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 Cypress Semiconductor (NAS: CY) 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.
Source: Capital IQ, a division of Standard & Poor's.
All of these companies far exceed our 10% threshold for attractiveness. While Cypress and Texas Instruments (NYS: TXN) have increased their margins substantially from five years ago, their margins have steadily declined over the past three years. Analog Devices (NYS: ADI) has also improved its cash king margins from five years ago, and has shown steady increases over the past three years. Linear Technology (NAS: LLTC) , on the other hand, has slightly lower cash king margins than it had five years ago.
Cypress Semiconductor specializes in creating touchscreen controllers used in smartphones and other products. The company also designs programmable system-on-a-chip (PSoC) products that are partially defined by the software the consumer uses to manage them. This is particularly useful to consumers who want a malleable product, which even competitors Texas Instruments and Analog Devices don't offer.
Analog Devices creates integrated circuits used to help convert light, sound, and other inputs into electrical signals. Now that Texas Instruments made a deal to take over National Semiconductor, some other large industry peers may be interested in following suit. Analog has a number of options that would make a logical fit, including Intersil, Linear Technology, or ON Semiconductor.
Finally, Analog offers a nice dividend yield at 2.7%, which outperforms Cypress Semiconductor's 2.1% yield and Texas Instruments' 2.2% yield. However, Linear Technology offers the highest dividend yield of its listed industry peers at 3.2%.
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 Texas Instruments.Motley Fool newsletter serviceshave recommended buying shares of McDonald's, Linear Technology, and Cypress Semiconductor. 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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