Free Cash Flow Is King

Updated from Aug. 15

Editor's note: The original version of this column contained a calculation error in Mohawk's free cash flow. We apologize for the error.

We've all heard the saying that "cash is king," but in investing, I like to say that "free cash flow (FCF) is king." Profits are great, but they don't count for much in the long-run if a company is not generating FCF. After all, FCF is the money left over after a business pays all its bills.

A few perfectly legitimate accounting adjustments can tweak earnings to management's delight, but at the end of the day, it's the cash that's left over that counts. Businesses that produce healthy amounts of free cash flow can be valued with a higher degree of certainty and margin of safety than simply going on profits.

With everyone sour on the market today, several wonderful businesses continue to pour out fantastic levels of free cash flow and are thus increasing intrinsic value while the equity price sits still. Sooner or later the stock price will catch up.

Cash Can Be Counted

Unlike profits, free cash flow can not be manipulated by the magic stroke of the accounting pen. An inventory adjustment here, extension of generous credit terms there, and you can manufacture a profit number without doing anything illegal.

However FCF, or cash flow from operations less capital expenditures, can't be manipulated through accounting changes. Remember that the value of any business is the present value of the future cash flows of the business.

Cash Cow at American Express

One of the world's most dominant consumer brands is currently trading at levels not seen for years. At $43 billion dollars, American Express (AXP - commentary - Cramer's Take) is trading at about 6 times 2007 free cash flow of some $7.5 billion. At six time's free cash flow, this would imply that Amex is trading at a free cash flow yield (annual FCF/market cap) of nearly 17%! So far, Amex has been producing healthy levels of free cash flow in 2008, suggesting that the overall business remains sound

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At the time of publication, Gad was long Berkshire Hathaway, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund, a value-centric investment partnership modeled after the original 1950s' Buffett Partnerships. Previously, Gad was a writer for The Motley Fool and a securities analyst for UAS Asset Management, a small, value-focused fund in New York City.

Gad also runs a value investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Gad is working on a value investing book (title forthcoming) to be published by John Wiley and Sons in the summer of 2009. Reach Gad at [e-mail].