Here's why Abbott Labs (NYSE: ABT) 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.

How Abbott stacks up
If Abbott 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 Abbott consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares Abbott'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, Abbott 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.

Let's examine Abbott alongside some of its peers for additional context:

Company

Price-to-Earnings Ratio

Price-to-Free-Cash-Flow Ratio

Abbott Labs

14.8

12.5

Bristol-Myers Squibb (NYSE: BMY)

15.1

16.9

Merck (NYSE: MRK)

9.1

27.4

Pfizer (NYSE: PFE)

15.7

7.8

Median Pharma

16.2

14.6

Source: Capital IQ and author's calculations. Similar adjustments were made in calculating FCF.

Abbott's free cash flow multiple is considerably less expensive than its earnings multiple, and it's somewhat cheaper than most peers' free cash flow multiples. Abbott may be cheaper than many investors think.

Ilan Moscovitz doesn't own shares of any company mentioned. Pfizer is a Motley Fool Inside Value selection. Johnson & Johnson is an Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.