Buy Quality on the Cheap

A quick check of the market's sale rack finds the following:

CVS Caremark (NYSE: CVS) is trading at an earnings multiples that clocks in below its industry and its own five-year averages. Target (NYSE: TGT) and Caterpillar (NYSE: CAT) are trading at discounts to their recent historical levels, too, and the likes of Google (Nasdaq: GOOG), EMC (NYSE: EMC), SanDisk (Nasdaq: SNDK), and Home Depot (NYSE: HD) are not even within shouting distance of their 52-week highs.

Which can only mean one thing, right? It's time to ...

Buy low! Sell high!
Just kidding, actually. I'm sure that's one piece of investment "advice" you've heard all too many times, and the only proper response to it is, "Well, duh." The real question, of course, is how to know whether you're buying low and selling high. Discounted cash flow (DCF) analysis is one compelling way to answer that question.

Show you the money
Rather than focusing myopically on earnings (which are easily fudged) or on some kind of short-term market catalyst (which may never materialize), DCF analysis requires companies to show you the money -- literally.

By zeroing in on a company's free cash flow (cash from operations less capital expenditures), making conservative assumptions about future earnings growth, and applying a discount rate (the return you require given the business' risk), you'll be in a good position to determine whether a company is trading above or below its intrinsic value -- and within your margin of investing safety.

Follow the Fool
That's the tack that Philip Durell -- the Fool who leads the charge at our Motley Fool Inside Value newsletter -- takes each month as he scoops up two picks from the market's bargain bin for his subscribers. Despite their loads of free cash flow, these companies' shares are currently on sale.

One of Philip's picks, a big-box retailer with a wide appeal, churned out more than $5 billion in free cash flow during fiscal 2007. Another is the aforementioned Home Depot, a hardware-industry titan whose current P/E represents a steep discount relative to its five-year average -- despite generating more than $2.2 billion of free cash flow in 2007.

Now what?
The next time you think you've found a quality company at a can't-miss price, make sure it shows you the money. Using DCF analysis can help guide you to real cash and real promise -- for a real bargain.

And if you'd like to peek at Philip's full lineup of recommendations, just click here to take Inside Value for a risk-free spin. Your trial won't cost a thing for 30 days, and it'll come in mighty handy, I suspect, as you go about the very important business of generating a little free cash flow of your own.

This is adapted from a Shannon Zimmerman article originally published on Jan. 25, 2007. It has been updated.

Rex Moore is an analyst for Motley Fool Stock Advisor and doesn't own shares of any of the companies mentioned. Home Depot is an Inside Value pick. The Fool has a strict disclosure policy.

Copyright © 2008 Universal Press Syndicate.