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# Meet the Cash Kings of Drug Stores

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As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight three big dogs in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio.

To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = free cash flow / sales

Let's take McDonald's as an example. Over the last four quarters, the restaurateur generated \$6.0 billion in operating cash flow. It invested about \$1.9 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment (\$1.9 billion) from its operating cash flow (\$6.0 billion). That leaves us with \$4.1 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of \$23.8 billion over the same period, we can figure that the company has a cash king margin of about 17% -- a nice high number. In other words, for every dollar of sales, McDonald's produces \$0.17 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Three companies
Today, let's look at three drug store companies:

Company

Cash King Margin (TTM)

1 Year Ago

3 Years Ago

5 Years Ago

CVS (NYSE: CVS  )

2.7%

1.6%

1.1%

(1.7%)

Walgreens (NYSE: WAG  )

4.0%

5.2%

0.7%

1.1%

0.8%

(0.3%)

(3.2%)

0.4%

None of these companies meets our 10% threshold for attractiveness, but CVS has offered us the kind of steady increase in cash king margins that we like to see. Walgreens has also increased its margins nicely from five years ago, but is down more than 1 percentage point from last year. Rite Aid has also grown its margins over the last three years, but its margins are still lower than 1%. These returns pale in comparison to the blue chips of software and biotech, of course, but it's useful to get some context.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

Want to read more about CVS? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.

Jim Royal, Ph.D., owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

• ###### Report this Comment On January 26, 2011, at 6:46 PM, johnjnlv wrote:

CVS may be the cash king but its at the expense of its employees that have not gotten a raise in 2 years and are told its because of the economy they are not making any money. Anyone know the real reason why its ceo is stepping down?

• ###### Report this Comment On January 27, 2011, at 10:56 AM, foresttool wrote:

seems only 1 drugstore is reinvesting in its older stores.......could be why wag is down 1% from last year. not only do they give raises to employees, they are keeping up with technology and still have cash left over.

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Jim Royal
TMFRoyal

Jim is a special-situations investor focusing on transactional events (such as spinoffs, recapitalizations, or reorganizations, among others) that create advantageous stock mispricings.

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