As an investor, you know that 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 four companies 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 received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Terra Nitrogen
The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow 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. A sustained high cash king margin can be a good predictor of long-term stock returns.
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. In the four quarters ending last June, the restaurateur generated $6.87 billion in operating cash flow. It invested about $2.44 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.44 billion) from its operating cash flow ($6.87 billion). That leaves us with $4.43 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $25.5 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.
Here are the cash king margins for Terra Nitrogen and three industry peers over a few periods.
|Company||Cash King Margin (TTM)||1 Year Ago||3 Years Ago||5 Years Ago|
Source: S&P Capital IQ.
Terra Nitrogen and PotashCorp both meet our 10% threshold for attractiveness, with Terra Nitrogen offering nearly 6 times our desired 10%. Both Terra Nitrogen and PotashCorp have also dramatically increased their margins from five years ago. Mosaic is 1.5 percentage points away from offering our desired 10%, and it has also grown its margins from five years ago, but its margins have steadily declined over the past three years. Scotts Miracle-Gro offers margins below 2%, and its current margins are the lowest they've been in five years.
It's worth noting that Terra Nitrogen offers an extremely high dividend yield at 9.2%, which far outperforms Mosaic's 0.4% yield, PotashCorp's 0.6% yield, and Scotts Miracle-Gro's 2.5% yield. That high yield comes from Terra Nitrogen's structure as a master limited partnership, which allows the company to pass its taxable income directly to shareholders instead of paying income tax.
Terra Nitrogen's stock price has grown from $109.19 per share last year to $179.48. Like other companies in the agricultural industry, it has benefited from major increases in crop prices, which has given farmers more money to spend on things like fertilizers and farming equipment. Terra Nitrogen has also been able to keep its costs down by avoiding the use of higher-priced mined goods like potash.
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. Conversely, the formula works better for slower-growing blue chips. 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 Terra Nitrogen? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.