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 actually received cash -- not just when it books those accounting figments known as "profits."
Today, let's look at priceline.com (NAS: PCLN) 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 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 Priceline and three industry peers over a few periods.
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Expedia (NAS: EXPE)
Orbitz Worldwide (NYS: OWW)
Ctrip.com (NAS: CTRP)
Source: S&P Capital IQ.
Priceline offers nearly triple our desired 10% cash king margins and shows the kind of steady growth in those margins that we like to see. Ctrip.com looks even more impressive, with cash king margins at nearly 50% and growth of nearly 15 percentage points from five years ago. Expedia offers more than double our 10% threshold for attractiveness, but its current margins are below what they were five years ago, though up more recently. Orbitz Worldwide doesn't quite meet our 10% threshold for attractiveness, but while its cash king margins are down slightly from five years ago, they have shown steady growth over the past three years. Compare these returns with the blue chips of software and biotech.
Priceline has a unique business model compared with other travel portals such as Expedia and Orbitz Worldwide, and customers seem to enjoy the option of naming a price and seeing whether the portal can offer them a deal for that amount rather than the set prices competitors offer. While some have criticized the company for failing to use social media to the extent that competitors such as Travelzoo have, Priceline has done a good job finding the deals that make it so appealing to its customer base. It's also expanding internationally at a very brisk clip.
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 rapidly 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 more closely 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 Ctrip.com International.Motley Fool newsletter serviceshave recommended buying shares of Travelzoo, priceline.com, McDonald's, and Ctrip.com International. The Motley Fool has adisclosure policy. We Fools don't 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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