Analysts normally use the discounted cash flow method to analyze stocks. But this method usually ends up returning shockingly poor results. Instead, there are three simple methods of stock analysis that work wonders, says Floyd Brown over at InvestmentU.com…

• Cash Balances and Debt
  When the economy turns down, the highly leveraged firms are the ones that get in trouble first. This is part of the problem for GM and Ford right now, and it was the problem with Bear Stearns. If you have large debts, the interest payments alone are a constant drain. On the other hand, a company like Microsoft – with large stores of cash and no debt – can weather any storm. Amazingly, sometimes a firm’s stock price won’t adequately value the cash it holds.

• Cash Flow
  The market will – over time – value cash flow in similar ways. Look for times when the market undervalues a company’s cash by finding out how much cash a company is producing today. Cash flow is the lifeblood of a company. You can reasonably expect that Wall Street will appreciate the value of free cash flow in the future, even if the firm is out of favor today. Therefore, keep track of the cash a firm generates.

• Dividends
  Between 1872 and 2002, stocks returned an average compound rate of 9%. Earnings-per-share (EPS) grew at 3.3% and price-to-earnings (PE) ratios grew at 0.7%. Reinvested dividends contributed 4.8% – more than half of the total return. Favor a stock with dividends for this very reason. You’ll get paid to hold a stock while the market takes time to recognize its value.

These three simple guides have worked wonders for me when analyzing many different stocks. One example would be the oil sector.

In the 1990s, oil stocks greatly underperformed the market. But they generated huge amounts of cash. I started buying these deeply undervalued stocks in the late ’90s knowing that eventually, the historic cash flow generation would win out.

In the late 1970s, the market valued a dollar of earnings from oil stocks more dearly than they did a dollar of earnings from those same stocks in 1997. Earnings ratios were out of line with the historic rates of return. Eventually they came back to normal, and proved the wisdom in buying earnings cheaply.

Many of today’s stocks show large differences between their price and their historical earnings ratios. You may find the market is incorrectly valuing many companies in relation to their cash balances and its ability to generate cash flow and dividends.

So instead of listening to analysts, do your own research and ask the right questions, like these: Can the company rebound to its historic price-to-earnings ratio? Is the market undervaluing a company? Can it continue to generate healthy cash flow and earnings? Will it be able to pay dividends and interest payments on debt?

In short, cash and cash flow can be a more reliable predictor of the future of a company’s stock price than your gut… and especially an analyst’s educated guess.

Source: Three Ways to Beat Analysts at Their Own Job