Net-Net vs. Free Cash Flow: 4 Kids, Kraft

Management can take the cash left over and buy back shares, increase the dividend, buy other companies, pay down debt or let the cash accumulate. A stock's price will eventually respond favorably if these five things are taking place. Following this method allows investors to find growing companies, not ones that are bleeding cash.

Let's look at the free cash flow king, Warren Buffett. He is either looking for companies that are at the bottom of a cycle and are going to come up in flows, or companies that are always progressively increasing cash flows.

One of Buffett's newer holdings is Kraft(KFT). The world won't stop eating cheese, and the company does not have too much debt. Its free cash flow has been about $2.3 billion over the last few years. Buffett obviously believes that this flow will increase in the future and that the stock's price will respond.

GlaxoSmithKline(GSK) and Sanofi Aventis(SNY) are two examples of his holdings that have not done much over the past few years. However, they have a ton of drugs in late-stage development. He must believe that the sales from these drugs are going to manifest into free cash flow and, ultimately, an increase in the stock's price.

Remember Buffett's two rules for investing. Rule No. 1: Don't lose money. Rule No. 2: Don't forget Rule No. 1.

This was originally published on RealMoney on Sept. 30, 2008. For more information about subscribing to RealMoney, please click here.

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