With apologies to Lord of the Rings scribe J.R.R. Tolkien, it's money -- not rings -- that makes the investing world go 'round. Literally. These days, thanks to the market's precipitous sell-off and see-sawing bounce-back, it's entirely possible to earn outsize returns over the long haul without taking on outsize risk.
Do tell
My preferred method: Focus on firms that can show you the money in the form of free cash flow (FCF).
Free cash flow is an excellent barometer when it comes to gauging the fiscal health of a prospective investment. Used in tandem with valuation metrics such as price-to-earnings (P/E) and price-to-sales (P/S) multiples, FCF can go a long way toward helping you narrow the vast universe of investment possibilities down to just a handful -- and perhaps even just one company, as we do just ahead -- that could warrant a spot in your portfolio, if the price is right.
FCF is relatively straightforward to calculate, too: Subtract a firm's capital expenditures from the cash it has cranked out from operations and -- voila! -- you have FCF on a silver platter. And if you don't want to show even that light work, cash flow math is exceedingly easy to come by on the Web, as with the row of no-muss, no-fuss historical information available at the bottom of this page (which will come in handy in just a bit).
Before we get too far ahead of ourselves, here are a couple of cash flow caveats to bear in mind:
- Smart move though it is, focusing like a laser beam on FCF will lead you toward certain kinds of companies and away from certain others. You'll need to use a different form of analysis, for example, to identify young-gun growth stocks with loads of potential but little money in the bank as yet. Such companies can play a useful role in your portfolio, but they aren't likely to make the FCF cut.
- Just as important as a company's ability to generate cash is what management does with the moola it cranks out. Return on equity (ROE) and return on assets (ROA) are the numbers to watch there. These metrics provide an excellent proxy for managerial acumen, revealing just how talented a team of honchos has been when it comes to wringing profits from the capital at its command.
Contenders list
With that in mind, consider that Chevron (NYSE:CVX), IBM (NYSE:IBM), ConocoPhillips (NYSE:COP), and Nokia (NYSE:NOK) all boast lengthy track records of generating gobs of FCF. Not coincidentally, they've also enriched their shareholders over the long haul, delivering market-surpassing returns for the 10 years that ended with May. The same is true of such free cash flow cows as Schlumberger (NYSE:SLB), McDonald's (NYSE:MCD), and United Technologies (NYSE:UTX).
Bottom line: If you're looking to snap back after the drubbing we've all taken of late, all of these names are clear watch-list contenders. And get this: Despite their strong cash positions and historical showings, each currently clocks in with a P/E that falls at or below the broader market.
ConocoPhillips, which has been cut in half over the past year, is the one stock I've profiled here that could rule your portfolio, and it provides an excellent opportunity to kick the tires of FCF as an investing tool, too. Tethered as it is to a volatile commodity, the company's cash flows are predictably lumpy. (See that handy link above for all the gory details.) For valuation purposes, then, you'll want to normalize (as the pros like to say) FCF, assessing the firm's average cash flows over a period of time long enough to capture up cycles and down.
And a more telling detail for this FCF-focused commentary is price-to-cash flow (P/CF). On that metric, COP is a bargain relative to both its industry and the broader market.
The Foolish bottom line
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Shannon Zimmerman does not own any stocks mentioned. Nokia is an Inside Value recommendation. You can check out the Fool's strict disclosure policy.
