Underlying value of a company is easily determined

Investors constantly worry about reported earnings, which is why the valuation shortcut that derives from it - the price-to-earnings ratio (PER) - gets a great deal of attention.

Investors constantly worry about reported earnings, which is why the valuation shortcut that derives from it - the price-to-earnings ratio (PER) - gets a great deal of attention.

Too much attention, in fact.

Reported earnings and the underlying value of a business often don't have much in common but many investors believe they're much the same thing.

As a result, they get into all sorts of problems with PERs.

There is a better way, called free cash flow yield.

Free cash flow is the cash a business produces, available to distribute to shareholders, buy new businesses or pay down debt.

It's different to reported earnings, which are more easily manipulated and surprisingly easy to calculate.

Free cash flow is key

Head to a company's statement of cash flows to establish a business's operating cash flow - look for "net cash inflow from operating activities". Now look for "payments for property, plant and equipment", or something similar, in the cash flow statement.

This is what businesses must spend to regularly upgrade their assets, called capital expenditure, or "capex" for short.

Companies play tricks with this number (Telstra excludes interest expenses, for example) so you should review it for potential adjustments. And while payments for intangibles, such as research and software, may not be for physical assets, they're arguably capex, so those should be deducted as well.

Free cash flow, then, is operating cash flow minus capex.

Yes, it's really that simple. So how do you use it? There are a number of considerations.

First, while operating cash flow can fluctuate from year to year, be wary of very high variability in operating cash flows. If you find it, it needs investigating.

Second, compare free cash flow to net profit over a multi-year period.

Free cash flow will often be less than net profit, particularly for growing businesses, but again, investigate large discrepancies.

If a company is spending significantly more on capex than its depreciation expense, you also need to understand why.

On the flipside, technology companies such as REA Group and IRESS depreciate large start-up costs over many years but have low ongoing capex.

That means free cash flow is much higher than reported earnings, so using the PER to value these stocks makes them appear more expensive than they really are.

Third, capex tends to be lumpy and, to some extent, discretionary. Make sure you account for large but irregular spending requirements.

Fourth, not all capex is created equal. Developing property, such as the supermarkets that Woolworths and Coles are building, is high-quality capex because these stores will eventually be on-sold. JB Hi-Fi's decision to continue rolling out stores into a declining consumer electronics market is not.

Sonic Healthcare

Let's look at Sonic Healthcare to see how to use this figure (see table).

The first line of the table shows the average, "normalised" free cash flows for 2011 and 2010.

If you divide this figure by the company's market capitalisation, you get the free cash flow yield. For Sonic the figure is 4.9 per cent.

If you're aiming for 10 per cent returns from the stockmarket, that might not sound attractive.

But this relatively high-quality company should be able to increase free cash flow by at least 5 per cent a year with acquisitions, producing annual returns above 10 per cent.

But if you compare Sonic's current 4.9 per cent free cash flow yield with its dividend yield of 4.7 per cent, it's evident Sonic is paying out almost all of its free cash flow as dividends. That means there is a strong chance dividends could be cut if profits fall.

The higher the free cash flow yield is compared to the dividend yield, the more sustainable dividends are likely to be.

So despite Sonic's relatively reliable profits, the stock is more suited to growth investors than conservative income investors.

You can also compare the free cash flow yield to a company's earnings yield, which is the inverse of the PER (one divided by the PER as a percentage).

While the free cash flow yield will often be lower than the earnings yield - as in Sonic's case - if a company's earnings aren't turning up as free cash flow, place a question mark over their quality.

Earnings might get all the attention, but it's cash that pays your dividends.

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