Is UPS 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 United Parcel Service (UPS -1.51%) 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

None of these companies meets our 10% threshold, but UPS comes close, and has shown significant growth from its margins five years ago. Expeditors International has the second highest margins at 5.4%, but they have gradually decreased over the past three years. FedEx has slightly lower cash king margins at 3%, but its current figures are the highest they have been in the past few periods. YRC Worldwide has consistently put up cash king margins below zero in the periods here.

UPS has benefited a great deal from its partnerships with eBay and Amazon.com, which have helped it achieve a recent bump in consumer shipping volume. However, UPS took a big hit recently when it was unable to carry out its planned acquisition of Europe's TNT Express. It may also face downward pricing pressure as competitors like FedEx lower their prices to appeal to consumers looking to lower their shipping costs.

Expeditors International has an extensive network for clients who want to ship things fast and cheaply. It does this by bundling goods from separate customers together before shipping them across the ocean, which lowers the rates for transport, and then separating the goods again so they can be dispersed to the individual recipients. Expeditors also takes care of the necessary customs forms for its clients. This niche market offers promise as the global market expands, and the interest in shipping products internationally is likely to grow. And with Expeditors' ability to offer low prices and its reputation for excellent customer service, the company is in a good position to fight off competitors.

YRC Worldwide also offers some hope for the future with plans to implement network improvements that will decrease costs and hasten delivery times, which could help the company improve its margins and gain higher customer loyalty through improved customer service.

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.