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."
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.
Today, let's look at ExxonMobil
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ.
None of these companies meets our 10% threshold for attractiveness, and ExxonMobil, ConocoPhillips, and BP all currently have lower cash king margins than they did five years ago. Chevron's margins, on the other hand, have slightly increased over the same time period. Compare these returns with the blue chips of software and biotech to get some context.
ExxonMobil, like Chevron, has been pushing for broad energy dominance, which is reflected in its move to buy XTO Energy in the past year, making it the largest natural gas producer in the United States. However, its involvement in dangerous areas of the world such as Russia and Iraq can put it in a precarious position. For example, ExxonMobil is moving forward with a joint venture with Rosneft, a Russian state oil company, despite worries that arose when Royal Dutch Shell had to hand its Sakhalin project over to Gazprom five years ago.
ExxonMobil is also still working with Venezuela in attempt to gain compensation for the assets it lost when Hugo Chavez nationalized the oil industry. However, great risk is often accompanied by great opportunity, which gives Exxon a strong incentive to work with these oil-rich countries.
It's worth noting that Exxon also offers the lowest dividend yield of these companies, at 2.2%. Chevron, on the other hand, offers a 2.9% yield, while ConocoPhillips offers a 3.6% yield, and BP offers 3.8%.
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.
Want to read more about ExxonMobil? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.
Jim Royal owns shares of McDonald's. Motley Fool newsletter services have recommended buying shares of Chevron. 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.