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 Dominion Resources (NYS: D) 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 last 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.
Here are the cash king margins for Dominion and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
FirstEnergy (NYS: FE)
Entergy (NYS: ETR)
NextEra Energy (NYS: NEE)
Source: S&P Capital IQ.
None of these companies meets our 10% threshold for attractiveness, and both Dominion Resources and NextEra Energy are offering cash king margins in the low negative numbers. Domion's margins are slightly better than NextEra's but worse than they were five years ago, while NextEra's margins have shown some improvement.
Entergy's margins are just barely in the positive but have also declined significantly from five years ago. FirstEnergy's margins are within 2 percentage points of our desired 10% and much higher than they were five years ago.
Dominion has a variety of client types, serving some governmental properties as well as residential and corporate properties in several eastern U.S. states, providing both natural gas and electricity. It also has the largest storage facility for natural gas in the U.S., which it has kept so it can continue its gas utility business even after selling its natural gas resources to Consol Energy in 2010. The company has become increasingly involved in highly regulated areas of the utility industry. While this involvement decreases its growth opportunities, it offers the benefit of more stable profits ongoing.
Utilities are a key source of dividends, and this group is no exception. FirstEnergy offers the highest dividend yield, at 5.2%, with Entergy close behind with a 4.7% yield. Dominion's yield is 3.9%, and NextEra Energy's is 3.7%.
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. 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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At the time thisarticle was published Jim Royal owns shares of McDonald's and Dominion. The Motley Fool owns shares of and has written puts on NextEra Energy.Motley Fool newsletter serviceshave recommended buying shares of Dominion Resources. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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