Is Novartis 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 Novartis (NVS 0.72%) 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 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 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: S&P Capital IQ.

While Pfizer’s cash king margins come in at a whopping 26.7%, it has seen gradual declines in those margins over the past three years. However, it still manages to offer a 3.4% yield. Novartis also offers high margins, double our 10% threshold. However, its margins have declined steeply over the past five years. Still, the company offers a 3.6% yield. Merck and GlaxoSmithKline also meet our standard, but both of them also offer lower margins than they did five years ago. Dividends here are higher still: Merck at 3.9% and GlaxoSmithKline at 6.1%.

Novartis' involvement in both the development of proprietary drugs and the production of generic drugs provides it with certain benefits. Its development of proprietary drugs gives it the potential to pursue some of the high-profit, high-growth opportunities related to that market. On the other hand, its involvement in generic drugs helps cushion revenue hits arising from patent-cliff issues and regulatory changes that direct consumers to lower-cost options.

Merck's revenues have suffered from the expiration of its Singulair asthma drug patent, but the company has a pipeline of drugs that may be able to replace those lost revenues in the future, including its Januvia and Janumet diabetes treatments, and its cholesterol drug Vytorin, which was recently deemed safe enough to continue a trial.

Pfizer has also faced challenges related to the expiration of a patent, which caused Lipitor sales to drop by more than half. To protect its margins, the company cut its staff to reduce costs. Also, there is some hope in drugs that have recently emerged from Pfizer's pipeline, including its Eliquis blood clot treatment and Xeljanz, which treats rheumatoid arthritis.

GlaxoSmithKline hopes to benefit from its acquisition of Human Genome Sciences, which gave it the full rights to Benlysta, developed with Human Genome Sciences to treat lupus. The acquisition also gave GlaxoSmithKline access to several drugs in the late stages of testing. The company is also looking to expand by pursuing growth opportunities in emerging markets. To this end, it has partnered with an India-based company to develop a single vaccine to guard against a variety of dangerous diseases including polio, hepatitis B, and whooping cough.

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.