This Is the Key to Finding Your Next 100% Gain in the Market

Editor's note: Our colleague Dan Ferris has discovered five financial "clues" for finding great investment opportunities.

And this weekend, he's sharing them with you.

In today's Masters Series – adapted from a series of 2013 essays that appeared in our free DailyWealth e-letter – Dan shares the first two clues... and shows you exactly where to look for them...

This Is the Key to Finding Your Next 100% Gain in the Market

Over the past decade, I've received many e-mails from folks who write in to ask me...

"Dan, how do you analyze the stocks you recommend? Is there a secret to finding great investments?"

The answer is no, there are no secrets... But we've found a process that works well. I've learned it over a period of years, by trial and error, maybe a little inspiration and intuition, and even a bit of luck.

After experimenting for many years, I finally arrived at my first simple template for finding great stocks. I call it "The Five Financial Clues." And this weekend, I'm going to share some of the first clues I look for...

This first clue led me to stocks like Prestige Brands (PBH) – which we sold for a 406% gain in my Extreme Value newsletter. And Constellation Brands (STZ) – which we closed out of for a 631% win, the third-largest in Stansberry Research history.

So what's the first financial clue I look for? Simply put, I want a business that gushes free cash flow.

Free cash flow is all the excess cash profit left over after a business pays its expenses and taxes and after it reinvests enough cash to maintain and grow the business.

When you buy a stock in your brokerage account, you're buying a piece of a business. It's not a debt interest, and it's not a preferred stock interest.

It's equity. And equity is a "residual claim" on the earnings of a business. "Residual" just means the equity holder doesn't get paid until everybody else gets paid.

This is really important.

You see, nothing is left over for equity holders until secured creditors, salary and wage earners, taxes, trade creditors, unsecured creditors, and preferred stock holders all get paid.

Only after all these obligations are met can you, the equity holder, expect your shares to be worth anything.

In fact, excess cash flows are the one thing that give your stock nearly all of its value.

It makes sense, right? This is what makes a business valuable: the ability to generate lots of extra cash. Without excess cash, your shares are worthless.

Think of it a different way... Suppose you own a business. You want that business to pay you as much cash as possible during the time you own it. And that's true whether you own 100% of a business you run yourself – or whether you own just one share of a multibillion-dollar company.

It's easy to find a company's free cash flow.

All you do is go to the "cash flow" section of a company's financial statements and subtract "capital expenditures" from "operating cash flow."

If you want to be nitpicky, sometimes operating cash flow is called "cash from operations" or "net cash from operations." And sometimes, capital expenditures are called "additions to property and equipment" or something similar.

Take iPhone maker Apple (AAPL), for example...

Here's how you calculate Apple's free cash flow. Through July 7, Apple's trailing 12-month cash flow from operations was $64.1 billion. Let's subtract $12.6 billion for capital expenditures. This equals $50.5 billion.

That's a lot of free cash flow, more than any nonfinancial company in the world.

What's interesting is most people have no idea how important this financial clue is, so they're unable to understand what an amazingly good business Apple really is. No other business generates as much free cash flow as Apple.

To sum up:

  • Free cash flow is the cash left over after a business pays all its expenses and taxes and reinvests enough to maintain and grow itself.
  • Free cash flow is important because it's the amount of excess cash available for creating shareholder value, which is how you make the most money.
  • Free cash flow = cash from operations minus property and equipment spending. Both those numbers are on the cash flow statements inside a company's quarterly and annual reports.

The thing is, not all businesses use their cash to reward shareholders... to pay their shareholders back. But the great ones do. That's the second clue.

Great companies reward their shareholders in two ways. The first strategy is pretty straightforward. But the second strategy... Most folks don't understand how it works.

The first way a great business rewards its shareholders is by paying cash dividends.

Cash dividends are usually paid quarterly, and they're good for two main reasons.

First, they provide you with a regular cash return on your investment. In fact, one study shows that investors earned 394% on stocks from 1991 to 2010, and that 43% of that return came from dividends.

That's a huge chunk of the return. If you're investing in stocks, you simply can't afford to ignore dividends.

Really great dividend-paying companies raise their dividends every year for many years in a row, often for decades.

For example, Extreme Value readers have seen gains of more than 300% on Automatic Data Processing (ADP), which has raised its dividend every year for 42 years in a row.

In fact, with some good dividend-paying stocks, you'll make more on the dividends than you will by the share price going up.

What's interesting is, companies that begin paying dividends after not paying them often perform just as well as companies that raise their dividends.

A study by Ned Davis Research shows that stocks in the benchmark S&P 500 Index that either raised or initiated dividends from 1972 to 2004 outperformed all other stocks in the S&P 500.

The worst performers were companies that cut their dividends – or never paid them in the first place.

Bottom line: Dividend-paying stocks are the best place to put a large chunk of your stock market money.

Now... the second way companies reward shareholders is by buying back their own stock.

Why is this good for you? Well, when a company reduces its share count, it's like cutting a pie into four slices instead of eight slices. You're getting a much bigger piece of pie. Likewise, as the company's share count falls, each remaining share is worth more.

For example, Apple has returned 164% in pre-tax capital gains and dividends since I recommended it in Extreme Value in June 2013. It has lowered its share count about 19% since then.

And here's another reason why share buybacks are good...

You have to pay taxes on cash dividends... but you DON'T PAY TAXES when a company is using cash to buy back shares... even though a share repurchase makes your shares more valuable...

In other words, a share repurchase is like a tax-deferred, noncash dividend that you receive for as long as you hold your shares.

So to sum up:

  • Look for companies that reward shareholders. Shareholders are rewarded in two ways: dividends and share buybacks.
  • Look for companies that raise their dividends every year.
  • Look for companies that buy back shares and reduce their share counts.

One more thing to keep in mind: Regardless of how much cash a business generates – or how much it rewards its shareholders – there's a major number you need to check before you know you've got a "sleep at night" investment. I'll share that in tomorrow's Masters Series...

Good investing,

Dan Ferris

Editor's note: If you've been with us for long, you know Dan is unlike any other analyst in our industry. He lives and breathes the principles he shares each month in his Extreme Value advisory... and will only recommend companies that meet his exacting standards. While most analysts recommend a new stock every month, this means Dan can sometimes take several months to make a single new recommendation.

But when he does, the results are often incredible... A quick look at the Stansberry Research Hall of Fame at the bottom of every weekday Digest shows Dan has recommended three of the best-performing recommendations in our company's history.

And today – for the first time in years – Dan has found a stock that he believes is likely to become the fourth. In fact, Dan thinks this stock could conservatively make you three to five times your money, beginning less than two months from today – on January 1, 2018.

But if you're interested in learning more, you must act quickly... This information will only be available for the next 72 hours. Click here for all the details.