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 Las Vegas Sands (NYS: LVS) 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
Las Vegas Sands
Melco Crown Entertainment
Source: S&P Capital IQ. TTM = trailing 12 months.
Wynn Resorts (NAS: WYNN) has current cash king margins more than double our 10% threshold for attractiveness. The company has also managed to steadily increase its margins over the past five years. Melco Crown (NAS: MPEL) and Las Vegas Sands also exceed our threshold and show massive and steady growth in their cash king margins over the five-year period. MGM Resorts (NYS: MGM) has by far the lowest margins of the listed companies, but has also shown dramatic growth from five years ago. Compare these returns to the blue chips of software and biotech to get some context.
While Las Vegas Sands (NYS: LVS) has gained some success from its expansion into the Asian market, future growth may suffer due to regulation in areas where it hopes to expand, as well as slowing economic growth in some of the Asian markets it is targeting. For example, further growth in the casino market is prohibited in Singapore until 2017. Wynn Resorts and Melco Crown have also profited from growth in Asia, and face the same obstacles for future growth.
MGM Resorts also has a presence in Asia -- particularly Macau, a popular gaming city. However, MGM's success primarily depends on its Las Vegas business, where it has the bulk of its properties. Unfortunately for MGM, the gaming business in Las Vegas has been declining. MGM also faces the obstacle of dealing with its huge debt pile, which is close to double its annual revenue. This puts MGM in a difficult position even when the gaming business in Las Vegas recovers. However, the possibility of online poker becoming legal in the U.S. would create a significant growth opportunity for MGM, in which case company leaders said they would join Boyd Gaming (NYS: BYD) to establish a joint venture with Party Poker.
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 serviceshave recommended buying shares of McDonald's. 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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