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 Boston Scientific (NYS: BSX) 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 December, the restaurateur generated $7.15 billion in operating cash flow. It invested about $2.73 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment ($2.73 billion) from its operating cash flow ($7.15 billion). That leaves us with $4.42 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.
Taking McDonald's sales of $27.0 billion over the same period, we can figure that the company has a cash king margin of about 16.4% -- a nice, high number. In other words, for every dollar in sales, McDonald's produces more than $0.16 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 different periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: Capital IQ, a division of Standard & Poor's.
CR Bard (NYS: BCR) and Hologic (NAS: HOLX) both offer more than double our desired 10%. CR also offers the kind of steady growth in its margins over the five-year period that we like to see. Hologic also offered a great deal of growth over the same period, but its margins have dropped 4% from last year. AngioDynamics (NAS: ANGO) also meets our 10% threshold for attractiveness, and while its margin has also grown a lot from five years ago, it's declined several percentage poi nts from last year. Boston Scientific (NYS: BSX) doesn't quite meet our 10% threshold for attractiveness, but it comes close. However, while it has increased its margins substantially from last year, its current margins are lower than they were three and five years ago. Compare these returns to the blue chips of software and biotech to get some context.
Boston Scientific produces medical devices, competing with companies like Abbott Labs (NYS: ABT) , St. Jude Medical, and Medtronic. It offers a wide range of products, including catheters, heart defibrillators, and stents. Recently, Boston Scientific hired Michael Mahoney, the former chairman of Johnson & Johnson's medical device group, as its CEO. Unfortunately, Mahoney is not allowed to serve as the company's CEO until late 2012 due to a non-compete clause. As a result, they will have to use an interim CEO for a one-year period, which will make a smooth leadership transition more difficult. It is also possible that Boston Scientific will benefit from Johnson & Johnson's decision to no longer sell drug-eluting stents; however, Medtronic and Abbott Labs are still competitors in this area, so Boston Scientific is not without competition.
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 instead follow the cash, 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 and J&J. The Motley Fool owns shares of Johnson & Johnson, St. Jude Medical, Abbott Laboratories, and Medtronic.Motley Fool newsletter serviceshave recommended buying shares of Johnson & Johnson, McDonald's, and Abbott Laboratories; and creating a diagonal call position in Johnson & Johnson. 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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