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 Whole Foods Market (NAS: WFM) 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 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 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.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Whole Foods Market
Source: Capital IQ, a division of Standard & Poor's.
None of these companies meets our 10% threshold for attractiveness. Whole Foods Market has the highest current cash king margins, and while its margins have fluctuated over the past five years, it has shown a general upward trend over the five-year period. Safeway has the next highest margins of the listed companies. Like Whole Foods, it shows some fluctuation and a general upward trend. However, its margins have seen a narrower range. SUPERVALU (NYS: SVU) has cash king margins a little over 1%, but they have grown by more than a percentage point from their negative margins five years ago. Kroger has current margins that are less than 1%, and they have not fluctuated by more than 1 percentage point over the five year period.
Whole Foods has been successful in creating a chain of popular stores selling a huge variety of natural and organic foods. In fact, its marketing of these types of foods has been so successful that it has inclined competitors like Wal-Mart (NYS: WMT) and Kroger to begin offering a wider range of organic products. Whole Foods has also been successful in consistently increasing its revenue and profit growth, even as competitors like SUPERVALU and Safeway have struggled to maintain their sales levels. On the other hand, Whole Foods is facing increasing pressure to find ways to compete with companies like Trader Joe's and The Fresh Market, which also focus on selling the natural and organic foods Whole Foods focuses on.
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 and Supervalu.The Motley Fool owns shares of Whole Foods Market, SUPERVALU, and Wal-Mart Stores.Motley Fool newsletter serviceshave recommended buying shares of Wal-Mart Stores, McDonald's, The Fresh Market, and Whole Foods Market.Motley Fool newsletter serviceshave recommended buying calls on SUPERVALU.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Wal-Mart Stores. 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.