As an investor, you know that 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 received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at Brookfield Infrastructure Partners (NYS: BIP) 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 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 last 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 Brookfield and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Brookfield Infrastructure Partners
Alliant Energy (NYS: LNT)
Ameren (NYS: AEE)
CMS Energy (NYS: CMS)
Source: S&P Capital IQ.
Brookfield Infrastructure far exceeds our 10% threshold for attractiveness. However, it shows a great deal of fluctuation in its cash king margins over the five-year period, and its current margins are lower than they were five years ago. Ameren also meets our 10% threshold for attractiveness, and it shows steady growth in those margins over the past three years. CMS Energy has current cash king margins close to 5%, and they have increased substantially from five years ago. Alliant Energy has current margins below 1%, and while its margins are also up from five years ago, they are down by more than two-thirds since last year. Compare these returns with the blue chips of software and biotech, to get some context.
Brookfield focuses on finding undervalued assets and making a lot of money on them. Its assets are in a wide variety of sectors. For example, its energy segment includes utilities, transmission lines, and natural gas pipelines. Outside the energy sector, it owns ports, rail lines, timberland, and other raw land assets. Its properties reside in the United States, Canada, Chile, and Australia. Brookfield Infrastructure, with its general partner Brookfield Asset Management, is also targeting investments in Brazil.
While Brookfield's involvement in such a wide variety of sectors makes it difficult to compare with other companies, it also creates a unique opportunity for investors to benefit from global growth and from smart businesspeople making investments in a variety of areas.
The cash king margin can help you find highly profitable businesses, but it should be only 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, Brookfield Infrastructure, and Brookfield Asset Management. The Motley Fool owns shares of Brookfield Infrastructure.Motley Fool newsletter serviceshave recommended buying shares of Brookfield Asset Management, McDonald's, and Brookfield Infrastructure. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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