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 Visa (NYS: V) 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 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.
Discover Financial Services
Heartland Payment Systems
Source: S&P Capital IQ.
Visa, MasterCard (NYS: MA) , and Discover Financial Services (NYS: DFS) all far exceed our 10% threshold for attractiveness. However, while Visa and MasterCard have both seen substantial increases in their cash king margins from three years ago, Discover's margins have declined by more than half from three years ago. Heartland Payment Systems' (NYS: HPY) margins are much lower than the other listed companies', and those margins have fluctuated a great deal over the past five years. Compare these returns to the blue chips of software and biotech, to get some context.
Visa has more cards than MasterCard, Discover Financial, and American Express (NYS: AXP) combined. While this gives the company a tremendous competitive advantage, its continued size advantage depends on its ability to compete with other companies to set up remote payment services with companies like Google and PayPal, which are increasingly considering strategic partnerships with credit card companies. Visa is in a strong position to compete with other companies for these partnerships and to maintain supremacy with a huge cash position and lack of long-term debt.
Heartland turned in a quarter that blew by analysts' estimates on increasing processing volumes. Revenue was up 13% for the quarter, and the company's 2012 earnings projection easily trumped analysts' expectations: $1.54 per share versus $1.32.
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 Google, Heartland Payment Systems, and MasterCard. Motley Fool newsletter services have recommended buying shares of Heartland Payment Systems, McDonald's, Google, and Visa. Motley Fool newsletter services have recommended creating a write covered strangle position in American Express. 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.
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