If you ask most people that question, they will likely pull up the company's stock quote from a financial website and give you that number. But they're confusing price with value.
Ben Graham, the father of value investing observed:
In the short-term, the market is a voting machine. In the long-term, it is a weighing machine.
In other words, the stock prices of both good and bad companies can change rapidly for several reasons in the short run. But over the long run, only the strong companies thrive.
So what is the real value of that piece of paper you hold? Is it worth anything at all?
When you buy a stock, you're actually buying an ownership interest in a company. And the value of any business is the present value of all of its free cash flows.
Free cash flow is calculated as:
Cash Flow from Operations
- Capital Expenditures
This is the cash a company generates for its shareholders after paying expenses and investing in its growth. Companies that are growing rapidly may have very little or even negative free cash flow. That doesn't make them worthless. The idea is that one day they'll stop expanding as quickly and start generating significant free cash flow for its shareholders.
Companies that generate substantial free cash flow can either hold onto that cash, pay down debt, buy back stock, or distribute it to shareholders through dividends.
The Kings of Cash Flow
So what companies are currently generating substantial free cash flow for their owners?
Here are 4:
Microsoft (Nasdaq: MSFT) may have had its missteps lately, but its Windows operating system and Office business software are still huge cash cows.
Microsoft generated over $22 billion in free cash flow in 2010, a 72% increase from 2006. The company has been using its cash to buyback stock and raise its dividend. It currently yields 2.5%.
The stock trades at just 10x free cash flow, a significant discount to the industry average of 24.8x. It is a Zacks #3 Rank (Hold) stock.
Proctor & Gamble (NYSE: PG) is about as stable as they come. The company markets more than 250 products to more than 5 billion consumers around the world.
In 2010, P&G generated over $13 billion in free cash flow, and it returned nearly $11.5 billion to shareholders through stock buybacks and dividend payments. It currently yield 3.2%.
Proctor & Gamble trades at 11.1x free cash flow, a discount to the industry average of 17.1x. It is a Zacks #3 Rank (Hold) stock.
International Business Machines (NYSE: IBM) may be famous for its hardware business, but it has been (successfully) transitioning to a services firm, which now accounts for more than half of total revenues.
Big Blue has been aggressively buying back shares with its substantial cash flows. In 2010, IBM spent over $15 billion repurchasing its common stock.
The company has also been steadily raising its dividend, hiking it every year since 2002 and at a compound annual rate of 18.6%. It currently yields 1.6%.
Shares are trading at 12.7x free cash flow. It is a Zacks #3 Rank (Hold) stock.
Verizon Communications (NYSE: VZ) may spend close to $17 billion on capital expenditures every year, but the company has been taking in nearly twice that in operating cash.
Although its earnings per share hasn't gone anywhere in the last 5 years, the company has been steadily increasing its free cash flow over that time. It has been rewarding its shareholders as a result. Verizon has been aggressively paying down debt and still has room to pay a dividend that yields a juicy 5.4%.
Shares trade at just 6.4x free cash flow, well below the industry multiple of 10.3x. It is a Zacks #3 Rank (Hold) stock.
Remember that when you buy a stock, you're buying an ownership interest in the business. As an owner, filter out the short-term noise and focus on the free cash flow your business will generate in the future. These 4 companies are currently generating tons of cash for their owners.
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