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Meet the Cash Kings of Software

By Jim Royal - Updated Apr 6, 2017 at 11:01AM

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These companies are rolling in greenbacks.

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 Nike as an example. Over the past four quarters, the footwear giant generated $3.2 billion in operating cash flow. It invested about $335 million in property, plant, and equipment. To calculate free cash flow, subtract Nike's investment ($335 million) from its operating cash flow ($3.2 billion). That leaves us with $2.8 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking Nike's sales of $19 billion over the same period, we can figure that the company has a cash king margin of about 15% -- a nice high number. In other words, for every dollar of sales, Nike produces $0.15 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 companies in the software industry:

Company

Cash King Margin (TTM)

1 Year Ago

3 Years Ago

5 Years Ago

Microsoft (Nasdaq: MSFT)

35.4

27.2

30.4

39.7

Google (Nasdaq: GOOG)

34.3

31.2

17.4

29.6

Oracle (Nasdaq: ORCL)

31.5

33.2

28.9

28.5

Source: Capital IQ; TTM = trailing 12 months.

Not surprisingly, all three companies in the table above are true cash kings, generating free cash of more than $.30 for every dollar of sales. The possibility of such astounding margins is what makes the software industry so attractive for investors. Still, the trend for Microsoft is less than ideal: Mr. Softy's margins have firmed up in the past few years, although they're down from five years ago. Google and Oracle, on the other hand, have noticeably improved their cash king margins since 2005, somewhat at the expense of Microsoft.

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.

The Motley Fool is recommending 50 stocks in 50 days for its new "11 O'Clock Stock" series. For more information, click here. Then come back to Fool.com every single weekday at 11 a.m. ET for a brand-new pick!

Jim Royal, Ph.D., owns shares in Microsoft. Google and Microsoft are Motley Fool Inside Value selections. Google is a Rule Breakers recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Google and Oracle. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Microsoft Corporation Stock Quote
Microsoft Corporation
MSFT
$282.91 (-0.26%) $0.74
Alphabet Inc. Stock Quote
Alphabet Inc.
GOOGL
$117.47 (-0.61%) $0.72
Oracle Corporation Stock Quote
Oracle Corporation
ORCL
$77.35 (-0.07%) $0.05

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