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 has actually received cash -- not just when it books those accounting figments known as "profits."
Today let's look at UnitedHealth (NYS: UNH) 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.
Source: S&P Capital IQ. TTM = trailing 12 months.
None of these companies meets our 10% threshold for attractiveness. Aetna (NYS: AET) has the highest cash king margins, at above 6%, and they are slightly higher than they were five years ago. UnitedHealth offers cash king margins close to 6%, but its current margins are down more than 2 percentage points from five years ago. WellPoint (NYS: WLP) and Cigna (NYS: CI) both have margins in the high 4% range, but while Cigna has improved its margins from five years ago, Wellpoint's current margins are lower than they were five years ago. Compare these returns to the blue chips of software and biotech, to get some context.
UnitedHealth has faced some challenges recently related to health-care reform that eliminated its ability to deny coverage to individuals with pre-existing conditions, creating extra pressure for the company to get healthy people on its rolls. The individual mandate is supposed to take care of that, but if the Supreme Court rules it unconstitutional, then insurers could be in trouble. In addition, the added requirement that insurance companies need to pay specified minimum amounts on claims has the potential to eat even further into the company's profit margins.
However, even amid this uncertain environment, the company has still managed to boost its dividend -- paving the way for competitors like Aetna and WellPoint to do the same and leaving competitors Humana (NYS: HUM) and Cigna behind. While the uncertain environment for health insurance may drive away conservative investors, the low prices in this sector offer an interesting opportunity for those willing to take on some risk.
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 UnitedHealth Group, McDonald's, and WellPoint. 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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