Going with the Cash Flow

If you had to narrow your stock search to one data point, cash flow would be a logical place to start. What's so great about free cash flow? To start, reported cash flows are much less subject to accounting gimmicks than reported earnings. While it's all too common for company management to stretch the limits of generally accepted accounting principles to meet targets for earnings per share, cash flows generally don't lie. Plus, free cash flow has tangible value. You can't take reported earnings to the bank, but free cash flow measures the amount of money the company has available to invest in new revenue opportunities, pay dividends, or buy back shares.

For this week's Five-Star Investor, we used Morningstar's  Premium Stock Screener to find companies that have consistently generated free cash flows equivalent to at least 5% of their annual sales. Fewer than 600 of the 7,000 companies in Morningstar's stock database were able to meet that hurdle.

Because it's tough to generate that much cash year after year, shares of these companies tend to be pretty pricey.  Microsoft (MSFT), for example, spins off about $13 billion in excess cash each year, but the company's stock typically carries a P/E at least 30% higher than the market. So we also limited the final cut to companies with free cash flows equivalent to at least 10% of their market capitalizations, to weed out the stocks with the most inflated market values.

Here are some highlights from the screen. We'll even put in a plug for one of our competitors--publisher McGraw-Hill, which owns Standard & Poor's, BusinessWeek, and other high-quality brands.

 McGraw-Hill (MHP)
Morningstar Rating: 5 Stars
Economic Moat: Wide
Business Risk: Below Average
From the  Analyst Report: "Our $75 fair value estimate assumes sales growth of 7% over the next five years, led by educational publishing, which we expect to grow at 10% (thanks to acquisitions). The financial-services and media-services divisions should each chip in 4%-6% growth over this period. We expect operating margin gains to continue over the next five years, to 20.6% in 2007 from 19% in 2002, as scale increases in the educational-publishing division and the domestic advertising market recovers."

 Altria Group (MO)
Morningstar Rating: 4 Stars
Economic Moat: Wide
Business Risk: Average
From the  Analyst Report: "Altria is a cash machine. It generated $7 billion in free cash flow in 2001 and $10.6 billion in 2002, despite the problems plaguing its Philip Morris USA unit. In 2002 it sold struggling Miller Brewing to South African Breweries, creating a $1.7 billion windfall that it used to accelerate its share-repurchase program. Yet its stock price does not reflect those positive fundamentals because of the competitive and legal challenges the company faces."

 Equifax (EFX)
Morningstar Rating: 4 Stars
Economic Moat: Wide
Business Risk: Average
From the Analyst Report: "High entry barriers help leading credit reporter Equifax earn healthy cash flow and large returns on capital. We think this is an excellent business and value the shares at $28. Because of Equifax's strong competitive position, we would require only a 20% margin of safety to our estimate before investing."

 H&R Block (HRB)
Morningstar Rating: 4 Stars
Economic Moat: Wide
Business Risk: Average
From the  Analyst Report: "The reason to invest in this company is the hegemony of its tax business, and that is stronger than ever. Solid core earnings make H&R Block an attractive investment below $38, in our opinion."

 Allied Waste Industries 
Morningstar Rating: 3 Stars
Economic Moat: Narrow
Business Risk: Above Average
From the  Analyst Report: "Like most waste companies, Allied sports a rock-solid business model. The residential waste-collection business throws off strong and stable cash flow. Customers are typically charged monthly fees that don't vary with the volume of trash collected. As long as households need garbage-collection services--a relative certainty for the foreseeable future--a large portion of Allied's revenue should be recessionproof."

 GlaxoSmithKline (GSK)
Morningstar Rating: 3 Stars
Economic Moat: Wide
Business Risk: Below Average
From the  Analyst Report: "Even with patent troubles regarding Paxil, Augmentin, and Wellbutrin--three of the company's best-selling treatments--we still expect healthy cash flow. We assume only 3% average revenue growth over the next five years, but that should provide $6-$7 billion in annual free cash flow (cash flow from operations less capital expenditures). And if Glaxo's marketing team is successful in promoting the new and improved versions of the aforementioned three drugs, our revenue forecast could prove low."

To run this screen yourself and see all the stocks that passed, click  here. (Note: You will need to be a Premium Member to view and save the complete screen.) After clicking, you can save the search to use later by using the "Save Criteria" button in the bottom right-hand corner of the screen.