Dig beyond the obvious when assessing stock

Free cash flow and return on equity help investors measure true stockvalues

With volumes of information at their disposal, savvy stock pickers increasingly are looking for quick ways to assess a company's value before studying that inches-thick annual report.

The analytical gurus at the Chicago-based investment research company, Morningstar, recommend two ways to measure a stock's value: free cash flow and return on equity.

Attention mathphobes and investment novices: Don't stop reading now. You too can benefit from the measures just as much as can professional money managers who long have used these figures, says Morningstar stock editor Haywood Kelly.

The numbers are regularly included in financial magazine articles but also come free on investment research services including Morningstar's Web site (www.morningstar.com).

Flow me the money

Free cash flow shows how much money from sales a company keeps after paying bills and buying the computers, paper clips, and other items it needs to operate. If the number is positive, the company generates more money than it needs to keep running and can use the extra dough to pay dividends, buy other companies, and reduce debt. If it's negative, however, a company will not generate enough cash to invest in itself or repay investors.

Free cash flow may seem tricky at first, but it offers a better picture of a company's health than just earnings or P/E ratios, says investment adviser Kurt Brouwer, president and co-founder of Brouwer & Janachowski in Tiburon, Calif.

Mr. Brouwer says profits could be altered if management divests a division, takes a big write-off, or shifts earnings from one global unit to another.

"More and more people are looking at cash flow because more and more companies play games with their earnings," he says. "But cash flow is harder to manipulate."

Companies strive for positive free cash flow but may forsake it in the short term if they are ramping up - building more stores or factories, stocking shelves, or buying other companies, says Mr. Kelly. He adds that Starbucks and Home Depot are examples of companies with negative cash flow but good prospects for moving out of the red because of their aggressive building and spending.

Once investors are comfortable with a prospect's cash flow, they should look at return on equity. ROE shows how wisely a company invests the money it has raised from shareholders. To calculate ROE, divide a firm's net income by shareholders equity. Then multiply that number by 100 to put the figure in percentage terms. The higher the ROE the better, but a good rule of thumb is about 15 percent.

This double-digit figure, however, holds only as long as the economy and company earnings remain strong. In a recession, ROEs may fall to single digits yet still be considered healthy.

"If a company is spending aggressively [and has negative or low free cash flow], it is key to see if it is spending that money well," Kelly says. "Earning a high return on spending and return on equity helps you gauge that."

Happy returns on equity

Home Depot, which has negative free cash flow and has been spending aggressively to expand its do-it-yourself empire, has a ROE of 21 percent. That's more than triple the 6 percent offered by a 30 year Treasury bond.

Just because a company has a low ROE does not mean it should be avoided, especially if it's not risky or is attached to a stock that's fairly cheap, Kelly says.

Riskier endeavors may carry negative free cash flow but should have a high ROE to compensate investors for the uncertain nature of their investment.

Determining what constitutes a good ROE and what makes a bad one can be risky because that 15 percent rule does not work for all industries, Brouwer adds.

A high-flying company with rapid growth should exceed 15 percent, but that figure would be more than respectable for a bank, he says. "It's hard for an ordinary investor to really comprehend those [ROEs]," he says.

One example of a company priced relatively cheaply but with a high ROE is SAP, the German software company whose stock has fallen largely because of Y2K concerns.

On the other hand, Kelly says, a company that is not particularly cheap, is fairly risky, and has negative free cash flow is the Japanese electronics company Hitachi, which has seen its ROE hover near zero year after year. "That's a company that's spending tons of money and isn't getting a good return. Over a period of time, that really destroys a shareholder's wealth," Kelly says.

He, Brouwer, and other portfolio managers call for companies with poor records of investing to return that money to shareholders in dividends and interest so they can invest the funds themselves, likely at a higher return.

(c) Copyright 1999. The Christian Science Publishing Society