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 Western Refining (NYS: WNR) 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 Western Refining and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Copano Energy (NAS: CPNO)
Tesoro (NYS: TSO)
Valero Energy (NYS: VLO)
Source: S&P Capital IQ.
None of these companies meets our 10% threshold for attractiveness, and only Western Refining has shown any growth in its cash king margins from five years ago. Copano and Valero Energy both have lower margins than they did five years ago, and Tesoro's margins are exactly where they were five years ago.
Western Refining has suffered a reduction in throughput volume just as it gained some benefit from an increase in refined oil prices. El Paso and Gallup, its biggest refineries, have accounted for 5% of the decrease in volume. The problem of reduced throughput has been exacerbated by the fact that Western's expenses in running the refineries do not reduce with reductions in throughput. It costs the same amount to operate a refinery running at maximum capacity. However, Western is in the process of selling a Virginia-based storage and distribution terminal to Plains Marketing, a subsidiary of Plains Exploration and Production, for $180 million, which will help streamline operations and provide Western with some cash.
While Copano's margins have declined the most, it also has the largest dividend yield, at 6.8%. Valero's is the next highest, at 2.9%, Western's is 1%, and Tesoro lacks any dividend whatsoever.
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. The Motley Fool owns shares of Western Refining. 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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