Analyst's Toolkit: Cash Tells GE's True Tale

Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.

Many investors focus on the bottom line when they're evaluating stocks. But net income offers little insight into the true health of a company, especially when it's as large as General Electric(GE Quote) or Microsoft(MSFT Quote).

They should consider the company's ratio of free cash flow to equity (FCFE) before they decide to invest. FCFE offers a more complete measure of the amount of cash a company generates, which directly impacts its growth potential.

To calculate FCFE, turn to the company's cash flow statement and balance sheet, and follow this equation:

FCFE = net income + depreciation - fixed capital investments - working capital investments +/- net borrowing

This formula takes a company's net income and figures out what's left for investors after it buys necessities and factors in debt financing.

In the first quarter, Microsoft had net income of $2.98 billion with $664 million of depreciation, a $1.75 billion decrease in working capital, $1 million in net borrowing and $116 million in fixed capital investments. That results in FCFE of $5.27 billion.

These numbers mean little without context. The value of this measure comes when you compare a company's FCFE from quarter to quarter and on a per-share basis versus those of its competitors.

Consider the following graph of GE's share price, FCFE and earnings per share over the past five years.

General Electric Free Cash Flow Trend Source: Yahoo Finance/Bloomberg

GE's share price follows its FCFE more closely than its earnings. That's because FCFE considers factors that don't directly affect its income statement.