Last week, we took the briefest of brief looks at a little company that, at first glance, appears to have big potential: JAKKS Pacific (NASDAQ:JAKK), maker of pencils, kites, toys, dolls -- if your kid uses it, there's a good chance JAKKS makes it. As you may recall, it enjoyed a banner year in 2004, with revenues growing by 82% and profits more than doubling over its 2004 numbers.

Free cash flow also seemed to increase substantially over 2003, a year in which JAKKS generated just $2.7 million in cash -- under the most generous interpretations. According to my preferred provider of usually reliable financial information, Yahoo! Finance, over the first nine months of 2004, JAKKS generated nearly $82 million in free cash flow, for a 30-fold increase.

If right about now you're scratching your chin and saying to yourself, "Mmm, something sounds fishy," well, congratulations, Fool! You've discovered the reason for this column. Let's take a brief stroll through JAKKS's financials now and run the company through my 7 Steps program for determining whether a company might qualify as a bona fide Hidden Gem -- or whether it's just another hunk of equity rock.

As I've said many times before, this test ordinarily takes about five minutes to run. Today, I've invested a few extra minutes at digging further than typically needed -- and we'll get to why in a moment.

Once more, for those not yet familiar with the 7 Steps, we'll be looking at JAKKS's:

  1. Market cap
  2. Enterprise value-to-free cash flow (EV/FCF)
  3. Historical and projected earnings growth
  4. EV/FCF/Growth
  5. Return on equity (ROE)
  6. Insider ownership
  7. Share dilution

Market cap
With its market cap currently hovering around $550 million, JAKKS fits the bill as a small-cap company with plenty of room for growth.

Enterprise value
JAKKS has roughly $195 million in cash and equivalents on its books and about $98 million in long-term debt. Subtract the first, and add the second, to its market cap, and we're looking now at a company with an enterprise value of $411 million.

Free cash flow
Here's where things get tricky. JAKKS still has not published its 10-K for fiscal 2004. Nor did it provide a cash flow statement with its earnings release last week. Thus, we have to resort to a bit of educated guessing to determine its free cash flow. If we use the basic definition of the concept, free cash flow is simply cash from operations minus capital expenditures. Over the past three quarters, we know that JAKKS generated $82 million under this formula. At a constant run rate of free cash flow, therefore, JAKKS should have generated nearly $110 million in free cash flow through the end of 2004.

Enterprise value-to-free cash flow
Which gives us our first clue that we need to look deeper on this one. With an EV of $411 million and an FCF of $110 million, JAKKS looks to have an EV/FCF ratio of 3.7. Even were JAKKS a lousy company stuck in a rut of declining sales, that would be an incredibly cheap valuation. But with JAKKS actually growing its top line by 27% organically, and 82% overall last year, it simply defies common sense. (On the other hand, if true, this valuation would make JAKKS the deal of the century.)

At this point in the due diligence process, you have to abandon the Yahoo! Finance shortcut and head straight to the company's SEC filings to determine the truth. It's there that you'll find that while JAKKS appears to have generated $82 million in free cash flow in the first three quarters of 2004, that number doesn't take into account $68 million in "Cash paid for net assets acquired, net of cash acquired" or $2 million in "Other assets."

To be conservative, it's probably best to consider those items "capital expenditures" as well, and affix to JAKKS an adjusted free cash flow number of $12 million. That would still be a huge improvement over 2003, but it increases the company's EV/FCF ratio to a much less attractive number: 34, which is more than three times our target valuation.

Historical and projected earnings growth vs. return on equity
Over the past five years, JAKKS has floundered, growing its earnings at a compound rate of just 0.6%. Over the next five years, analysts expect the company to post 20% gains on average. With a discrepancy like this, I usually look to the company's return on equity to provide a tie-breaking vote. JAKKS's ROE, however, just splits the difference: 9%.

At this point in the 7 Steps, I usually divide the target company's EV/FCF by its growth rate. Then double check that against its ROE. But honestly, with JAKKS sporting an EV/FCF of 34, there's no need for this. For JAKKS to make the grade for a deep value investor like myself, I'd need to divide its EV/FCF by its zip code.

Insider ownership
Even if we reached this step successfully, JAKKS would fail the 7 Steps here. Insiders own less than 5% of all shares outstanding at JAKKS. Consider also that the top four officers at JAKKS raked in a combined $13 million in salary last year (plus stock options). That's 2.7% of total revenue, or 28% of total profits. Given their fat paychecks, these officers make out just fine whether the company as a whole succeeds or flounders. Between these two factors, I simply don't see management as having its interests aligned with that of shareholders. Sure, if the company succeeds, their stock options increase their total haul a bit. But if it fails, the officers will still make out like bandits. In short, this is not a horse to which I'd hitch my wagon.

Share dilution
As mentioned briefly last week, the company's share count increased 14.5% last year, only partially due to shares being issued as part of a pair of big acquisitions. Too much, too fast.

Sad to say, the 7 Steps are not without their flaws. Relying on a single source of financial information leaves open the door to mistakes in measuring free cash flow from time to time. On the other hand, in the system's defense, I'd point out that even if Yahoo!'s numbers on free cash flow had been true, JAKKS would have failed the test on several other points: minimal historical growth, mediocre return on equity, low levels of insider ownership, and massive levels of share dilution.

My final analysis, therefore, is this: JAKKS may be a great company. It really might be. After all, its shares have risen steeply over the past year, and shareholders have been well rewarded for sticking with management. However, the company comes nowhere near the strict requirements I set for companies that I'm looking at as possible hidden gems.

And speaking of the 7 Steps, for the record and in the interest of ensuring my own Foolish accountability, the following are the columns in which I have analyzed companies according to the 7 Steps, the dates of each analysis, my conclusions and the performance of the companies since:

With a couple of exceptions, the 7 Steps appear to be doing a pretty good job of finding strong prospects and avoiding pitfalls so far. But remember, I've been using this evaluation tool for less than a year. If you'd like a system with even better results and a two-year track record of success, consider taking a free trial to Motley Fool Hidden Gems newsletter, which is currently beating the Street by a margin of 43% to 10% since inception.

Fool contributor Rich Smith owns shares of Corillian, but has no position, short or long, in any other company mentioned above. The Motley Fool's disclosure policy could play a valuable role in setting up 12-step programs for Wall Street mutual fund managers.