How to Invest $1,000 or a $1,000,000

Over the past decade, I’ve received dozens of e-mails from folks who write in to ask me:

“Dan, is there a secret to finding great investments?”

Well, it’s a difficult process… but the answer is yes.

If you know what to look for, there’s a definite secret to finding what we call “slam dunk” great investments. The kind of stocks that could make you a fortune – with very little risk. Often, these are such good investments, you can pass your stake on to your children or grandchildren.

It all boils down to what I call “Finding The Financial Clues.” Today, I’m going to share the first clue I look for.

Simply put, I want a business that gushes with free cash flow.

Free cash flow is the excess cash profit left over after a business pays all its expenses and taxes and after it reinvests enough cash to maintain and grow the business.

When you buy a stock in your brokerage account, you’re buying a piece of a business. You’re buying equity. Equity is a “residual claim” on the earnings of a business. “Residual” just means the equity holder doesn’t get paid until everybody else gets paid. This is really important.

You see, there’s nothing left over for equity holders until secured creditors, salary and wage earners, taxes, trade creditors, unsecured creditors, and preferred stock holders all get paid. Only after all these obligations are met can you, the equity holder, expect your shares to be worth anything.

In fact, excess cash flows are the one thing that give your stock nearly all of its value.

It makes sense, right? This is what makes a business valuable: the ability to generate lots of extra cash. Without excess cash, your shares are worthless.

Think of it a different way…

Suppose you own a business. You want that business to pay you as much cash as possible during the time you own it. And that’s true whether you own 100% of a business you run yourself – or whether you own just one share of a multibillion-dollar company.

Free cash flow is easy to find. All you do is go to the “cash flow” section of a company’s financial statements and subtract “capital expenditures” from “operating cash flow.”

If you want to be nitpicky, sometimes operating cash flow is called “cash from operations” or “net cash from operations.” And sometimes, capital expenditures are called “additions to property and equipment” or something similar.

Take software giant Microsoft (MSFT), for example.

Here’s how I calculate Microsoft’s free cash flow:

• Net cash from operations is $28.8 billion.
• Let’s subtract $4.3 billion for additions to property and equipment.
• This equals $24.5 billion.

That’s a lot of free cash flow.

Few businesses generate as much free cash flow as Microsoft.

What’s interesting is most people have no idea how important this financial clue is, so they’re unable to understand what an amazingly good business Microsoft really is right now, despite all the negative headlines about it.

To sum up:

1. Free cash flow is all the excess cash left over after a business pays all its expenses and taxes and reinvests enough to maintain and grow itself.

2. Free cash flow is important because it’s the amount of excess cash available for creating shareholder value, which is how you make the most money.

3. Free cash flow = cash from operations – property and equipment spending. Both those numbers are on the cash-flow statements inside a company’s quarterly and annual reports.

The thing is, while a company may generate lots of cash, it might not use it to benefit shareholders.

Great businesses “pay back” their investors, and that’s the second clue you want to find when looking for a long-term investment.

Great companies reward their shareholders in two ways. The first strategy is pretty straightforward. But the second strategy… Most folks don’t understand how it works.

Today, I’ll cover both strategies. And I’ll show you how the second strategy offers a huge tax “loophole.”

Let’s get started…

The first way a great business rewards its shareholders is by paying cash dividends.

Cash dividends are usually paid quarterly, and they’re good for two main reasons.

First, they provide you with a regular cash return on your investment. One study shows that investors earned 394% on stocks from 1991 to 2010, and that 43% of that return came from dividends.

Forty-three percent is a huge chunk of return. If you’re investing in stocks, you simply can’t afford to ignore dividends.

Really great dividend-paying companies raise their dividends every year for many years in a row, often for decades.

With some good dividend-paying stocks, you’ll make more on the dividends than you will on the share-price appreciation.

What’s interesting is, companies that begin paying dividends after notpaying them often perform just as well as companies that raise their dividends.

A study by Ned Davis Research shows that stocks in the S&P 500 that either raised or initiated dividends from 1972 to 2004 outperformed all other stocks in the S&P 500.

The worst performers were companies that cut their dividends – or never paid them in the first place.

Bottom-line: Dividend-paying stocks are the best place to put a large chunk of your stock-market money.

Now… the second way companies reward shareholders is by buying back their own stock.

Why is this good for you? Well, when a company reduces its share count, it’s like cutting a pie into four slices instead of eight slices. You’re getting a much bigger piece of pie. Likewise, as the company’s share count falls, each remaining share is worth more.

And here’s another reason why share buybacks are good…

You have to pay taxes on cash dividends… but you DON’T PAY TAXES when a company is using cash to buy back shares… even though a share repurchase makes your shares more valuable…

In other words, a share repurchase is like a tax-deferred, non-cash dividend that you receive for as long as you hold your shares.

So to sum up:

1. Look for companies that reward shareholders. Shareholders are rewarded in two ways: dividends and share buybacks.

2. Look for companies that raise their dividends every year.

3. Look for companies that buy back shares and reduce their share counts.

 

[Editor’s note: Every month, Dan scours the market for companies with little debt and lots of cash. And when he finds them trading far below their true value, he highlights them for subscribers. To learn more about subscribing to Extreme Value, click here.]