Price-to-Earnings (P/E) ratios are a very convenient snapshot to gauge whether a stock is cheap or expensive. But they don't tell the whole story, and on occasion can be downright misleading.
If you take just a few more steps, you can truly assess a stock's value relative to the profits being generated. We're talking about free cash flow. Understanding this concept can help you avoid bad investments and target good ones.
Understanding Free Cash Flow
To highlight the cash flow statement, assume we have two companies, both of which are valued at $500 million and generated $25 million in net income last year, for a P/E ratio of 20. Also assume that the first company needs to keep reinvesting those profits in upgrades to its factories just to stay on the cutting edge, while the second company no longer needs to make these types of investments.
The first company will have nothing to show for that $25 million profit, while the second company can add that $25 million in cash onto its balance sheet.
That $25 million profit figure may be a bit misleading. Any past investments such as factory upgrades are noted on the balance sheet as an asset (in this case under Plants, Property & Equipment or P, P & E). Each year, the company gets to write-down some of that P, P & E, (as assets such as factories and equipment become less valuable as they age). Yet the company must also reduce its earnings by a commensurate amount, as that 'depreciation' is considered to be an expense on the income statement.
So if a company had $5 million in depreciation, then income (or more correctly, cash flow) might actually be higher than that stated $25 million. You can see depreciation added back to the income statement by checking out the cash flow statement.
Martek Biosciences (Nasdaq: MATK) offers a clear example. The company built a vast manufacturing facility to process ingredients that go into baby formulas and nutritional supplements.
The good news: Martek is done with those investments and no longer needs to sp/end its hard earned profits. The bad news: A high level of depreciation gives the appearance of lowered profits.
Savvy investors know to incorporate this information into their analysis.
In the company's first nine months of Fiscal (October) 2011, Martek has earned around $34 million ($1.02 a share) in net income. Yet free cash flow (or the cash that Martek actually gets to keep) was roughly $100 million (nearly $3 a share).
If you just looked at projected net income for the full fiscal year, than Martek trades for a reasonable 15 times projected profits. But if you value shares on a free cash flow basis, then they look extremely cheap, at less than seven times projected free cash flow.
Free Cash Flow Yield
When markets hit a rough patch, as they have now, free cash flow becomes more important as it provides a very real and accurate gauge of a stock compared to other investments, such as bonds. While many investors look for stocks based on their dividend yields, investors that don't need income right now should instead check out stocks based on their cash flow yield.
It's easy to calculate. You simply divide 100 by the free cash flow multiple.
In the case of Martek, which has a free cash flow multiple of seven, then its free cash flow yield is about 14%. That compares to the measly 1% to 3% that CDs and Treasury Bills pay out. Interest rates (and these fixed-income yields) could rise by a significant amount, and Martek's stock would still compare favorably.
The P/E ratio came into vogue in the late 1920s as investors had no idea how to value the stocks they were buying. We've come a long way since then, yet the EPS and the P/E ratio still dominate the headlines. Take the extra step and calculate the free cash flow ratio and the free cash flow yield. Stocks that look attractive by these measures will help your portfolio to hold its own in down markets and appreciate in rising markets.