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 RPM International
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.
|Company||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. PPG Industries
RPM International produces and sells specialty chemical product lines frequently used in the construction industry, including roofing systems, specialty paints, and sealants. Despite the rough market, the company has managed to improve its gross, net, and operating margins over the past six months.
PPG Industries, which makes protective and decorative coatings as well as glass and chemical products, is also subject to the marketing conditions of the construction industry. However, it has still managed to increase its net income for the past three quarters and to increase its revenue in the past four quarters.
HB Fuller has clients in a variety of industries, which reduces risk of involvement in a particularly troubled market at any given time. In addition, it does not rely on any one client for more than 10% of its net revenue, which increases its pricing power and reduces the risk of a devastating loss of revenue from losing one client.
All of these companies offer a dividend. RPM offers the highest dividend yield at 3.6%, PPG offers a 2.6% yield, and HP Fuller and Albemarle offer a 1.2% yield.
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 RPM International? 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 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.