Talbots (NYSE: TLB) 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.

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, often more accurate measure of earnings that can give you an advantage.

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

This graph compares Talbots' 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, Talbots 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 Talbots alongside some of its peers for additional context:


Price-to-Earnings Ratio

Adjusted Price-to-Free-Cash-Flow Ratio

Talbots 13.7 3.8
Chico's FAS (NYSE: CHS) 17.6 16.9
Pacific Sunwear (Nasdaq: PSUN) N/A* N/A*
American Eagle Outfitters (NYSE: AEO) 14.6 11.0

*Negative earnings and free cash flow.

Like many of its peers, Talbots tends to generate more free cash flow than net income. Its free cash flow multiple is less expensive than its earnings multiple, suggesting that, while Talbots might not be quite as cheap as its free cash flow multiple suggests it is, the stock might be considerably cheaper than many investors realize.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.