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 Amgenand 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 $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: S&P Capital IQ.
All of these companies far surpass our 10% threshold, with Amgen offering more than three times our desired 10%. However, Amgen has seen its margins fluctuate significantly over the past five years, with current margins more than nine percentage points lower than they were three years ago. Biogen is close behind Amgen, with margins at nearly 30%. Like Amgen, Biogen has seen some fluctuation in its margins, but its current margins are more than 6 percentage points higher than they were five years ago. Gilead is right behind Biogen, offering margins of nearly 29%. However, its current margins are the lowest they have been in the periods here. AstraZeneca's margins are several percentage points behind the rest of the listed companies, but are still more than double our desired 10%. Also, aside from a spike in its margins 3 years ago, the fluctuation of its margins has been pretty narrow.
Amgen has managed to offer a wide range of products treating illnesses as diverse as arthritis, cancer, and psoriasis. It also has some promising drugs in its pipeline, and its recent acquisition of deCODE Genetics may allow it to take the lead in providing personalized medicine options based on patients' genetic codes. However, Amgen has taken a hit from competition put up by Teva Pharmaceuticals and companies outside the U.S. that have developed biosimilar drugs that compete with some of Amgen's offerings, including its Neulasta/Neupogen treatment system, which battles the side-effects of chemotherapy.
Biogen got some good news last week when the EU's drug regulatory agency recommended approval of its MS treatment drug Tecfidera. Also, Biogen expects an approval decision for the drug from the FDA later this week.
Gilead Sciences' acquisition of Pharmasset last year poised the company to dominate the market for hepatitis C treatments after Bristol-Myers Squibb and Idenix Pharmaceuticals faced major setbacks from introducing their own hep-C drugs into the market.
AstraZeneca has suffered from the loss of its patent on Seroquel, which treats schizophrenia. In addition, the company lacks a strong pipeline of drugs that could offer hope of replacing the revenue lost due to its expired patent on Seroquel, and the upcoming loss of revenue that will likely occur when the patents expire on its Nexium and Crestor drugs.
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.
While you can certainly make huge gains in biotech and pharmaceuticals, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.
The article Is Amgen a Cash King? originally appeared on Fool.com.
Jim Royal has no position in any stocks mentioned. The Motley Fool recommends Gilead Sciences. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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