Is Home Depot 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 Home Depot (HD 0.22%) 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: Capital IQ, a division of Standard & Poor's.

Of the listed companies, only Trex meets our 10% threshold for attractiveness, and has shown us some attractive cash king margin growth over the past five years. The Home Depot has the second-highest margins, and has also shown some decent growth over the five-year period. Lowe's and Lumber Liquidators have cash king margins at 5% or below. However, they too have shown some reasonable growth in their margins from five years ago. Home Depot and Lowe's also offer the benefit of a dividend, with Home Depot offering a 2.1% yield and Lowe's 1.7%. Also, Lowe's has notably managed to increase its dividend every year for the last 25 years, which is a rare feat.

All of the listed companies have benefited from an improving housing market, with Home Depot seeing a particularly large increase in sales, reporting a 14% increase in its most recent quarter. Despite their size, companies like Home Depot and Lowe's still need to worry about competition from niche players like Lumber Liquidators and Trex, who specialize in the lucrative segments of flooring and deck materials, respectively. Unless Home Depot and Lowe's can draw consumers away from those specialized stores, they risk being pushed into a greater reliance on lower-margin areas like appliances for their revenues.

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.