Tuesday, May 13, 2008

It's Free-Cash-Flow Stupid!, Part I

This is what I like in every crisis and downturn: people are finally talking get back to basics. They give up sophisticated valuation methods, earning surprises and etc. Like prodigal sons going back to the father, they finally going back to what Warren Buffett preaches all along: it's Free-Cash-Flow. The table above speaks very clearly, those with highest free-cash-flow yield are able to withstand selling pressure because it has something very solid to offer: CASH!

Just to share with you further, I extracted part of article published in WSJ on 12 May 2008.

Headline earnings numbers -- typically net income -- can be massaged by perfectly legal accounting tricks, such as changing depreciation schedules or the way revenue is recognized. Cash flows -- how much actual money a company spits out -- are by no means immune from shenanigans, but many analysts consider them a cleaner way to assess a company's health.

There are other reasons to search out companies with strong cash flow. A company generating extra cash can avoid the costly proposition of raising money in today's unsteady markets. It also gives companies the flexibility to boost dividends or stock buybacks.

Operating cash flow is the amount of cash a company creates from its operations, unvarnished by earnings that come from things like asset sales. Free cash flow -- considered an even purer measure of a company's true profitability -- subtracts from operating cash flow the money going into capital investments. It's "as close as there is to a silver bullet when it comes to sorting out good companies from the pretenders," says David Sowerby, a portfolio manager at Loomis Sayles & Co.

Mr. Sowerby tracks free-cash-flow yield, or a company's free cash flow divided by its shares outstanding. He likes Hewlett-Packard Co. The computer and printer maker sports a free-cash-flow yield that is double that of the Standard & Poor's 500-stock index's 4% and has seen its cash flow grow by more than 30% over the past three years. H-P's shares are down 2.5% this year, but they are up some 9% in the past 12 months.

Among companies with weak cash flow is Goodyear Tire & Rubber Co. Its earnings are expected to grow 80% this year, according to Thomson Reuters. But its cash flow has been negative in part due to heavy capital expenditures. The stock is flat in 2008 and down 16% in the past year.

Cash flow isn't a new idea on Wall Street. In the past, some consultants and Wall Street firms turned it into a fad and even marketed variations of the idea as a measure of business performance.

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