Buy Quality on the Cheap

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

Citigroup (NYSE: C) and Microsoft (Nasdaq: MSFT) are trading at trailing-12-month price-to-earnings (P/E) ratios that clock in below their respective industries' and their own five-year averages. Johnson & Johnson (NYSE: JNJ), Wal-Mart (NYSE: WMT), and Pfizer (NYSE: PFE) are trading at significantly discounted levels, too, and the racier likes of Apple Computer (Nasdaq: AAPL) and Yahoo! (Nasdaq: YHOO) are more than 20% below their respective 52-week highs.

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

Buy low! Sell high!
Just joshing. Indeed, that's one piece of investment "advice" that I suspect 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 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 firm's free cash flow (cash from operations less capital expenditures), making conservative assumptions about future earnings growth, and applying a discount rate (i.e., the return you require given a firm's 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 (FCF), these companies' shares are currently on sale.

One of Philip's picks, for example, is the aforementioned Wal-Mart, a company that, over the course of its last five fiscal years, has delivered nearly $16 billion in FCF. Another is a tech-industry titan whose current P/E is less than half its five-year average -- despite generating more than $4.1 billion of FCF in fiscal 2006 alone!

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 sneak a peek at Philip's full lineup of picks, just click here to take Inside Value for a risk-free spin. Your trial won't cost a thing for 30 days and will 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 article was originally published on Jan. 25, 2006. It has been updated.

Shannon Zimmerman is the lead analyst for the Motley Fool Champion Funds newsletter service and doesn't own shares of any of the companies mentioned. Pfizer, Microsoft, and Wal-Mart are Inside Value recommendations. Johnson & Johnson is an Income Investor recommendation. The Fool has a strict disclosure policy.