Companies with Accelerating Free Cash Flow

What is Free Cash Flow (FCF)?
Free cash flow is defined as follows:
FCF = Operating Cash Flow - Capital Expenditures

To get a better understanding of this equation, we need to take a closer look at each of its components:

Operating Cash Flow -- This can be found as a line item on every public company's statement of cash flows. As the name suggests, it represents the cash a given firm generates from its day-to-day operations. To come up with this figure, you essentially take a firm's net income, add back any non-cash charges (such as depreciation), and then make a few other adjustments (changes in accounts receivable, inventories, etc).

Capital Expenditures -- This represents the money that a company uses to purchase or improve upon its physical assets -- its property, plant and equipment.

Why is Cash Flow Important?
Cash flow represents the lifeblood of any growing business. With it, companies are able to invest in future growth, pay down debt, complete value-added acquisitions, repurchase stock and pay dividends (if done properly, all of these tend to be shareholder-friendly activities). Without a healthy stream of free cash flow, however, most businesses tend to run into a host of problems. These include ballooning debt burdens, financing troubles and cash flow management issues, among other things.

Although most analysts and investors tend to focus almost exclusively on income statements, the reality is that the statement of cash flows gives one of the clearest pictures of a firm's financial well being. The reason for this is simple -- whereas net income is often distorted by one-time events, non-cash charges and a host of accounting tricks, the cash flow statement gives a clear, unbiased view of exactly how well a company's core operations are performing.

What To Look For
Because cash flow is so critical to every company's ultimate success or failure, I recently went on a hunt for firms that have shown strong FCF growth in recent years. And while strong growth is important, I also looked for companies that have posted consistent FCF gains in each of the last three years. This type of continued steady growth is indicative of firms that are expanding at a sustainable clip and whose products and services are gaining real momentum in the marketplace.

Companies that are delivering strong FCF growth often look promising, but keep in mind that stellar growth in and of itself doesn't make them great investments. I want to invest in firms that are not only growing strongly, but that are also highly profitable. With this in mind, I also looked for companies that are delivering solid cash flow for each dollar of goods and services that they sell. In the process, I looked exclusively for firms with FCF/Sales ratios of at least 25% (based on ttm data).

Next, since I'm always mindful of valuation levels before making any investment, I also searched for companies that are trading at reasonable prices relative to their underlying cash flow. I did this by searching for firms with Price/FCF ratios of less than 15.

And finally, even though historical growth rates are important to examine, the reality is that most companies are valued based on their projected future earnings stream. With this in mind, I also looked for firms with strong projected future growth of at least +15% per year (based on analyst estimates).

With the above analysis as a backdrop, I recently searched through a comprehensive listing of 10,000 stocks to find companies that met the following criteria:

-- Market capitalization of greater than $100 million
-- Growing FCF over the trailing 12-month (TTM) period, as well as in each of the last three years
-- FCF/Sales of at least 25% (based on TTM data)
-- Price/FCF per share of less than 15
-- Projected long-term growth of at least +15%

My goal was to come up with a list of reasonably valued firms with consistent cash flow growth and healthy cash flow margins. After running this data through StreetAuthority's advanced screening software, I came up with the following list of companies:

Although each of the above stocks may be worth exploring further, as always, please make sure to do your own due diligence on each of these firms to decide if they are right for your portfolio. Any and all final investing decisions for your own account are entirely up to you.

Paul Tracy founded StreetAuthority and became Editor in Chief in 2001. Prior to that he spent several years as Managing Editor at a multi-million dollar financial publishing firm with over 150,000 subscribers. In addition to his role as managing editor and lead financial writer, he was also responsible for equity research and managing a team of seasoned professional financial writers, researchers and market commentators.

Paul's previous experience includes a position at Robert W. Baird & Co.'s full-service brokerage operations as well as economic research work on a Money and Banking project funded by the National Bureau of Economic Research. He has also spent time doing outside consulting and research for the University of Virginia, has appeared as a guest expert on several prominent financial radio shows, and has been a featured speaker at various investment conferences across the U.S.

Paul graduated with a B.S. in Finance and Management from the McIntire School of Commerce at the University of Virginia.

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