From highly-innovative companies like Apple to cyclical companies like U.S. Steel, investors will seemingly invest in anything as long as it might provide market-beating returns. It takes a lot of time and effort to figure out whether or not a company represents a good investment, but one free cash flow-based trick makes the task a lot easier for long-term investors who have a full-time job outside of investing — and thus little time to spend figuring out what innovative new product Apple will come out with next.
The trick that I present in the following paragraphs automatically eliminates the vast majority of stocks in the market by defining a narrow universe of stocks from which to choose. Next, the trick whittles down the universe of possibilities to only cheap stocks within that universe. Investors who buy only cheap stocks from the select universe will likely outperform the market by a wide margin over the long run.
Step 1: Define the universe
Some investors focus on tech stocks, others are experts in retail, still others consider all stocks to be possible investments. However, the trick that I present here is designed to build a universe comprised only of companies that have a long history of stable profits.
Companies with a history of stable profitability tend to have durable competitive advantages that keep competition from lowering their profits. As a result, these companies will tend to continue earning a predictable profit year after year — making their fair values calculable with a high degree of confidence.
We will have to use a little statistics to identify these companies. First, calculate the company’s average free cash flow margin over the last ten years.
For Johnson & Johnson (NYSE:JNJ), we take each year’s revenue and divide it by each year’s free cash flow and then take an average of the results to get 19.87%.
After calculating the average margin, divide it into the standard deviation of the cash flow margins. The Microsoft Excel function for the standard deviation of a population is STDEVP(values). Johnson & Johnson (NYSE:JNJ)’s standard deviation is 1.81%. So, in any given year, the company’s free cash flow margin is likely to be within 1.81 percentage points of the mean (19.87%). When you divide 1.81% by 19.87%, you get a coefficient of variation of .09.