When a publicly traded company makes money, who is the first
to get paid?
Imagine a line of people waiting in line on payday. They
include the company's creditors, employees, preferred
shareholders and of course, the government.
Like it or not, as a common shareholder, you're the last in
You don't get paid dividends until everyone else has been
And this is why free cash flow (
) is such an important valuation metric when analyzing a
StreetAuthority's sister site InvestingAnswers.com defines
free cash flow as "a measure of how much cash a business
generates after accounting for capital expenditures such as
buildings or equipment."
And here's why it's important:
The presence of free cash flow indicates that a company has
cash to expand, develop new products, buy back stock, pay
dividends, or reduce its debt. High or rising free cash flow is
often a sign of a healthy company that is thriving in its current
Furthermore, since FCF has a direct impact on the worth of a
company, investors often hunt for companies that have high or
improving free cash flow but undervalued share prices -- the
disparity often means the share price will soon increase.
Let's look at a company that matches up perfectly with these
Over the past 12 months,
JPMorgan Chase (
has generated $6.7 billion in free cash flow. This equates to
$1.77 per share.
That's quite a turnaround for a company that lost $38 billion
during the financial crisis in 2008.
Did the biggest bank in the U.S. (by assets) learn anything
from its devastating experience in 2008? According to CEO Jamie
Dimon, it did.
The man who analyst group Morningstar named as its CEO of the
year in 2002 says JPMorgan emerged from the crisis a much
In fact, between 2007 and 2013 management has doubled tangible
book value per share. Since 2008, earnings per share have risen
like clockwork, from $1.37 to $6 today.
The company's operating margins are stellar. Over the past 12
months, the company has reported an operating margin of 33%.
And right now, with a forward price-to-earnings (P/E) ratio of
8.5 and a price-to-book (P/B) ratio of 1, the company is
inexpensive. This is despite a solid gain of 25% over the past
The company pays a dividend of 2.5%, backed by a low payout
ratio of only 21%.
However, JPMorgan has been in the headlines recently, and not
for reasons investors like to see.
The company has offered to pay $3 billion to settle criminal
and civil investigations by federal and state prosecutors into
its mortgage-backed-securities activities.
This scandal follows the "London Whale" losses sustained in
2012, when JPMorgan's Chief Investment Office lost $2 billion on
a series of transactions involving credit default swaps. The
chief officer responsible for the mess has since stepped
So what are we to make of JPMorgan's management?
On one hand, JPMorgan's management team has doubled book value
since 2007 and tripled revenue since 2003.
On the other hand, some members of management have made
terrible decisions, resulting in billions of dollars in losses
due to bad derivatives trades and government fines.
The problem may stem from its size. The company manages more
than $2 trillion worth of assets in dozens of countries.
Economics of scale help JPMorgan compete by offering rates and
services that smaller banks simply can't compete with.
But this same size makes the company much more difficult to
manage, and the resulting headaches caused by far-flung managers
making bad decisions could continue to plague the
Still, the current negative sentiment and bad press has
resulted in the company's stock selling for cheap. For the
investor who is willing to stomach the risks, buying shares of a
financial juggernaut like JPMorgan at a price even to book value
may be too good to pass up.
Risks to Consider:
The banking industry is subject to significant regulatory and
macroeconomic risk. While JPMorgan is more conservatively
governed than some of its peers, the financial crisis of 2008
proved that even institutions of its size are subject to dramatic
shortfalls when the U.S. economy stagnates or dips into
Action to Take -->
For contrarian investors looking for a bargain, JPM rates a buy
at today's prices. Once the current litigation is resolved, the
company should continue to do what it does best -- generating
enormous free cash flow at impressive margins.