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Borrow from Buffett's playbook: Keep your eye on free cash flow Add to ...

The collapse of Enron has been held up as a crucial piece of evidence that the investing community is guided by all the wrong numbers.

The illusion of profitability at the company was conjured through earnings reports, which were positive in 15 of its final 16 quarters. Yet despite such horror stories, retail investors, sell-side analysts and financial media remain fixated on earnings. Many of the brightest minds in finance, however, including Warren Buffett, pay closer attention to a different measure of corporate performance – free cash flow. It can be a helpful measure not just in exposing corporate fraud and conspiracy, but in finding a good bargain.

While highly influential, earnings results and guidance are susceptible to the whims of management, who can employ various forms of accounting trickery to nudge the numbers closer to a target.

Sell-side analysts typically use near-term earnings estimates and apply a multiple befitting the particular industry to arrive at a company’s value. Divide by the number of shares and there’s your target price on the stock.

With so much depending on earnings, billions of dollars can be heaped onto or lopped off a company’s valuation based on one surprise quarter or revised guidance. But a company’s true value depends more on its earning potential over decades. Investors like Mr. Buffett examine potential cash flows and earnings far into the future when evaluating equities.

Free cash flow is a measure of the amount of cash that can be withdrawn from a company while leaving it no worse off. The simplest measure subtracts cash required for capital from operating cash flow.

Mr. Buffett prefers to look at a calculation he calls “owner’s earnings,” but the rationale is much the same. Owner’s earnings, too, are a measure of how much money can be returned to shareholders through dividends or share buybacks, or used to increase the value of a company through investments or debt reduction.

Discount all of those future free cash flows back to their net present value, and you arrive at an alternative valuation for a company.

While these techniques exceed the resources of the average retail investor, Morningstar has a free-cash-flow tool that calculates market value for all of the 1,500 equities it covers. “It’s probably the only source out there that calculates that number across a broad spectrum of stocks,” says Dan Hallett, director of asset management with HighView Financial Group.

Morningstar’s free online resource groups all of those valuations by industry, sector, super sector and all equities collectively (valuations on individual stocks require a Morningstar subscription). Matthew Coffina, the editor of Morningstar Stock Investor, said the tool is more valuable at a higher level where averages smooth out the potential distortions that result from forecasting so far into the future. “It has been good at getting a sense of the overall valuation of the market,” Mr. Coffina said.

At the market’s extremes, stocks were undervalued by 45 per cent at the bottom of the recession, and 33 per cent in late 2011, according to the model. Right now, the market appears to be more or less fairly priced.

At the industry level, technology stocks appear to be the most overpriced right now, while energy stocks are the cheapest. The latter conforms with Validea Capital’s Value Index, which has the integrated oil and gas industry as the current top pick. Validea tracks a number of portfolios based on the leanings of Wall Street’s investing gurus.

Morningstar’s discounted free cash flow model also appears to bear some consistency with Validea’s Buffett-based portfolio. Some of Validea’s top-ranked Buffett-inspired picks, including Coach Inc., Oracle Corp., Infosys Ltd., and Novo Nordisk, are all estimated by Morningstar to be at least 10 per cent undervalued. But the correlation with Morningstar’s model is “very imperfect,” and doesn’t hold up for the whole portfolio, said John Reese, Validea’s CEO.

There’s no guarantee this particular resource by Morningstar will help the average investor pick undervalued stocks, but attention to free cash flow is a common feature among many of the world’s most successful value investors. Plus, free cash flow is less vulnerable to the kind of accounting manipulation that made Enron’s earnings look so good.

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