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 Lockheed Martin
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 in December, the restaurateur generated $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $27.0 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice, high number. In other words, for every dollar of sales, McDonald's produces more than $0.16 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 Lockheed and three 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. Lockheed Martin and Raytheon both offer current margins in the 7% range, but while Lockheed has grown its margins slightly from five years ago, Raytheon's margins are down by more than more than 5 percentage points. AeroVironment offers margins close to 7%, but its current margins are the lowest they have been in three years. ManTech offers cash king margins just below 6%, but its current margins are the lowest they have been in these four periods. Compare these returns with the blue chips of software and biotech, to get some context.
Defense contractor Lockheed Martin has fared reasonably well during tough economic times for defense contractors, resulting from budget cuts. However, the company has faced some setbacks of its own, associated with the Department of Defense's decision to postpone some of its F-35 purchases and the potential that other countries will cancel or defer their orders as well. As a result, Lockheed has had to look for growth in other areas. For example, it's hoping to gain a contract to develop a Joint Light Tactical Vehicle. However, like competitors Navistar and General Dynamics, it has had trouble developing an appealing prototype.
For retirees and other conservative investors, a steadily rising dividend has been good news. But all eyes have to look to the future to see whether the company can survive the budget cuts intact. Retirement investors have to be willing to take on some risk to buy Lockheed shares, even at the attractive valuation the stock offers now.
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.
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Jim Royal owns shares of McDonald's. The Motley Fool owns shares of Northrop Grumman, Lockheed Martin, General Dynamics, ManTech International, and Raytheon. Motley Fool newsletter services have recommended buying shares of AeroVironment and McDonald's. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.