Here's why Vonage (NYSE: VG) 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 Vonage stacks up
If Vonage 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 Vonage consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares Vonage'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.)

vg cheaper.jpg

 

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

As you can see, Vonage 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 – N/A for companies like Vonage with negative earnings -- may overstate its price tag.

While Vonage might be a disruptive force to large telecoms, it shares in a common industry theme of producing cash flow in excess of earnings. This means that many may be cheaper than investors think, though the effect declines substantially when we consider their debt burdens in the third column.

Company

Price-to-Earnings Ratio

Adjusted Price-to-Free-Cash-Flow Ratio

Adjusted Enterprise-Value-to-Free-Cash-Flow Ratio

Vonage

N/A

356.7

423.4

Windstream (Nasdaq: WIN)

16.5

8.4

27.3

Qwest (NYSE: Q)

22.4

8.2

17.9

Frontier Communications (NYSE: FTR)

18.2

9.4

27.3

Median Diversified Telco*

17.3

9.4

17.9

*Of mid- and large-cap peers.

While Vonage may not yet generate enough free cash flow to satisfy investors looking for low multiples, its slight free cash flow profitability means the company may be cheaper than investors realize.

Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool has a disclosure policy.