Investors 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 Frontier Communicationsand 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 $6.97 billion in operating cash flow. It invested about $3.05 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment from its operating cash flow. That leaves us with $3.92 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 14% -- a nice, high number. In other words, for every dollar of sales, McDonald's produces $0.14 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: Capital IQ, a division of Standard & Poor's.
CenturyLink offers the highest cash king margins at 17.1%, but its margins have declined by nearly 10 percentage points from five years ago. Frontier has the next highest margins, but those margins have also declined dramatically over the same period. However, its dividend stands out with a whopping 10.1% yield. Verizon also surpasses our 10% threshold, with 13.2% margins, and it's the only one of the listed companies that has seen those margins grow from five years ago. It also offers a 4.2% yield. Windstream has the lowest margins at 11%, and its margins have declined by nearly half from five years ago. However, its dividend yield is even higher than Frontier's, at 11.3%. Also, while Frontier has cut its dividend twice over the past few years, Windstream has managed to maintain its dividend. CenturyLink offers a 6.3% yield, following a recent dividend cut.
The fact that much of Frontier's existing business comes from rural landlines puts it in a difficult position, given the overall decline of consumer interest in those services. While the company has tried to lure customers into its higher-margin broadband services, it hasn't had much success in doing so. Windstream, on the other hand, has managed to grow its revenues, and CenturyLink's involvement in cloud computing offers promise of growth in high-margin areas that we aren't seeing in Frontier. Also, while Frontier's acquisition of Verizon's landline business allowed Frontier to very quickly grow its size and revenue stream, the acquisition forced it to take on a great deal of debt, ultimately leading to a dividend cut. The sale also gave Verizon more resources to grow its wireless network.
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.
When it comes to dividend yields, you won't find many higher than Frontier Communications. While its juicy dividend is tempting, every Frontier investor has to understand that it's not a sure thing. A huge acquisition has transformed the company forever. Will the move bear fruit, or are investors destined for another disappointing dividend cut? In this premium research report on Frontier Communications, we walk you through all of the key opportunities and threats facing the company.
The article Is Frontier Communications a Cash King? originally appeared on Fool.com.
Jim Royal has no position in any stocks mentioned. The Motley Fool recommends and owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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