Building a high-value stock portfolio begins with an understanding of value-creation performance.
The first step in putting together a value portfolio is to assess the value creation of companies you're considering. This involves the application of two value-oriented metrics: free cash flow and return on equity. It's a task that is greatly simplified with the help of free Web-based stock screeners.
Excess Cash Equals Flexibility
As anyone familiar with the day-to-day operations of a business can attest, "cash is king." Professional money managers apply the same mantra in looking at potential investments.
"Excess cash" allows management several options:
• Return it to shareholders as dividends.
•Use it to pay down debt.
•Expand by acquiring another company.
•Buy back some of the company's stock to reduce the number of shares outstanding and boost the value of remaining shares.
Excess cash comes from two sources: cash in the bank ("cash on hand" on the balance sheet) and cash generated from operations ("operating cash flow").
While cash on hand is fairly self-explanatory, operating cash flow is a bit more nuanced. In calculating a company's true "cash earnings," money managers tend to favor free cash flow (FCF). This is cash left after a company funds operations and makes the investments necessary to maintain and/or expand its fixed asset base. FCF is calculated by subtracting capital expenditures from operating cash flow.
Comparing Unlike Enterprises
In comparing companies of different sizes and across industries, FCF must be adjusted.
The first step is to divide FCF by the total number of shares the company has issued, and divide that by the price per share to determine "FCF yield." Broadly speaking, companies exhibiting high FCF yields generate attractive amounts of excess cash vis a vis their stock price. This cash may be returned to investors or reinvested in the business.
Generation of copious amounts of excess cash doesn't always mean the company will put the capital to good use, however.
To measure efficiency in this respect, return on equity (ROE) is considered. ROE measures how much profit management has been able to generate for every dollar of equity capital. It is calculated by dividing net income by total equity.
Next, though there are no hard and fast rules for determining what a healthy FCF yield or a good ROE is, a company's metrics can be compared with those of its industry peers, an average of all listed companies, and, finally, its own historical performance.
Stock Screening Made Easy
So how do you put these ideas to work in your own portfolio? The first step is to screen for FCF and ROE. Fortunately plenty of free stock screeners are available online – with companies' FCF per share and ROE already calculated.
A few examples of Web sites with free stock screening capabilities include Reuters.com, Finance.Yahoo.com, and WSJ.com.
For a representative sample of the types of companies that exhibited attractive FCF and ROE metrics at the time of this writing – and a comparison of this sample portfolio's average price performance versus Standard & Poor's 500 average over the preceding year.
With this foundation in place, a potential next step in portfolio building is to consider incorporating a growth component.
Juan A. Landa is a founder and principal of Matterhorn Capital Management, a portfolio management firm in San Antonio.
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