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 last 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 tobacco industry:
|
Company |
Cash King Margin (TTM) |
1 Year Ago |
3 Years Ago |
5 Years Ago |
|---|---|---|---|---|
|
Reynolds American |
5.5% |
21.1% |
15.7% |
10.1% |
|
Lorillard |
25.5% |
21.0% |
24.5% |
27.3%* |
|
Altria |
20.2% |
21.3% |
41.8% |
14.4% |
Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months. *For fiscal 2005.
Tobacco can be a lucrative business, as the above margins suggest. Reynolds American and Altria have both seen declines in their cash king margins over the past three years. In the past year, Reynolds saw discontinued operations take a bite out of free cash flow, so its margin is likely to bounce back. Although Altria is down from a few years ago, it's also putting up a very impressive margin regardless. Lorillard offers us high margins, too, and has proven more steady than the other two companies, at least for this metric. These levels compare very favorably to some of the blue chips of software and biotech.
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.
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