How can you tell whether a stock is undervalued or overvalued? The received way to make that determination is to divide the projected growth rate by the p/e ratio. But there are some financial analysts who argue that a firm's present and estimated future free cash flow is a much better criterion of value. Free cashflow, crudely defined, is operating cash flow (net income plus amortization and depreciation) minus NECESSARY (to sustain the business) capital expenditures.
From the bible of free cash flow freaks (Kenneth S. Hackel & Joshua Livnat: Cashflow and Security Analysis, 2nd edition, 1996): "Instead of focusing on earnings of a firm that can be manipulated by the selection of accounting methods, we focus on the maximum amount of cash that can be distributed to shareholders without sacrificing future growth. The investment approach is a bottoms-up process, which identifies firms that are consistent generators of free cash flows, that have low financial leverage, and that have low free cash flow multiples."
This thread is for discussion of stocks that meet, or appear to meet, those criteria, as well as for discussion of the problems of cash flow analysis.
There are two ways of identifying firms that are either overpriced or underpriced in terms of their free cash flow. The first, which certifiable math idiots like myself use, is simply to look at the PRESENT cashflow situation: that is, to look at the 10-K statement of cashflows; the amount of free cashflow per share; and the price/free cashflow ratio.
One of the things you discover when you do that is that there are quite a few firms out there that appear to be overvalued using the conventional method (projected growth rate divided by p/e), but undervalued in terms of their present free cash flow.
The second method -- estimating the stream of future cash flows (discounted back to the present) -- is probably much better, but it is also much more complicated and much more speculative. Hopefully, to get the ball rolling, Andrew will repost the explanation of this method he originally posted on the Unitrode thread (which is also where the idea for this thread was born). |
