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 wallet. 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 Transocean (NYS: RIG) 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 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 retail, 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.
Diamond Offshore Drilling
Source: S&P Capital IQ. TTM = trailing 12 months.
Diamond Offshore (NYS: DO) offers nearly double our desired 10% cash king margin, and it has grown its margin substantially from 5 years ago. However, its margins have consistently declined over the past 3 years. None of the other companies meets our 10% threshold for attractiveness. Transocean comes the closest with 8.4%, but its current margins are the lowest they have been over the past 5 years. Noble (NYS: NE) and Nabors Industries (NYS: NBR) both have current subzero cash king margins, and their numbers are the lowest they have been in the past 5 years.
Transocean has faced a number of challenges over the past couple of years, including BP's (NYS: BP) attempt to get Transocean and Halliburton to help cover its huge expenses in cleaning up the Gulf oil spill. In addition, Transocean's recent financial performance has failed to compete with that of its industry peers. While Transocean blames new regulations for its recent performance, competitors like SeaDrill have seen sales and profits rise.
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 these investments poor decisions. 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 Transocean. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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