Boiled down to its absolute core, business is about one thing: turning assets into free cash flow.
It really is as simple as that!
It strikes me as odd, then, that free cash flow is not popularly used to tell if a stock is cheap. We use the exploitable earnings number for calculating the P/E ratio and earnings yield. We use another maneuverable number - book value - to calculate the P/B ratio. While these numbers are useful, there are a lot of "yeah buts" involved... particularly if a company has a lot of one-time write-downs, tax adjustments, goodwill, etc.
Free cash flow, on the other hand, is a "pure" metric. All publicly listed companies are required to provide it. It drills through accounting tricks and tells you exactly how much CASH the business generates. It may not be a smooth and "predictable" as earnings, but it is a far more reliable measure of business performance.
So then, why not use free cash flow to gauge how cheap a stock is? Better yet, why not start right at the top and find 4 stocks with outrageously cheap free cash flow yields against their enterprise values?
No stock gets super cheap without a reason. But analyzing the reasons is not the point of this article, nor is it the point of Magic Formula® Investing (MFI). The point is, why wouldn't you buy an asset that returned 24% or more a year on your invested cash? Here they are:
4) Kulicke & Soffa (KLIC, Financial) - 24.3% FCF yield
Kulicke & Soffa is a small semiconductor equipment company, focusing mainly on the packaging step. The company has been buoyed by the move from gold to copper wire bonding that has taken place over the last several years. The firm has consistently generated free cash flows exceeding its reported pre-tax earnings and carries a massive amount of cash ($600 million) with no debt. Investors have been worried about the copper transition flaming out, but we haven't seen it yet, and KLIC has been diversifying its business for the last several years.
3) Take Two Interactive (TTWO, Financial) - 28.9% FCF yield
Take Two is one of the 3 big video game publishers worldwide. Their blockbuster franchises are headlined by Grand Theft Auto, and also include Midnight Club, BioShock, Civilization, and the 2K Sports lines. The launch of Grand Theft Auto 5 led to a massive influx of cash last year (earning over $1 billion in its first three days), so this yield is probably not sustainable. Still, the cash is very real and given its franchise nature, it stands to reason that GTA will continue to deliver huge shots of cash every few years for the foreseeable future, while the company works on developing new and similar titles.
2) magicJack (CALL, Financial) - 29.1% FCF yield
One of the litany of voice-over-IP (VoIP) providers out there, magicJack sells a dongle that turns any cable modem or computer into a landline access phone jack. The selling point here is price: the company's service cost is just $30 a *year* (less than $3 per month), making it far cheaper than VoIP service from cable firms or wireless providers, and even similar providers like Vonage (VG). magicJack is trying to expand internationally, and has had some revenue difficulties recently, but the company throws off a ton of cash and is selling at an undeniably bargain basement valuation right now.
1) CTC Media (CTCM, Financial) - 30.8% FCF yield
CTC Media runs Russia's 5th largest over-the-air TV network, as well as a couple other demographically targeted networks. Like most media firms, it generates a reliable stream of cash and has a built-in competitive moat in the form of regulatory hurdles. Unlike most media firms, it has a great balance sheet and shareholder-friendly management. The issue here is not the operating business but the new Russian Media Ownership act, which was just signed into law this week. While this creates an uncertain environment for foreign investors like us, I still believe there are several courses of action the company may take to provide those investors a reasonable return, particularly from current share prices.
With the exception of TTWO, all of these stocks have been previously recommended as Top Buy stocks here on the site, and all are certainly selling cheap enough for consideration for a Magic Formula® style portfolio.
