One trick to identifying great companies is to work backwards. Find companies that generate lots of free cash flow every year. Usually, these businesses will have plenty of cash sitting in the bank to weather the inevitable soft periods in the economy, not to mention the potential perks of growing dividend payments, share repurchases, and having a sizable war chest for investments and acquisitions.
NVIDIA: The leader in graphics processors
NVIDIA has long dominated the market for graphics processing units (GPUs). Selling graphics cards to PC gamers is its core business, which last year made up 51% of total revenue. But the chip maker has also had tremendous success providing its core graphics processing technology to other high-growth markets, such as data centers.
At the rate it's growing, the data center business will soon become NVIDIA's largest. Major cloud providers like Amazon.com and Microsoft continue to spend heavily on cloud infrastructure services, which is the tailwind fueling NVIDIA's data center growth. The company reported that its data center revenue increased 80% year over year in the fiscal 2021 first quarter.
Making GPUs for gaming and high-performance computing applications has been extremely profitable for NVIDIA. The company is on track to hit a 66% gross margin this quarter, which would be a record high.
Likewise, NVIDIA's free cash flow has been building steadily over the last decade, reaching $4.4 billion on a trailing-12-month basis. NVIDIA returns less than 10% of free cash flow to shareholders through dividends, with the stock currently yielding 0.2%.
As of April 26, NVIDIA held $9.4 billion in net cash, of which approximately $7 billion was used after the end of the quarter to finance the acquisition of Mellanox, further beefing up NVIDIA's position in the data center space. Mellanox also generates high margins consistent with NVIDIA's data center business, so the deal will just enhance the chip maker's margins and free cash flow from here.
Microsoft: The leader in productivity software
During the shelter-in-place period of the coronavirus pandemic, more companies shifted to remote work and communication with video meetings. If this trend becomes permanent, there is no company better positioned to benefit than Microsoft.
The software giant has been providing essential productivity tools for 30 years, and it seems more people than ever before are relying on Microsoft software. More than one billion devices are now actively using Windows 10, an increase of 30% year over year as of the most recent quarter.
CEO Satya Nadella masterfully shifted Microsoft's focus to services. The number of users covered under a paid subscription to Office 365 commercial reached nearly 258 million last quarter, up 20% year over year.
Moreover, Microsoft has tremendous momentum with its Azure cloud service, where it's growing faster and nipping at the heels of the leader, Amazon Web Services.
Microsoft's leadership in software translates to huge streams of cash flowing into the company's coffers. On a trailing 12-month basis, free cash flow totaled $43.4 billion. Microsoft's balance sheet is naturally cash rich, with $71.0 billion in net cash. It distributes about a third of its free cash flow to shareholders through dividends with the stock yielding 1.0% as of this writing.
Apple: The leading consumer brand
You will be hard pressed to find a bigger cash cow than Apple. The iPhone maker generated $66.6 billion in free cash flow over the last four quarters and is sitting on nearly $94.1 billion of cash and investments on its balance sheet.
Apple recently increased its quarterly dividend by 6% and announced a new commitment to repurchase $50 billion of its own shares, in addition to the $40 billion left on its previously announced share repurchase program. Management remains committed to returning its excess cash to shareholders, which should lead to a growing stream of dividend payments over time.
This abundance of cash reflects Apple's enviable position in hardware and software. In the most recent quarter, the installed base of active devices across Mac, iPad, and iPhone reached an all-time high, and 75% of the customers who purchased an Apple Watch last quarter were new to the product.
The high satisfaction customers have with these products spills over to several other categories where Apple can further monetize its installed base of users. For example, revenue from services, including Apple TV+, Apple News+, and wearables also hit a new high last quarter.
Apple has an incredibly strong ecosystem of products and services that all but guarantees future upgrades and subscriptions. That should lead to plenty of cash available for dividends, share repurchases, and investments in new products to keep the cash wheel spinning. The stock currently has a dividend yield of 0.9% with a payout ratio of 24%.