Follow the cash to find better stocks

In many ways, investing is all about cash. You invest cash in an asset and you expect more cash in return in the form of dividends, perhaps, and hopefully by selling your investment for more than you paid for it. It makes sense to look at companies in the same way.

A good company uses its investors' cash to invest in assets such as machinery, raw materials and property, then uses these to generate a lot more cash. The better it is at doing this, the better an investment it will make at the right price, of course.

Yet, you rarely hear about a company's cash performance. Instead, the focus is on profits. That's because a smart accountant can make a company look a lot more profitable than it really is.

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But profits don't fund dividends: cash does. The good news is, it only takes a few minutes of number-crunching to get nearer the truth.

Investment's most important number

In the long run, cash flow is much harder to fudge than profit, which is a more subjective figure. The number to focus on is free cash flow' (FCF). This is the cash flow left after a company has paid its bills in other words, it's the money it has available to pay out to shareholders and to invest in further expansion.

You can work it out using the cash flow statement. Take the trading (or operating) cash flow. Subtract all cash expenses the company must pay we're talking things like interest bills, taxes and vital investment in the business (capex'). Then add back items such as interest received from investments, and cash from selling assets.

Table 1 on the right shows how to calculate FCF, using household goods giant Reckitt Benckiser (LSE: RB).

Checking profits and dividends

Now, the FCF figure on its own doesn't tell us much. But having calculated it, we can use it to check the quality of reported profits, the sustainability of dividends, and the all-important valuation.

Here's how. Take FCF per share (divide FCF by the number of shares outstanding). Now compare it to the company's earnings per share (EPS).

If FCF per share is significantly lower than EPS, try to find out why. If profits aren't being turned into cash, profits may be being overstated.

You can also use FCF to check dividend cover a company needs hard cash, not paper profits, to pay dividends, so this gives a clear view of just how sustainable a dividend payout is.

As table 2 shows, on these measures Reckitt's profit quality looks high. Most of its earnings are being turned into cash there's just a 4% gap between FCF and EPS. Dividend cover is healthy too, suggesting its payout is safe.

FCF is also a handy way to look at how efficient a company is how good is it at turning sales into cash for shareholders? You can find this out by calculating its FCF margin, rather than its profit margin.

Reckitt's performance on this front is impressive, as table 3 shows it is managing to turn a healthy 18.1% of its turnover into FCF.

Great company but is it worth the price?

So, we know that Reckitt Benckiser is a high-quality company. It's good at turning sales into cash, and its dividend is well covered. But is it good value?

One way to value an investment is to check the yield it offers. You can use this to compare the valuation of the asset with similar companies, but also with other assets are you being offered enough yield to take the risk of investing in this particular asset?

That's why free cash flow yield is used by many investors to weigh up whether a share is good value or not. The higher the yield the better.

As table 4 shows, Reckitt offers a 5% FCF yield on its current share price. That's OK, but nothing stellar so if you buy today, you are hoping that FCF will continue to grow strongly and give you a decent return on the purchase price that way.

For a company of lesser quality, you'd want to see a much higher FCF yield before you invested.