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 PPL (NYS: PPL) 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 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 PPL and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Calpine (NYS: CPN)
Dominion Resources (NYS: D)
Progress Energy (NYS: PGN)
Source: S&P Capital IQ.
None of these companies meets our 10% threshold for attractiveness. Calpine has the highest cash king margins at 1.4%, and while those margins have increased by 4.5 percentage points from five years ago, they are currently the lowest they have been in three years. PPL's margins are just above 0%, and they are the lowest they have been in the five-year period. Dominion Resources and Progress Energy both have cash king margins that are in the negative numbers, and both have seen their margins decline from five years ago. Compare these returns with the blue chips of software and biotech to get some context.
Like several other utility companies, such as Southern and FirstEnergy, PPL has performed well in the past year, with increases of more than 10 percentage points in its gross margins. It has benefited from recent low gas prices, allowing the company to reduce costs and gain a competitive advantage over power plants relying on other forms of energy, like nuclear-powered plants run by Exelon. However, with business outside the United States, PPL's geographic diversity also gives it a nice competitive advantage over other utilities companies, a competitive advantage that has also benefited National Grid.
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, Exelon, Southern, Dominion, and National Grid.Motley Fool newsletter serviceshave recommended buying shares of National Grid, Exelon, McDonald's, Dominion Resources, and Southern and creating a write covered strangle position in Exelon. 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.