Yes, the price-to-earnings ratio is important when analyzing stocks. The same for the debt-to-equity ratio, dividend yield and earnings-per-share growth rate.
But another variable is worth seriously considering, though often overlooked by both investors and the media. That variable is free cash flow, which is the amount of money generated from a company's operations, less capital expenses. Free cash flow yield is free cash flow per share divided by the stock's price.
This focus on operating earnings is beneficial because it removes one-time gains or losses that often distort how well a company is really performing and is less susceptible to accounting tricks that can be used to manipulate reported earnings.
Savvy investors appreciate how important free cash flow can be when analyzing a stock. To find promising investments, my computerized guru strategies based on the thinking of Warren Buffett, Peter Lynch and Kenneth Fisher all include free cash flow yield as a key factor when analyzing a stock.
As important as this variable is, be aware of its limitations. Very high free cash flow may be more a function of a company postponing necessary capital expenditures rather than being a sign of a strong business. The reverse may also be true: weak cash flow may reflect a short-term rise in major capital investments rather than being a reflection of a faltering business. As with all stock analyses, do not rely solely on one variable when studying a stock.
To find stocks to recommend, I just screened for those with a cash flow yield of 25% or more. In addition, those that passed this test had to get a high approval rating from one of my guru strategies. One such company is Middleby (MIDD), which manufactures cooking and warming equipment used in commercial restaurants and institutional kitchens, as well as in residential kitchens. Its brands include Viking, Holman and Blodgett. Middleby's cash flow yield is 25.7%, and it is a favorite of my Warren Buffett-based strategy. The strategy likes the company's prominent market position, earnings per share that have increased in nine of the past 10 years, moderate amount of debt and an expected rate of return to investors over the coming decade of 16.6%.
The ubiquitous credit card company MasterCard (MA), whose cash flow yield is 25.8%, earns kudos from the strategy I modeled on Martin Zweig's writings. This strategy looks for stocks with a P/E ratio of at least 5, but less than 3x the current market P/E, which is 18, yet never more than 43. MasterCard's P/E of 28.27 is well within the desired range. In addition, there has been positive earnings growth in recent quarters, earnings per share increases in each of the past five years, and long-term EPS growth of 23.89% (15% is the minimum).
Another financial company worth a look is Signature Bank (SBNY), whose cash flow yield is 28.5%. This is a full-service commercial bank with 27 private client offices in the New York metropolitan area. Its clients include privately-owned businesses, their owners and senior managers. My Peter Lynch-based strategy likes this bank because its P/E/G ratio (price-to-earnings relative to growth) is 0.78, well below the strategy's 1.0 ceiling. Its equity-to-assets ratio is also strong: 9.0% vs. the strategy's 5.0% minimum.
All of these companies have a strong free cash flow yield, while being high performers for a variety of other reasons, as measured by the guru strategies.