Cash flow is a concept that applies to anyone trying to create and stick to a budget.
The idea is straightforward: Don't spend more cash than what is coming in. But free cash flow is also an important indicator when considering investing in a company as it reflects the financial strength and viability of the underlying business.
There are numerous metrics that should be considered when purchasing a stock, such as the dividend yield, earnings and the price-earnings ratio.
But a company's free cash flow, defined as the amount of money generated from operations less capital expenditures, offers investors a clue as to how well a company can sustain its operations and, subsequently, build wealth for shareholders. A healthy level of cash generation allows a company to buy back shares, make acquisitions, pay dividends and/or repay debt.
Alternatively, if a company consistently uses more cash than it generates, the outlook isn't good.
Several of the investing legends who inspired our stock screening models focus on free cash flow as part of their evaluative process.
Warren E. Buffett, for example, looks for positive cash flow and tends to be wary of companies with heavy capital expenditures such as facilities upgrades and/or research and development costs because they can burn through more cash than they generate.
John Neff, who managed the Windsor Fund for more than 30 years, thought that earnings figures could be subject to accounting gimmicks, so cash flow was a go-to metric evaluating the strength of a business.
And Peter Lynch, manager of Fidelity's Magellan Fund for 13 years and author of One Up on Wall Street, looked for free cash flow yield -- cash flow per share divided by the share price -- of at least 35% before he got excited about a stock.
A company can have high levels of free cash flow for the wrong reasons such as because management is putting off needed repairs or other capital investments, so it is important to evaluate cash generation along with other fundamentals.
Using our guru-inspired stock screening models, here are six picks that pass muster.
Cash Flow Metric(s)
Free cash flow per share: $6.68
Free cash flow per share: $9.09 Free cash flow yield: 6.7%
Free cash flow per share: $5.22 Free cash flow yield: 12.4%
Cognizant Technology Solutions
Free cash flow per share: $3.07 Free cash flow yield: 5.4%
Universal Forest Products
Free cash flow per share: $5.45 Free Cash Flow Yield: 5.3%
Free cash flow per share: $2.12 Free cash flow yield: 2.7%
Maiden Holdings scores well under the Lynch-based stock screening model, due to its free cash flow yield -- free cash flow divided by share price -- of 37.01%, which satisfies the minimum 35% requirement under this model. Return on assets is also strong at 2.42%, versus the 1% minimum.
The company's price-earnings in relationship to its earnings per share growth or PEG ratio meets this model's requirements at 0.60, compared with the maximum allowed of 1.
2. Lear (LEA) - Get Report
This supplier to the global automotive industry earns a perfect score under the Neff-based stock investment strategy, due to its healthy free cash flow per share of $9.09 and P/E ratio of 10.20, favorable compared with the market's P/E ratio of 18. Average historical growth in both earnings-per-share and sales, based on three-, four- and five year averages, of 9.4% and 7.6% pass this model's requirements.
This strategy prefers stocks whose total return -- EPS growth plus yield -- divided by the P/E ratio is at least double that of the market or of its industry. At a level of 1.01, Lear passes this test.
Greenbrier earns a perfect score under the Kenneth Fisher-inspired investment methodology based on its level of free cash per share of $5.22, which is sufficient to cover three years of losses, a requirement under this model. Greenbrier also gets high marks for its price-sales ratio of 0.44, well under the 0.75 allowed maximum.
Long-term EPS growth of 57.80% is nearly four times the required minimum, and the three-year average net profit margin of 6.44% versus the minimum requirement of 5% adds appeal.
4. Cognizant Technology Solutions (CTSH) - Get Report
This business process services, consulting and information technology provider earns a perfect score under the Buffett-inspired model, due to its free cash flow per share of $3.07 and its ability to pay off all debt with earnings in under two years. Long-term EPS growth is favorable at 16.5%, based on three-, four- and five-year averages, and the company has shown consistently strong average return on equity of 20.4% over the past 10 years, well above the 15% required minimum.
Management's use of retained earnings reflects a return of 16.2%, considered favorable under this model.
5. Universal Forest Products (UFPI) - Get Report
Through its subsidiaries, Universal Forest Products supplies wood, wood composite and other products to the construction, industrial and retail markets.
The Fisher-based stock screening model likes the company's free cash per share of $5.45, which is adequate to cover three years of losses, and long-term EPS growth of 60.12% far exceeds the 15% minimum requirement under this model. The price-sales ratio, an earmark metric for Fisher, falls within the required range at 0.69, and total debt to equity is considered moderate at 15.04%.
The company also gets a thumb's-up from the James O'Shaughnessy screen, due to its persistent EPS growth and the stock's relative strength of 80, which places it in the top 50 preferred stocks under this model.
6. TJX (TJX) - Get Report
This global off-price apparel and home fashions retailer also earns a perfect score under the Buffett-based investment strategy. It has free cash flow per share of $2.12, as well as a strong historical ROE of a 10-year average of 40.3% versus the 15% minimum.
Management's use of retained earnings reflects a 16% return, favorable under this model, and earnings per share have increased every year for the past 10 years. Long-term average EPS growth based on three-, four- and five-year averages is considered favorable at 13%.
The company also scores well under the O'Shaughnessy-based model. It has strong cash flow per share and trailing 12-month sales of $32.67 billion, which, as required under this strategy, exceeds the market mean by more than 1.5 times.
TJX is a holding in Jim Cramer's Action Alerts PLUS Charitable Trust Portfolio. See how Cramer rates the stock here. Want to be alerted before Cramer buys or sells TJX? Learn more now.
At the time of publication, John Reese and/or his clients were long all five stocks mentioned in the article, CTSH, GBX, LEA, MHLD, TJX and UFPI.