Is Exelon a Cash King?

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 Exelon (EXC 2.44%) 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.

None of these companies meets our 10% threshold for attractiveness. Both Duke Energy and Dominion have cash king margins in the negative numbers, and Southern's margins are just half a percent. Exelon has the highest cash king margins at 1.4%. However, they all have attractive dividend yields, with Exelon offering a 5.7% yield, Duke Energy offering 4.1%, Dominion Resources offering 3.7%, and Southern offering 4.2%.

Exelon and Dominion both have extensive exposure to nuclear power. While Exelon's stock price has suffered because of this exposure and low natural gas prices, Dominion's has not. Dominion has a huge natural gas distribution platform, which has been doing well lately, as prices have been low. Dominion's peers Southern and Duke Energy have also benefited from the boom in natural gas and expect to continue to profit from the boom as long as gas prices remain low. Also, Dominion's ownership of an extensive network of natural gas pipelines and storage systems has allowed Dominion to further leverage this natural gas boom.

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.