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 McKesson (NYS: MCK) 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, 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.
Owens & Minor
Source: S&P Capital IQ.
None of these companies meets our 10% threshold for attractiveness, and McKesson is the only company to offer margins above 2%. AmerisourceBergen (NYS: ABC) and Cardinal Health (NYS: CAH) both offer current margins in the 1% range, but while AmerisourceBergen has improved its margins from five years ago, Cardinal Health's are down slightly from five years ago. Owens & Minor (NYS: OMI) has margins below 1%, and while they have improved from five years ago, they are down by almost a percentage point from last year. Compare these returns to the blue chips of software and biotech, to get some context.
McKesson has faced challenges related to a highly competitive environment in the drug distribution sector, which has forced it to deal with narrow margins. McKesson, along with Cardinal Health and AmerisourceBergen, dominates the industry. The 2010 health care reform law caused a lot of concern among investors, but the reform has the potential to help McKesson increase its sales by bringing more insured patients who can now afford the wholesale pharmaceuticals the company distributes. Also, McKesson doesn't stand to lose if there is a shift to offering more generic drugs, as generics are higher margin for McKesson and other drug distributors. McKesson also has some growth opportunities related to its currently small technology division, which is trying to find a way to improve access to electronic health records systems.
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. Motley Fool newsletter services have recommended buying shares of McKesson and 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.
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