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 Tyson Foods (NYS: TSN) 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 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.
Source: Capital IQ, a division of Standard & Poor's.
None of these companies meets our 10% threshold for attractiveness, and you can see the thin (and sometimes negative) cash margins in this tough sector. Hormel Foods (NYS: HRL) has the highest cash king margins, at 4.6%. While Hormel's margins have fluctuated a great deal over the five-year period, they are currently higher than they were five years ago. Smithfield Foods (NYS: SFD) and Tyson Foods both have margins in the 1% range. Tyson's margins have doubled from five years ago, and Smithfield's margins have grown even more. Sanderson Farms (NAS: SAFM) has margins in the low negative numbers, and are even lower than they were five years ago. That consistent cash burn could be worrisome.
Tyson has been facing a tough economic climate in the meat commodities businesses. Increases in feed and increases in the cost of raising animals are eating into Tyson's profit margins. In addition, the oversupply of chicken has pressured Tyson and its competitors to lower prices. While the industry as a whole could address these issues by cutting back on prices, individual businesses in this sector are reluctant to do so out of fear of losing market share. However, while things are still looking rough in the U.S., American meat companies have the opportunity to extend their sales in Japan, whose local meat supply was crushed by recent disasters there.
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.
Want to read more about Tyson Foods? Add it toMy Watchlist, which will find all of our Foolish analysis on this stock.
Add Tyson Foods to My Watchlist.
Add Smithfield Foods to My Watchlist.
Add Sanderson Farms to My Watchlist.
Add McDonald's to My Watchlist.
Add Hormel Foods to My Watchlist.
At the time thisarticle was published Jim Royal owns shares of McDonald's. Motley Fool newsletter services have recommended buying shares of McDonald's. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.