Here's why EMC
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, also known as 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.
Free cash flow -- the amount of cash a company earns on its operations, minus what it spends on them -- is another, often more accurate metric that can help you identify cheap stocks. That means investors like us who peek at free cash flow can gain a significant advantage in the market.
How EMC stacks up
If EMC tends to generate more free cash flow than net income, there's a good chance that earnings-per-share figures understate its profitability and overstate its price tag. Conversely, if EMC consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.
This graph compares EMC'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, EMC 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.
It's an imperfect comparison, because many of these companies are involved in various other businesses, but let's examine EMC alongside some of its competitors for additional context:
Company | Price-to-Earnings Ratio | Price-to-Free-Cash-Flow Ratio |
|---|---|---|
EMC | 28.3 | 16.2 |
Hewlett-Packard | 11.2 | 9.8 |
IBM | 12.1 | 9.7 |
Citrix | 49.2 | 30.9 |
Microsoft | 11.6 | 12.7 |
Oracle | 19.0 | 14.9 |
NetApp | 32.5 | 23.6 |
Median | 19.0 | 14.9 |
It's not unusual for these companies to generate more free cash flow than earnings. Still, the disparity between EMC's price-to-earnings and price-to-free-cash-flow ratios is jarring. Much of the difference is due to amortization charges on EMC's many prior acquisitions and deferred revenue; EMC's customers are paying cash in advance of EMC's expenses.
EMC is still pricier than many of its peers, but when we take cash flow into account, the company is substantially cheaper than many investors may realize.
