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 Foot Locker (NYS: FL) 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:
Cash King Margin (TTM)
1 Year Ago
3 Years Ago
5 Years Ago
Source: S&P Capital IQ. TTM = trailing 12 months.
None of these companies meets our 10% threshold for attractiveness. Foot Locker and DSW (NYS: DSW) both have cash king margins in the 6% range, and have grown their margins from five years ago. Genesco's (NYS: GCO) current margins are just above 4%, and has grown its margins from a half-decade ago. Weyco (NAS: WEYS) has the lowest margins of the listed companies, and while the company has managed to grow its margins from five years ago, they are down substantially from three years ago. Compare these returns to the blue chips of software and biotech, to get some context.
Foot Locker suffered a great deal from the impact the recession had on customer spending. However, Footlocker has come a long way since then. While it hasn't offered the growth of Under Armour or Nike, its shares doubled from late 2009 to late 2010 and have still shown some growth since then. The company also offers a 2.5% dividend and has put a share repurchase program in place, which should help boost their price.
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 Under Armour.Motley Fool newsletter serviceshave recommended buying shares of McDonald's, Nike, and Under Armour.Motley Fool newsletter serviceshave recommended creating a diagonal call position in Nike. 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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