Each year, a certain financial magazine trumpets its list of the top 500 corporations. Top, I ask? Top in what? Revenues?
This leaves me cold. There is no more useless a measure than how much a company sells. The net margin in selling groceries is a penny, maybe. It's a lot more for selling Viagra. Yet maybe a retailer, such as Wal-Mart (NYSE:WMT), produces more earnings due to efficient inventory management, while a drug company, such as ImClonedBristol-Myers Squibb (NYSE:BMY), stuffs the channel, gets caught, and has to restate years of earnings. And in a few sentences, I just mentioned a minimum of five things more important than sales.
"Calm down, Tom," you say. "Too much heat under that jester cap." After all, the annual list is just a marketing tool designed for the Captains of Industry (we're not saying "generals" these days, for obvious reasons) and others to rate "bigness" and "importance."
My response: Look at the top 10 and tell me with a straight face that they are equally "important." Wal-Mart (NYSE:WMT), General Motors (NYSE:GM), ExxonMobil (NYSE:XOM), Ford Motor (NYSE:F), General Electric (NYSE:GE), Citigroup (NYSE:C), ChevronTexaco (NYSE:CVX), IBM (NYSE:IBM), American International Group (NYSE:AIG), and Verizon Communications (NYSE:VZ).
Important? Included in this bunch are debt-laden, financially questionable, decaying, self-enriching, past their prime, and otherwise lowlife companies, along with a decent business -- or three or four, depending on how indulgent one feels on a given day. They don't belong in the same bed together.
So, enough with the revenues already.
The green river of cash flow
For as long as we have been around, The Motley Fool has, in one way or another, beaten the drum for cash flow. Specifically, free cash flow (FCF) determined from the cash flow statement -- our favorite of the three financial statements (which you can learn all about in our fun and Foolish Crack the Code how-to-guide). We want to know how much cash flow from operations a company produces, minus capital expenditures (sometimes called "purchases of property, plant, and equipment," which can include software expenses for software companies). These appear clearly in a company's cash flow statement, which domestic U.S. companies must file each quarter and annually with the Securities and Exchange Commission. (You can find them easily through our Quotes & Data page.)
Why do we care? Because the company adds this money to its bank account and can further invest it to grow its business, buy others, pay down debt, or pay dividends, in the best of worlds. Revenues are nice; earnings per share are interesting; but FCF makes us smack our lips. And we like that it can be lumpy quarter to quarter, because it's less prone to manageability than earnings. And the more consistent earnings are, the more suspicious we become of funny business.
If, after reading these two paragraphs of inescapable logic, you still subscribe to another financial religion, please enjoy these Foolish resources that will convert you, as well as make it easy to understand and compute FCF:
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Can't Beat Cold Cash (Rex Moore, 8/29/02)
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The Joy of Free Cash Flow (Jeff Fischer, 2/28/02)
- What Is Free Cash Flow? (Bill Mann, 4/2/00)
A better list
Now, doesn't it feel more useful to rank by trailing-12-month FCF than by revenue? I'll give you the top 10 of this list, but with one caveat: I screened out financial services companies, such as American International Group (NYSE:AIG) and Citigroup (NYSE:C), because FCF doesn't really work for them.
Financial services companies aren't like other companies when it comes to FCF. Because business for them isn't as simple as cash from operations minus capital expenditures, they require their own separate, more complicated analysis. That means for this column's purposes, they're out!
So, without further ado, a better, non-financial FCF list:
Company FCF (TTM)
General Electric $16.1 billionMicrosoft 15.6 Ford Motor 11.4 Verizon 10.1 ExxonMobil 9.8 China Petroleum & Chemical 8.9Altria Group 8.6Pfizer 8.4SBC Communications 8.4IBM 8.3
[based on SEC filings as of 4/4/03]
Oops! Uh, wait just a darned minute.... Five of these companies are in the famous 500 list. I'm not provin' nuttin'! Blush.
Margin, not size
The reason is this: Just as the size of revenue doesn't tell us how much money a business produces for its shareholders, the size of FCF doesn't, either. We like it, but more importantly, a company is only more powerful than another if it produces more FCF from each dollar of revenue than another. That makes every extra dollar of revenue that much more useful to shareholders.
So, which companies have the highest FCF margin (we also call it "Cash King Margin"), defined as FCF as a percentage of revenue?
It's now time to take a few more liberties to eliminate outliers, as the statisticians say. I require companies with market caps above $100 million; with shares prices above $5.00; that trade on the NYSE, AMEX, or Nasdaq; and that have more cash and equivalents than total debt. I also tinker with things slightly by mandating positive return on invested capital (ROIC). Why? Bill Mann and Matt Richey explained ROIC in Part Iand Part II of a super series.
Now, things become interesting:
Company Business FCF Margin (TTM)
Intergraph Corp. Computer Networks 87%Royal Gold Precious Metals 74%Intuit Software 60%Microsoft Software 51%Macrovision Video Rights Mgmt. 49% Linear Technology Semiconductors 46%Corp. Exec. Board Corp. Mgmt. Services 46%Rambus Semi. IP licensing 44% Goldcorp Gold Producer 42%CYTYC Corp. Medical Instr. 39%
[based on SEC filings as of 4/4/03]
Now this is a list a truly Foolish investor can enjoy. Be warned that it's just a start to research, and no investment would be based on this alone. Valuation is especially key. But you learn a lot by determining this handy percentage.
Royal Gold (NASDAQ:RGLD) is interesting because it's not a gold miner. Instead, it acquires and manages royalty streams from precious metals. It showed up in our newsletter, The Motley Fool Select, as a Foolish 8 small-cap, fast-growth company.
Looking at this list, we now know at least one reason for all the fuss over Rambus (NASDAQ:RMBS): its high-margin intellectual-property-licensing business model. And a high FCF margin is clearly one reason Fool co-founder Tom Gardner lauded Corporate Executive Board (NASDAQ:EXBD) in Motley Fool Stock Advisor.
Curious about the top 10 from the other guy's list? Taking out AIG and Citigroup, we have:
Company FCF Margin (TTM)
Verizon 15%General Electric 12%IBM 10% Ford 7%ExxonMobil 5%General Motors 4%ChevronTexaco 2%Wal-Mart 1%[based on SEC filings as of 4/4/03]
Not one would land in or anywhere near our FCF margin top 10.
Beyond the margins
There's much more to FCF and FCF margin. If you're interested in a company, dig deeper. Some companies' cash flow from operations is boosted by tax benefits from stock options, and it's best to subtract that from your cash flow numbers to get a more accurate picture of cash generation.
Also, FCF alone means nothing. While it can mean more money for company investment or distribution to shareholders, it can also be frittered away by unscrupulous or unwise management in the form of excessive salaries and perks, parties for CEO's wives on Greek islands, company-owned country clubs, and more. Investors need FCF in the hands of those who can invest it wisely.
Be armed
Investors should focus on better rather than big. Whether your investing strategy includes stocks from the high-yield, fast-growing, speculative, or value universes, or some of each, a key measure is either current or potential FCF generation. If it's growing, slowing, inexistent, know how much and why. For valuation, compare its growth to a market-cap or enterprise-value multiple of FCF.
A Foolish investor makes free cash flow her best investing buddy. So, why not tell us who's your buddy, or what you would use to rate companies, on our Fool on the Hill discussion board?
Have a most Foolish week!
Tom Jacobs (TMF Tom9) sends coalition troops best wishes for safety and success. You can find his columns in his archive and his stocks, including Rambus, on his profile . Motley Fool writers are investors writing for investors .
