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 Career Education (NAS: CECO) 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, plants, 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 either 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 of 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 periods.
American Public Education
ITT Educational Services
Source: Capital IQ, a division of Standard & Poor's. TTM = Trailing 12 months.
ITT Educational Services (NYS: ESI) and American Public Education (NAS: APEI) both exceed our 10% threshold for attractiveness. While both have seen fluctuations in their margins over the five-year period, their current margins are much higher than they were five years ago. DeVry (NYS: DV) comes very close to meeting our 10% threshold for attractiveness, but its current margins are the lowest they have been in five years. Career Education has the lowest margins of the listed companies, and while it only shows a little bit of growth from five years ago, its range of fluctuation in either direction has been much smaller than that of the other listed companies. Compare these returns to the blue chips of software and biotech to get some context.
Career Education, like other businesses in the for-profit education industry, has faced several challenges arising from recent controversies. Some of these controversies relate to poor student loan repayment rates. In addition, the Government Accountability Office found evidence of fraud and deception in recruitment procedures at several for-profit schools. The government responded with threats to no longer offer subsidized loans for students to attend these schools.
While these issues raised a lot of concerns in the industry, when the final regulations came out in June of last year, they were not as stringent as expected. Strayer Education and Corinthian Colleges (NAS: COCO) were particularly relieved about this, as they were more concerned about these new regulations than several other schools. However, new regulations prevent for-profit education companies from paying enrollment-based incentives to their recruiters.
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 American Public Education.Motley Fool newsletter serviceshave recommended buying shares of American Public Education and McDonald's. 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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