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 PG&E (NYS: PCG) 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:
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, and Exelon (NYS: EXC) is the only listed company with positive cash king margins. However, Exelon's margins have steadily declined over the past three years. Sempra Energy (NYS: SRE) and Edison International (NYS: EIX) both have current margins in the low negative numbers, and both have also seen declines in their margins over the five-year period. PG&E also has negative cash king margins, but while its margins are down from five years ago, it has steadily improved over the past three years. Compare these returns to the blue chips of software and biotech, to get some context.
PG&E provides natural gas and electricity to millions of individuals and businesses in central and northern California. Generally, the company has produced steady growth in its revenues and a more steady stock performance than Edison International and Sempra Energy. It also has a solid dividend yield, at 4.2%, which outperforms Edison International's 3.1% yield, Exelon's 3.9%, and even Sempra Energy's 3.8%. Also, PG&E has been working to innovate in the renewable energy space by trying to use compressed air storage to store power from solar and wind energy instead of the battery-related storage systems used by A123 Systems and Enerl.
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 and Exelon.Motley Fool newsletter serviceshave recommended buying shares of Exelon and McDonald's.Motley Fool newsletter serviceshave recommended creating a write covered strangle position in Exelon. 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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