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 to you.
In this series, we'll highlight three big dogs 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."
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.
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. Over the past four quarters, the restaurateur generated $6.0 billion in operating cash flow. It invested about $1.9 billion in property, plants, and equipment. To calculate free cash flow, subtract the company's investment ($1.9 billion) from its operating cash flow ($6.0 billion). That leaves us with $4.1 billion in free cash flow, which McDonald's can save for future expenditures or distribute to shareholders.
Taking the company's sales of $23.8 billion over the same period, we can figure that it has a cash king margin of about 17% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.17 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, an indication 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.
Today, let's look at Pfizer
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ.
All of these companies meet our 10% threshold for attractiveness. Pfizer has the highest cash king margins of these companies, but its margins have not grown significantly from five years ago. Celgene and Sanofi also have very high margins, and they have grown those margins tremendously from five years ago. Merck has the lowest margins of the companies, and its current margins are down more than 10 percentage points from five years ago. Compare these returns ith the blue chips of software to get some context.
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 rapidly 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. 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. Motley Fool newsletter services have recommended buying shares of Pfizer and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.