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 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 actually received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at VMware (NYSE: VMW ) and three of its peers.
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. 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 in December, the restaurateur generated $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $27.0 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice high number. In other words, for every dollar of sales, McDonald's produces more than $0.16 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 four 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. TTM = trailing 12 months.
VMware offers cash king margins that are nearly five times our 10% threshold for attractiveness, and its margins have seen steady growth over the past five years. Citrix Systems (Nasdaq: CTXS ) , CA Technologies (Nasdaq: CA ) , and LogMeln (Nasdaq: LOGM ) all offer current cash king margins in the mid-20% range. While Citrix and CA have seen slight growth in their margins from five years ago, LogMeln has shown dramatic growth in its margins. These returns compare very favorably to the blue chips of software and biotech to get some context.
VMware is involved in the high-growth market of virtual computing, which allows businesses to put individuals in a position to gain access to information and computing power from shared computer resources. VMware's early involvement in this cloud technology has helped the company achieve high growth in its business and its stock price, and has allowed it to pull ahead of even companies like Microsoft in this area. Also, the growth in mobile devices puts the company in a good position to serve individuals who may turn to cloud computing due to the fact that they cannot carry all their data with them.
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 VMware? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.