Broadcom and Bristol-Meyers Squibb are among the high-quality stocks with strong operating performance and manageable debt.
In an uncertain economic environment, it can pay for investors to focus on companies that can weather any storm. You can find such high-quality companies by looking beyond the usual revenue and earnings numbers on income statements and focusing instead on cash statements. This can shape a better understanding of companies’ financial might and stability.
In a nutshell, the more a company can generate cash—and manage that cash wisely—the greater its quality. Companies with strong cash flows include semiconductor manufacturer Broadcom AVGO, drugmaker Bristol-Myers Squibb BMY, and United Parcel Service UPS.
What Is Free Cash Flow?
While revenue and earnings are important metrics for getting a snapshot of a company’s profitability and growth potential, they are far from the whole story when determining the company’s financial stability and how well it will hold up in an economic downturn or recession.
Earnings and revenue can also be misleading, especially at turning points in market cycles. When interest rates jumped swiftly and steeply in the past year and pushed up the cost of capital, the high-flying, high-growth tech stocks and startups (which had long relied on cheap money to finance their businesses and were valued more on their prospects for future earnings) saw their share prices and business models take a hit. There are also opportunities to skew revenue and earnings through accounting maneuvers on the income statement.
With a cash flow statement, investors will learn how much cash a company is producing from operations and how much is left over after it accounts for day-to-day expenses such as payrolls, inventories, rents, and taxes—a measure known as free cash flow. That gives a more honest appraisal of how well a company is managing its operations and how equipped it is to handle debt payments, reinvest in its businesses, expand opportunistically, and return capital to shareholders in the form of dividends and share buybacks.
The more positive a company’s free cash flow, the greater its flexibility to manage its business. Negative free cash flow suggests a company could struggle to meet obligations, face constraints when innovating, and risk becoming less competitive.
Screening for Free Cash Flow
We’ve identified seven U.S. companies in a range of industries—including drugs, semiconductors, aerospace and defense, and railroads and freight—that can give investors comfort in uncertain times, based on their financial profiles and operating performance. While these companies could hit rough patches, their cash-rich status can help them through.
First we screened companies with market values of $50 billion or more for the ones that generate the highest operating cash flows and the highest free cash flow yields and margins, and that also deliver the highest return on invested capital.
To assure debt loads were manageable, we then screened for companies with debt/equity ratios (a measure of the level of debt to assets) below 2.0. We also looked for companies with low current debt/equity ratios—another gauge of liquidity that indicates how quickly a company could pay off its short-term, or “current,” debt.
While it varies from one industry to another, a rule of thumb is that a company’s current ratio should be 1.0 to 2.0, while an optimal debt/equity ratio should not exceed 2.0.
For this particular search, we excluded energy companies. Most of these companies are currently generating large amounts of cash thanks to the rise in oil prices in recent years, and would have been overrepresented on the list. We also excluded financials because unlike other companies their business models are all about cash and predicated on attracting cash deposits and using those deposits to finance activities.
