Welcome back to part 6 of our nine-lesson look at the measurements we use to spot Rule Maker companies, a series that should help you understand the kind of pitches we swing at in the Rule Maker portfolio.
It's important to remember the Rule Maker, which seeks to invest in the highest quality companies at reasonable prices, is just one strategy. There are many other ways to invest, but the Rule Maker is a strategy we understand, one that makes good sense to us. We minimize trading costs and defer taxes by finding the best companies available and investing for the long term.
Today, we're looking at the Cash King Margin. It's similar to our net margin criteria except that it's based on free cash flow, a more accurate measure of the money that's actually flowing through a business. We want to invest in companies that generate lots of green stuff.
In an article last week, I wrote that we pay attention to cash for two main reasons:
"First, cash flow isn't as easily manipulated as net income. Since cash on the cash flow statement actually represents funds moving in and out of the company (as opposed to income on the income statement, which isn't necessarily cash the company has already received), we look for companies that generate strong cash flow from operating activities.
"Second, companies are valued on future cash flows. There's a bit more to it than this, but investors should understand that a business' value is based on how much cash it's expected to produce -- not on how many great partnerships it has, or how many new stores it's opening, or how much you love its products. Keep your eye on cash and you'll stay on the right track."
That's the concept behind the Cash King Margin. Here's the formula:
Cash King Margin = Free Cash Flow / Sales
There's a bit of work that goes into calculating free cash flow, but don't panic, we'll walk you through it. Incidentally, you will see many variations of free cash flow, and many different ratios that use the word "cash" in one way or another. We're going to give you what we believe is the simplest accurate way to understand how much cash a company is producing.
Start by pulling up networking giant Cisco's (Nasdaq: CSCO) most recent 10-K and clicking on the cash flow statement. The most straightforward definition of free cash flow is cash from operations (CFO) minus capital expenditures (plant, property, and equipment). What we're doing here is trying to figure out how much cash Cisco's core business generated over the last 12 months. Since cash is what makes the engine hum, and cash from operations represents money Cisco makes doing what Cisco does -- selling routers, optical equipment, and other networking products -- that's what we want to focus on, not, for example, cash brought in by selling more shares of stock or taking on debt.
Next, we back out capital expenditures for a very important reason. To remain competitive every company must replace its physical assets. A railroad company must purchase and maintain railcars; a casino has to revamp sparkly hotels; and Cisco has to build new facilities and purchase equipment for its researchers. If you simply take Cisco's CFO number and assume it represents excess cash spun off by the company, you're ignoring a prominent expense. Thus, using Cisco's 10-K Cash Flow Statement, Cisco's fiscal 2000 free cash flow looks like this (all numbers in millions of dollars):
$6,141 - $1,086 = $5,055
So, last fiscal year, Cisco generated over $5 billion in free cash flow. With me so far? OK, I'm going to throw a wrench into the works. When analyzing a company's financial statements, ratios are frequently adjusted one way or another to account for different conditions. Knowing how to tweak these values is part of the investing puzzle, and it takes a little work. Here's one important adjustment for free cash flow you should be aware of.
Look on the statement of cash flows under the operations segment. You'll see a line item called tax benefits from employee stock options. In a nutshell, this represents cash from a tax break the company receives when its employees exercise stock options. It's real cash the company gets to use, but is it sustainable? Cisco generated $2.495 billion from this tax break last year as employees cashed in on the company's go-go results.
It's common for Rule Maker companies to generate cash from a tax break for options, but when it increases almost 500% in two years and represents nearly 50% of free cash flow, well, a lot of it is probably due to a frothy market. A conservative investor, in my opinion, will back out a big chunk of this number, maybe all of it, maybe all but $500 million. This is about what Cisco reported for tax benefits two years ago. You should make your own decision how much to back out depending on how conservative you want to be. So, backing out all but $500 million, Cisco's free cash flow looks like this:
$5,055 - $1,995 = $3,060
Now, just take this number and put it over sales for the last fiscal year:
$3,060 / $18,928 = 16%
We're looking for companies with at least a 10% free cash flow margin, or, as we call it, Cash King Margin. This isn't a sacred number, but it's very useful since there are few companies that produce enough cash to generate this kind of profitability. Screening out companies that aren't up to the task saves a lot of time.
If you're interested in learning more about the Rule Maker approach, more about issues such as competitive advantage and sustainable profitability, think about joining us for the Rule Maker 2001 Online Seminar. It costs just $49. You get a money back guarantee (no questions asked) and our best thinking on Rule Maker investing. Participants will receive eight succinct lessons, work through homework problems with Motley Fool staff members on the discussion boards, and receive a free report of the top 25 Rule Maker investing ideas. We hope you'll join us!
Tomorrow, I'll be back to talk about our Rule Maker criterion on cash versus debt.
Have a great day.
Part 7: High Debt = High Risk ï¿½
Richard McCaffery lives in Laurel, Maryland with his wife Linda, who won't let him buy a dog. In addition to not owning a dog, he doesn't own shares of Cisco. Any comparison between Cisco and a dog is purely coincidental. The Motley Fool is investors writing for investors.