Tuesday, 6 September 2011

A cash cow is a company with plenty of free cash flow.

A cash cow is a company with plenty of free cash flow - that is, the cash left over after the company meets its necessary yearly expenses.

Cash cows tend to be slow-growing, mature companies that dominate their industries. Their strong market share and competitive barriers to entry translate into recurring revenues, high profit margins and robust cash flow. Compared to younger companies - which tend to reinvest their profits more aggressively to fuel future growth - more mature businesses (with less room for growth) often generate more free cash since the initial capital outlay required to establish their businesses has already been made

Finally, a cash cow can often be a tempting takeover target. If a cash cow company seems like it can no longer use its excess cash to boost value for shareholders, it is likely to attract acquirers that can.


The Life of the Cash Cow: Free Cash Flow

To see if a company is worthy of cash-cow status, you of course need to calculate its free cash flow. To do so, you take cash from operations and subtract capital expenditures for the same period:

Free Cash Flow = Cash Flow from Operations - Capital Expenditure

The more free cash the company produces the better. A good rule of thumb is to look for companies with free cash flow that is more than 10% of sales revenue.


Cows That Stand Apart from the Herd: Price and Efficiency

A Low Cash Flow Multiple
Once you've spotted a cash cow stock, is it worth buying? For starters, look for companies with a low free cash flow multiple: simply, divide the company's stock price (more precisely, its market capitalization) by its underlying free cash flow. With that calculation, you can compare how much cash power the share price buys - or, conversely, you see how much investors pay for one dollar of free cash flow.

Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful.

High Efficiency Ratios

Besides looking for low free cash flow multiples, seek out attractive efficiency ratios. An attractive return on equity (ROE) can help you ensure that the company is reinvesting its cash at a high rate of return.

Return on Equity = (Annual Net Income / Average Shareholders' Equity)

To double check that the company is not using debt leverage to give ROE an artificial boost, you may also want to examine return on assets (ROA).

ROA = Return on Assets = (Annual Net Income / Total Assets)

An ROA higher than 5% is normally considered a solid performance for most companies.

Conclusion
Cash cows generate a heap of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high return on equity and return on assets, and if they trade at a reasonable price, then cash cows are worth a closer look.

http://www.investopedia.com/articles/stocks/05/cashcow.asp#axzz1X5QRWuqP

SUMMARY:
Cash cow is a company with plenty of free cash flow.
FCF/Total Sales Revenue > 10%
Low Price/FCF multiple
High ROE > 15%
ROA > 5%


Also read:

Free Cash Flow Return on Invested Capital. 

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