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There's one deceptively simple question that all investors seek to answer -- how much is a company worth? The bad news is that there's no one, single correct answer to that question. There is, however, one, simple cardinal rule for investors -- when purchasing a stock, all you're doing is purchasing a stake in the future stream of cash flows from that business. A company is only worth what it can deliver in the form of cash to investors over the long haul. This is the money that can ultimately be used to buy back stock, expand into new growth markets or pay out to investors in the form of dividends. Many investors buy companies because they offer exciting or attractive stories -- a bright new technology or, perhaps, a promising cure for a widespread disease. In most cases, however, these types of "story stocks" don't stand the test of time. Instead, the real winners are often the boring, mundane "Old Economy" names that simply earn loads of cash year after year. Remember, exciting story stocks aren't simply a 1990s tech-bubble invention. Back in the 1970s, Polaroid was a hot momentum stock. The company's novel instant cameras captured investors' attention and had some predicting the end of traditional film photography. But while Polaroid cameras remain popular even today, the promise of a dominant global market share never came to pass. In fact, Polaroid ultimately went bankrupt. Instead, some of the real winners since 1970 include boring consumer companies like razor-maker Gillette (G), finance and travel giant American Express (AXP) and beverage maker Coca-Cola (KO). While these three stocks all operate in fairly ordinary, low-tech fields, all three share one thing in common -- they tend to generate enormous piles of cash throughout both good times and bad. Although it's extremely important to examine the actual cash a business generates, most investors choose to focus instead on a company's net income. And since these historical and estimated earnings figures are so widely available, it can often be tempting to use net income data instead of looking at cash flows. However, just as with any financial metric, earnings have their problems. Earnings are really an accounting measure -- not a record of actual money received by a company. Contrary to popular belief, earnings do not represent the actual dollars a company brings in over a one-quarter or one-year period. For example, although items like depreciation -- a way of spreading the cost of an asset over many years -- appear on a company's income statement, they don't actually reflect an exchange of cash in that particular period. In addition, companies can use a variety of accounting tricks to manipulate their earnings numbers. For example, so-called extraordinary items -- meant to refer to one-off gains or losses -- can be used to "hide" all-too-ordinary, recurring charges. There's also the issue of revenue recognition. Companies can recognize revenues from a sale and book earnings even if they haven't yet been paid. If the firm then has trouble collecting those payments, then those earnings may never materialize. By recognizing revenues in creative ways, companies can also shift their earnings from quarter to quarter. For better or for worse, earnings management is an accepted practice in many large companies. Given that no company wants to disappoint Wall Street by missing its guidance, accounting "tricks" are often used to smooth earnings streams. Clearly, if earnings don't represent the actual cash available to shareholders, then they shouldn't be the sole basis for valuing a stock. Over the long term what really matters is how much cash a company generates, not how accountants measure profitability on a quarter-to-quarter basis. Enter, Cash Flow Cash flow measures the actual money paid out or received by a company over a certain period of time. This measure excludes non-cash accounting charges like depreciation. And, more importantly, cash flows are objective. There is no value judgment about when and how revenues are recognized -- the cash flow statement only recognizes the actual cash that passes into or out of a business. My staff and I focus particular attention on operating cash flow when evaluating a company. Operating cash flow excludes extraordinary items from the cash flow equation. For example, if a manufacturing company sells a subsidiary for $1 billion in cash, then that money would show up as cash flow, but not as operating cash flow. We believe that operating cash flows are a truer measure of a company's ability to generate value for investors over the long haul term. Even more importantly, operating cash flows exclude cash flows from financing activities. In other words, if a company takes out a $5 billion loan in the form of cash, that $5 billion represents actual money flowing into the company. However, borrowed funds reflect little about the actual fundamentals of a company's business; in fact, a heavy reliance on borrowing can reflect underlying business weakness. Operating cash flow excludes these types of items. Applying Cash Flow By dividing a company's operating cash flow by its enterprise value, we're able to calculate the firm's operating cash flow yield (OCF Yield). This measure reflects how much cash a company generates annually compared to the total value investors have placed on the firm. All other things being equal, the higher this ratio, the more cash a company generates for its investors.
With all of the above factors in mind, my staff and I recently sifted through our database of over 10,000 companies in search of stocks with operating cash flow yields of more than 8%. We also excluded all companies priced under $5 per share or with enterprise values of less than $1 billion. (Since it's a lot easier for smaller companies to generate huge cash flow yields over a short period of time -- one or two fiscal years -- we decided to eliminate these stocks from our list.)
In addition, we eliminated any companies with an average operating margin of less than 10% over the past three years. This criterion helped us to identify companies with solid long-term profitability. Finally, we required projected future annual growth of greater than +10%. (Unfortunately, not all companies have published long-term cash flow forecasts. As such, we instead used earnings growth projections to look for companies that are likely to deliver above-average growth over the long haul.) The table below shows a number of companies that fit our screening criteria. In the analysis that follows, my staff and I examine two of the most promising plays from this list.
Our two favorite picks from the list above are... Important: To view the remainder of this article, in which StreetAuthority.com founder Paul Tracy and his staff provide an in-depth profile of two of the most promising stocks from the list above, you'll need to subscribe to our premium Market Advisor newsletter. Please visit one of the following links to continue...
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Companies
like American Express and Coca-Cola are well known for generating a
great deal of operating cash year-in and year-out. As such, both of
these stocks have been outstanding performers over the long haul. Our
chart to the right shows the operating cash flow yield for a select few
well-known cash flow generators. These companies all sport annual
operating cash flow of at least 5% of enterprise value.
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