As an investor, you know that 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 received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at SanDisk
The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow 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 last 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 SanDisk and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ.
SanDisk and STEC both meet our 10% threshold for attractiveness, and both have grown their cash king margins dramatically from five years ago. However, SanDisk's margins have declined by more than 10 percentage points since last year, partially because of higher capital expenditures. Western Digital is within 1 percentage point of meeting our desired 10% and has also grown a great deal from five years ago, but its margins have declined almost 2 percentage points from last year. Seagate offers less than half of our desired 10%, and its margins have declined by 4 percentage points from three years ago.
SanDisk's low P/E ratio and strong revenue growth are appealing, but the company, along with STEC and Western Digital, lack a dividend, while Seagate Technology offers a whopping 4.4% dividend yield.
Part of SanDisk's growth is no doubt due to the increasing popularity of smartphones and tablets, which have created a high demand for its flash memory products. In the long run, though, SanDisk will have to compete with competitors like Micron Technology
Also, if solid-state storage becomes the industry standard, SanDisk will be ahead of the game in its competition with Western Digital, STEC, and Seagate Technology, which focus on optical and magnetic storage technology.
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.
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Jim Royal owns shares of McDonald's. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.