Telefonica Is Better Than You Think

Telefonica (NYS: TEF) may be cheaper than you think.

In the daily noise machine of CNBC, analyst estimates, and quarterly announcements, investors are inundated with talking heads obsessing over earnings-per-share figures.

Earnings, or net income, is an accounting construction that is the basis for the price-to-earnings ratio, the most popular way of measuring how cheap or expensive a stock is.

But free cash flow -- the amount of cash a company earns on its operations minus what it spends on them -- is another, oftentimes more accurate measure of earnings that can give you an advantage.

How Telefonica stacks up
If Telefonica tends to generate more free cash flow than net income, there's a good chance earnings-per-share figures understate its profitability and overstate its price tag. Conversely, if Telefonica consistently generates less free cash flow than net income, it may be less profitable and more expensive than it appears.

This graph compares Telefonica's historical net income to free cash flow. (I omitted various gains and charges such as tax deferrals, restructurings, and benefits related to stock options.)

Source: Capital IQ (a division of Standard & Poor's) and author's calculations.

As you can see, Telefonica has a tendency to produce more free cash flow than net income. This means that the standard price-to-earnings multiple investors use to judge companies may overstate its price tag.

There can be a variety of reasons to disregard such a discrepancy; for example, free cash flow can overstate earnings in businesses with volatile working capital needs, or understate earnings in high growth companies that are reinvesting capital in the business.

Alternatively, in cases where free cash flow more accurately measures earnings, such a discrepancy can indicate a company that is more -- or less -- expensive than investors realize.

Let's examine Telefonica alongside some of its peers for additional context:

* Not meaningful due to negative net income.

While Telefonica looks cheap on a net income basis, it -- like many of its telco peers -- tends to generate more free cash flow than net income, suggesting that the company's stock might be even cheaper than many investors realize.

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At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. The Motley Fool owns shares of Telefonica.Motley Fool newsletter serviceshave recommended buying shares of Vodafone Group and AT&T. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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