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Free Cash Flow Rules: AmEx, Mohawk

This was originally published on RealMoney. It is being republished as a bonus for readers.

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 - Get Report) 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 divided by 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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