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 Herman Miller
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 June, the restaurateur generated $6.87 billion in operating cash flow. It invested about $2.44 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.44 billion) from its operating cash flow ($6.87 billion). That leaves us with $4.43 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 17% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.17 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.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Armstrong World Industries
Source: S&P Capital IQ.
As you can see, the struggling economy has hit Herman Miller and its industry peers hard. None of these companies meets our 10% threshold for attractiveness, and all of them have lower current margins than they did three years ago. Mohawk Industries has the lowest margins of the listed companies, with massive reductions in its margins from five years ago.
Despite the struggling economy, Herman Miller and Knoll, on the other hand, offer margins above 5%. Also, as the economy has started to improve, so have Herman Miller's sales and earnings. In June, the company saw a 37% jump in sales and its earnings more than doubled. Product orders were also up 21%, and the company expects to see good news into 2012.
Knoll's 2.7% dividend yield far outperforms Herman Miller's very modest 0.4% dividend yield, but the other listed companies do not offer a dividend at all.
Herman Miller still has plenty of work to do to improve its financials, including reducing debt and hopefully boosting its dividend above its current token payout. Most of its competitors have much higher dividend yields. If it can keep up its recent earnings momentum, though, Herman Miller could quickly move much closer to perfection in the years to come.
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 Herman Miller? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.Jim Royal owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.