In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures.
Earnings, or net income, is an accounting construction that is the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.
But free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, oftentimes more accurate measure of earnings that can give you an advantage.
How Hercules stacks up
If Hercules 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 Hercules consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.
This graph compares Hercules' 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, Hercules 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.
There can be a variety of reasons to disregard such a discrepancy; for example, free cash flow can overstate earnings in businesses with volatile working capital needs, or understate earnings in high-growth companies that are reinvesting capital in the business.
Alternatively, in cases where free cash flow more accurately measures earnings, such a discrepancy can indicate a company that is more -- or less -- expensive than investors realize.
Let's examine Hercules alongside some of its peers for additional context:
Adjusted Price-to-Free-Cash-Flow Ratio
* Negative free cash flow.
Unlike many of its drilling peers, Hercules doesn’t have a price-to-earnings ratio, because the company failed to report earnings over the past year. But that doesn’t mean it didn’t produce profits of a free cash flow basis.
Hercules tends to generate much more free cash flow than net income, suggesting that the company’s stock might be much cheaper than many investors realize.
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Ilan Moscovitz doesn’t own shares of any company mentioned. The Motley Fool owns shares of Ensco and Diamond Offshore Drilling. Motley Fool newsletter services have recommended buying shares of Atwood Oceanics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.