Cash Flow 101: Morningstar, Moody's, CME

This was originally published on RealMoney on May 28, 2008 at 2:59 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Normally, when you analyze financial stocks, unlike industrial or retail or health care companies, cash flow is much less meaningful to the analyst, and capital and capital adequacy are the name of the game.

However, not all financial stocks are regulated by the banking or insurance industry, and in fact they have business models similar to those of other businesses, and thus cash flow and free cash flow become meaningful analytical measures.

• Cash flow is defined as cash generated from operations (or CFO, as defined on the statement of cash flows) and not EBITDA or some other derivation.
• Free cash flow is defined as cash from operations less capital expenditures (or capex). Unlike most Wall Street analysts, we deduct the dividend from free cash flow calculations, thus our free cash flow calculation is cash from operations less capex and less dividends.
• Free cash flow yield is defined as free cash flow divided by revenue, and in the case of our analysis we use four-quarter trailing numbers to smooth out seasonal fluctuations.

The significance of substantial cash flow and free cash flow generation is obvious to most analysts. Robust cash flow and free cash flow are signs of a healthy business with a much lower bankruptcy risk, and strong free cash flow generation gives company management options in terms of uses of the cash, many which can benefit equity shareholders.

Some of these options include investing in future growth initiatives, repurchasing more shares of stock to reduce share count, paying down debt (thus reducing interest expense), increasing the dividend or even making a non-dilutive acquisition, using cash and not stock.

The downside of cash and cash flow is that unless a company makes the right choice on their use, they can cut into returns on capital. Strong cash generation can become an Achilles' heel to company management if it chooses to simply collect cash on the balance sheet and it starts to burn a hole in its pocket. Managements still have to make the right decision in terms of using the cash.

Making the Grade

Three financials that we follow have very high free cash flow yields:

Morningstar(MORN Quote - Cramer on MORN - Stock Picks): A $2 billion market-cap financial with an operating model more like Moody's(MCO Quote - Cramer on MCO - Stock Picks) than the typical financial, MORN has had a free cash flow yield better than 20% since mid-2006, and prior to that, MORN's free cash flow yield was in the mid to high teens.

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