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 - Get Report): A $2 billion market-cap financial with an operating model more like Moody's ( MCO - Get Report) 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.

MORN doesn't yet pay a dividend and has no long-term debt outstanding. The company has made some smart acquisitions to broaden its product portfolio, but we hope to see a dividend at some point. As of March 31, MORN had $4.40 per share in cash just sitting on the balance sheet. I wish it would give some of that to shareholders in the form of a special dividend.

Chicago Mercantile Exchange ( CME - Get Report): CME currently has a free cash flow yield of between 27% and 30% (the last three quarters), and it has consistently been greater than 25% since CME came public in late 2002. The dividend yield is still below 1%, but CME management boosted the quarterly dividend just recently from 86 cents to $1.13. The acquisitions of the old Chicago Board of Trade and now the New York Merc have been done with a combination of cash and stock. The stock hasn't traded well since February. Let it bottom first.

Moody's: Like finding out the pretty girl in your senior high school class has extraordinarily bad breath, one of the best business models and one of the best financial stocks this decade has taken gas on the subprime issue, thanks to the failure of the rating models. Be careful shorting this stock, since the free cash flow yield on MCO has been between 25% and 35% for the last three years.

MCO pays a small dividend of just 32 cents per year, but it has been buying back stock religiously since it came public. With analyst compensation being the real fixed cost in the model, MCO has tight control over compensation expenses, and if it moves to a ratings model that is more "implied" or "market spread-driven," analysts could become less important to the model. This stock is a very tempting long in the low $30s.

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

At the time of publication, Gilmartin was long MORN and CME, although positions may change at any time.

Brian Gilmartin, CFA, founded Trinity Asset Management (TAM) in 1995, where he is currently a portfolio manager. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Gilmartin appreciates your feedback; click here to send him an email.