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 Teck Resources (NYS: TCK) 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:
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:
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Cliffs Natural Resources
Source: Capital IQ, a division of Standard & Poor's.
Teck Resources has the highest cash king margins of the listed companies. While those margins have grown consistently over the past three years, they currently are lower than they were five years ago. Cliffs Natural Resources (NYS: CLF) has the next highest cash king margins, but it's down after last year. Walter Energy (NYS: WLT) has seen a great deal of fluctuation in its margins over the past five years, and its margins are currently lower than they were five years ago. Cameco (NYS: CCJ) has the lowest cash king margins of the listed companies. Five years ago, its cash margins were in the negative numbers, and while they improved since then, they have declined slightly YOY.
Because of the kinds of products it offers, Teck Resources' success is closely tied to the global economy. It competes with Freeport-McMoRan and Southern Copper in copper sales and production. Its growth in this area depends on infrastructure and housing growth in emerging markets. It competes with Alpha Natural Resources and Arch Coal in metallurgical coal production, which is an area that has seen a lot of growth recently. Teck has benefitted from great opportunities in these areas. However, due to other challenges associated with the current financial crisis, Teck's need for cash forced it to sell its stake in Hemlo Mines at an extremely low price.
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 Freeport-McMoRan Copper & Gold.Motley Fool newsletter serviceshave recommended buying shares of McDonald's and Cameco. 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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