Is Compass Diversified Holdings a Cash King?

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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 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 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.

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 June, the restaurateur generated $6.87 billion in operating cash flow. It invested about $2.44 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.44 billion) from its operating cash flow ($6.87 billion). That leaves us with $4.43 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 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, 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.

The companies
Today, let's look at Compass Diversified Holdings (NYS: CODI) and three of its peers:

Company

Compass Diversified Holdings

3.9%

0.5%

4.0%

3.7%

DDI (NAS: DDIC)

7.3%

1.1%

4.2%

(1.3%)

Paychex (NAS: PAYX)

28.4%

27.3%

29.1%

30.7%

Automatic Data Processing (NAS: ADP)

15.4%

17.7%

18.2%

25.6%

Source: S&P Capital IQ.

Compass Diversified has the lowest cash king margins of the listed companies, but its margins are slightly down from three years ago. Paychex and Automatic Data Processing both exceed our 10% threshold for attractiveness, but both of their margins have declined from five years ago. DDI is within 3 percentage points of our desired 10%, and shows significant growth from five years ago.  Compare these returns to the blue chips of software and biotech, to get some context. You should also note that last week the company announced it was selling Staffmark, its largest subsidiary, for an enterprise value of $295 million. So the company's numbers going forward could be much different.

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. 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.

Want to read more about Compass Diversified? Add it to My Watchlist, which will find all of our Foolish analysis on this stock.

At the time this article was published Jim Royal owns shares of McDonald's. Motley Fool newsletter services have recommended buying shares of Automatic Data Processing, McDonald's, and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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