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 received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Johnson & Johnson
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 $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $27 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice, high number. In other words, for every dollar of sales, McDonald's produces more than $0.16 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.
Here are the cash king margins for Johnson & Johnson and three industry peers over a few periods.
|Company||Cash King Margin (TTM)||1 Year Ago||3 Years Ago||5 Years Ago|
|Johnson & Johnson||17.5%||22.7%||18.7%||21.7%|
Source: S&P Capital IQ.
Aside from Regeneron Pharmaceuticals, all of these companies meet our 10% threshold for attractiveness. Regeneron's current cash king margins are in the negative numbers and are down dramatically from five years ago. Eli Lilly has the highest margins of the companies, at just 3 percentage points below 30%, and its margins have grown substantially from five years ago. Abbott has margins close to 20%, but its current margins are the lowest they've been in three years. Johnson & Johnson's margins are less than 2 percentage points behind Abbott Labs', but its current margins are the lowest they've been in the period shown here. Compare these returns with the blue chips of software and biotech, to get some context.
Johnson & Johnson has a long track record of offering solid growth, with annual sales gains for more than 75 years in a row until 2009. After that, the company suffered from the expiration of patents on some of its most important drugs, reduced demand for its medical devices, a weak economy, and product recalls. The last factor may have hit J&J the hardest in the long term, with customers turning to Merck and Pfizer to fill their drug needs. J&J also faces a new challenge related to a joint venture between Teva Pharmaceutical
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.
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Jim Royal owns shares of McDonald's, P&G, and J&J. The Motley Fool owns shares of Abbott Laboratories and Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, McDonald's, Teva Pharmaceutical Industries, Pfizer, and Procter & Gamble and creating a diagonal call position in Johnson & Johnson. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.