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 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 actually received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Crocs (NAS: CROX) 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 (NYS: MCD) 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.
Here are the cash king margins for four industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: Capital IQ, a division of Standard & Poor's.
Of these companies, only Cherokee (NAS: CHKE) meets our threshold, with cash king margins more than 3 times our desired 10%, but those margins have consistently declined over the past 3 years. Crocs has margins just over 2 percentage points away from meeting our threshold, and its margins have increased substantially from five years ago. Quiksilver (NYS: ZQK) has negative cash king margins, which have declined drastically from its 8.5% margins last year. Skechers (NYS: SKX) also has negative cash king margins, which have declined consistently over the past three years. Compare these returns to the blue chips of software and biotech, to get some context.
Crocs gained notoriety for its classic rubber shoes, which earned the company 62% of its revenue in 2006. When this fad declined, the company faced an epic collapse, after which it began to search for ways to avoid over-dependence on the continued popularity of a single product. To this end, it has developed a new line of golf shoe, and a line of children's shoes marketed to back-to-school shoppers. However, Crocs continues to face plenty of competition from other shoe companies like Nike (NYS: NKE) , Deckers Outdoor, and Under Armour. Though Nike and Crocs traditionally produce different products with different target markets, Crocs' foray into golf shoes may begin to encroach on the athletic footwear titan's market.
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. 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 Under Armour.Motley Fool newsletter serviceshave recommended buying shares of Under Armour, Nike, McDonald's, and Skechers USA.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Nike. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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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