Another reason I heavily rely on free cash flow is that it is quite easy to manipulate earnings per share. It is a lot harder to fake cash flow over the course of many years. Cash does not lie.
There is usually a reason why a company trades cheaply and one must make sure that the cash flow will continue. Such questions that must be asked are as follows
- Is the company in secular decline? If the company has a product that might be made obsolete or is in an industry that is in decline than the low multiple might be justified.
- Is the industry the company is in cyclical? How bad would a downturn in the economy hurt free cash flow?
- Does the company have a strong enough capital structure to withstand a rough period?
- Can the management be trusted to return the cash to shareholders or invest it wisely? Or will they burn the cash on bad acquisitions and the likes?
- Are the cash flows unsustainable for any other reason?
- Is there a catalyst to bring out the value? Do I get paid a dividend while I wait? Are they buying back shares?