stagnant accounts payable along with ballooning inventory and accounts receivable -- the company is stocking up on inventory and extending generous terms to its customers or failing to collect the bills, even as it pays its suppliers on a timely basis. Investors should keep an eye on these factors to make sure the China Agritech can turn all its reported profits into cash.

Ilan Moscovitz owns shares of Yongye and China Green. China Green Agriculture and Yongye International are Motley Fool Global Gains selections. The Fool owns shares of China Green Agriculture and Yongye International. The Motley Fool has a disclosure policy.