Is Coca-Cola a Cash King?

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 Coca-Cola (KO -0.17%) and three of its peers.

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 $6.97 billion in operating cash flow. It invested about $3.05 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment from its operating cash flow. That leaves us with $3.92 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 14% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.14 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.

Four companies
Here are the cash king margins for four industry peers over a few periods.

Source: Capital IQ, a division of Standard & Poor's.

While Coke exceeds our 10% threshold for attractiveness by more than six percentage points, none of these other companies meets the mark. However, PepsiCo (PEP 0.60%) isn't far from meeting the standard, with cash king margins of 8.8%. However, both Coke and Pepsi have cash king margins below what they were five years ago, as they've acquired bottlers. Dr Pepper Snapple's (NYSE: DPS) cash king margins are less than 5%, but the company offers a 3.5% dividend yield, while Coke and Pepsi both have yields below 3%. SodaStream's (SODA) cash king margins are below 1%. It has also seen massive fluctuation in its margins over the last five years and doesn't yet offer a dividend.

With soft-drink growth in the U.S. slowing to a trickle, companies such as Coca-Cola and Pepsi increasingly have to look to emerging markets such as China and India for growth opportunities. The burgeoning middle class in these foreign markets offers tremendous growth opportunities as more consumers gain the income to purchase such affordable luxuries as soda. But along with these opportunities comes fierce competition for market share. While Coke has certainly benefited from its powerful brand -- No. 1 in the world -- Pepsi has managed to put up a strong fight. In China, Pepsi has managed to grab some market share, with Coke suffering a 4% decline in sales volume there at the end of last year.

But as these companies battle it out in foreign markets, they can't afford to neglect the competition at home. Dr Pepper Snapple remains small compared to the big players, but it has managed to gain a foothold in the U.S. Still, it has faced obstacles related to limited domestic growth opportunities. Its fourth-quarter earnings from 2012 indicated a volume decline of 1% and suggested that 2013 earnings would not meet analyst expectations.

SodaStream also poses a threat as it expands its retail presence and forms strategic partnerships with well-known brands such as Kraft (NASDAQ: KRFT), which can help build SodaStream's popularity as it promotes its own Crystal Light and Country Time SodaStream syrups.

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.