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 actually received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Foot Locker
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 four industry peers over a few periods.
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, but Foot Locker offers the kind of growth in its cash king margins that we like to see, with current margins more than 12 times higher than they were five years ago. DSW and Weyco Group, on the other hand, have lower current margins than they did five years ago. Genesco has higher margins now than it did five years ago, but they have steadily declined after peaking three years ago.
Foot Locker suffered a dramatic sales decrease at the beginning of the recession, when consumers were anxious to cut out any unnecessary spending. However, while it has not shown the growth of Nike and Under Armour recently, it has seen significant growth in its stock price over the past year. One thing that has pleased many shareholders is the company's repurchase program, which takes the place of dividend increases. The NBA lockout previously caused worries about Foot Locker's ability to sell basketball shoes and NBA merchandise, though the disagreement has since ended.
For income seekers, Genesco lacks a dividend, whereas DSW has a 1.3% dividend yield, Foot Locker has a 2.7% yield, and Weyco has a 2.8% yield.
The cash king margin can help you find highly profitable businesses, but it should be only 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 Foot Locker? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.
Jim Royal owns shares of McDonald's. The Motley Fool owns shares of Under Armour. Motley Fool newsletter services have recommended buying shares of Under Armour and Nike and creating a diagonal call position in Nike. 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.