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 Time Warner Cable (NYS: TWC) 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 Time Warner Cable and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Time Warner Cable
EarthLink (NAS: ELNK)
United Online (NAS: UNTD)
NTELOS Holdings (NAS: NTLS)
Source: S&P Capital IQ.
Time Warner Cable, United Online, and NTELOS Holdings all meet our 10% threshold for attractiveness, but only Time Warner Cable offers the consistent growth in its cash king margins that we like to see. NTELOS has also grown its margins from five years ago, but its margins have declined since last year.
United Online's margins have shown steady declines over the past three years, and they are less than half of what they were three years ago. EarthLink's margins are just over 5% and are the lowest they have been in the past five years.
At the end of its second quarter, Time Warner Cable benefited from a 4.4% increase in its sales, which can largely be attributed to an increase in subscriptions and the average revenue brought in from each subscriber. As Time Warner Cable brings in these strong cash flows, it is also reinvesting in its business. Last year, the company bought out Insight Communications, becoming the second largest cable television company in the U.S., behind Comcast. In addition to its dividend, Time Warner Cable has bought back $2.8 billion of its own shares in the past four quarters.
For you income seekers, NTELOS offers the highest dividend of these companies, with an 8.2% yield. United Online also has a high yield, at 7.1%. EarthLink and Time Warner Cable have 3% and 2.9% yields, respectively. But given the future uncertainty of these businesses (especially EarthLink and United Online), I'd have to investigate much further before I invested.
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. 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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