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 line.
You don't get paid dividends until everyone else has been paid.
And this is why free cash flow (FCF) is such an important valuation metric when analyzing a business.
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 environment.
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 criteria.
Over the past 12 months, JPMorgan Chase (NYSE: JPM) 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 stronger company.
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 year.
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 down.
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 company.
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 recession.
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.