Here's why Apple (Nasdaq: AAPL) may be cheaper 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 don't indicate 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 Apple stacks up
If Apple 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 Apple consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

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


Source: Capital IQ, a division of Standard & Poor's, and author's calculations.

As you can see, Apple has a tendency to produce more free cash flow than net income.

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

Company

Adjusted Price-to-Earnings Ratio

Adjusted Price-to-Free-Cash-Flow Ratio

Apple

18.8

15.6

Hewlett-Packard (NYSE: HPQ)

11.1

9.1

Research In Motion (Nasdaq: RIMM)

10.6

14.1

Dell (Nasdaq: DELL)

15.0

5.7

Although Apple still appears to be pricier than some of its top competitors (with some justification, too!), its free cash flow multiple is considerably less expensive than its earnings multiple. Apple may be much cheaper than investors realize.

Ilan Moscovitz owns shares of Apple, a Motley Fool Stock Advisorrecommendation. The Fool has a disclosure policy.