Tell tale signs of good cash generation: Dividends, Share Buybacks and Accumulation of Cash on the Balance Sheet

Economies of scale refers to a company's ability to leverage its fixed cost infrastructure across more and more clients.

The result of scale economies should be operating leverage, whereby profits are able to grow faster than sales.

The combination of operating leverage and low ongoing capital requirements suggest that the firms should have plenty of free cash to throw around.

Tell tale signs of good cash generation are dividends, share buybacks, and an accumulation of cash on the balance sheet.

Another characteristic to look for when evaluating investments is predictable sales and profits. That makes financial results more stable and predictable.

Should there be high barriers to entry into this business, the firms in this business tend to have wide, defensible moats.

When they are trading at cheap prices, they are usually worth a good look.

Super-profitable companies with too much cash pile up on the balance sheet. Be proactive.

Company ABC

It has no long-term debt.

Its current ratio is around 4; rather high for a company with no debt to worry about.

It has consistently kept around 15% of total assets in cash.

Asking the ONE most important question: How much cash can be generated from the business?

Asking the ONE most important question: How much cash can be generated from the business?

If a businessperson is asked about what goes into consideration when purchasing a business, the number one answer should be:

How much cash can be generated from the business?


Other answers, though important, are of secondary importance, such as:

What is the business worth?
Who is the biggest competitor?
What is motivating the seller of the business?


Therefore, the businessperson when purchasing a business should examine the business aspects of his investments.  This involves looking at:

1.  the income statements
2.  the capital reinvestment requirements, and
3.  the cash generating capabilities of the business or investments.

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. 

Spotting Cash Cows

Spotting Cash Cows
Posted: Aug 26, 2005

Cash cows are just what the name implies - companies that can be milked for further ongoing profits with little expense. Producing plenty of cash, these companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to increase their dividend or reinvest that cash to boost returns further. Either way, shareholders stand to benefit. To help you spot cash cows that are worthy of your investment, we look at what sets these companies apart and offer some guidelines for assessing them.

The Cash Cow: An Overview
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. Smart investors really like this kind of company because it can fund its own growth and value. A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital. Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.

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. (For more on what this means, see The Basics of Mergers and Acquisitions.)

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


(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

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.

Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.

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.

To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.

So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.

Free cash flow multiples are a good starting point for finding reasonably priced cash cows. But be careful: sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem. Or its cash flow may be erratic and unpredictable. So, take care with very small companies and those with wild performance swings.

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)

You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.

On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)

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). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)

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

Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.

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.


by Ben McClure
Ben McClure is a long-time contributor to Investopedia.com.


Read more: http://www.investopedia.com/articles/stocks/05/cashcow.asp#ixzz1X5R2fwXM

Product portfolio - the Boston Matrix (or Boston Box)

Introduction

The business portfolio is the collection of businesses and products that make up the company. The best business portfolio is one that fits the company's strengths and helps exploit the most attractive opportunities.

The company must:

(1) Analyse its current business portfolio and decide which businesses should receive more or less investment, and

(2) Develop growth strategies for adding new products and businesses to the portfolio, whilst at the same time deciding when products and businesses should no longer be retained.

Methods of Portfolio Planning

The two best-known portfolio planning methods are from the Boston Consulting Group (the subject of this revision note) and by General Electric/Shell. In each method, the first step is to identify the various Strategic Business Units ("SBU's") in a company portfolio. An SBU is a unit of the company that has a separate mission and objectives and that can be planned independently from the other businesses. An SBU can be a company division, a product line or even individual brands - it all depends on how the company is organised.

The Boston Consulting Group Box ("BCG Box")

Using the BCG Box (an example is illustrated above) a company classifies all its SBU's according to two dimensions:

On the horizontal axis: relative market share - this serves as a measure of SBU strength in the market

On the vertical axis: market growth rate - this provides a measure of market attractiveness

By dividing the matrix into four areas, four types of SBU can be distinguished:

Stars - Stars are high growth businesses or products competing in markets where they are relatively strong compared with the competition. Often they need heavy investment to sustain their growth. Eventually their growth will slow and, assuming they maintain their relative market share, will become cash cows.

Cash Cows - Cash cows are low-growth businesses or products with a relatively high market share. These are mature, successful businesses with relatively little need for investment. They need to be managed for continued profit - so that they continue to generate the strong cash flows that the company needs for its Stars.

Question marks - Question marks are businesses or products with low market share but which operate in higher growth markets. This suggests that they have potential, but may require substantial investment in order to grow market share at the expense of more powerful competitors. Management have to think hard about "question marks" - which ones should they invest in? Which ones should they allow to fail or shrink?

Dogs - Unsurprisingly, the term "dogs" refers to businesses or products that have low relative share in unattractive, low-growth markets. Dogs may generate enough cash to break-even, but they are rarely, if ever, worth investing in.

Using the BCG Box to determine strategy

Once a company has classified its SBU's, it must decide what to do with them. In the diagram above, the company has one large cash cow (the size of the circle is proportional to the SBU's sales), a large dog and two, smaller stars and question marks.

Conventional strategic thinking suggests there are four possible strategies for each SBU:

(1) Build Share: here the company can invest to increase market share (for example turning a "question mark" into a star)

(2) Hold: here the company invests just enough to keep the SBU in its present position

(3) Harvest: here the company reduces the amount of investment in order to maximise the short-term cash flows and profits from the SBU. This may have the effect of turning Stars into Cash Cows.

(4) Divest: the company can divest the SBU by phasing it out or selling it - in order to use the resources elsewhere (e.g. investing in the more promising "question marks").

http://tutor2u.net/business/strategy/bcg_box.htm

http://en.wikipedia.org/wiki/Growth-share_matrix

What management does with cash flow is key to long term performance.

Cash Deployment – After playing the stock-picking game for a while I notice that what management does with cash flow is key to long term performance. Sometimes they can't think of anything better to do than to load up with debt and then go on to spend the proceeds buying back shares at inflated prices. Of course when trouble hits it becomes necessary to raise capital by selling shares at fire sale prices. Readers who have avoided these types of problem during the downturn have done better than I and deserve to be congratulated.

Mr. Market does not like capex. It's a real turnoff, peeing away money that could support a nice special dividend or be used to pump up share prices. Actually risking it in an effort to make money from expanded or more efficient operations is less attractive than the alternatives, in terms of immediate price action.

http://seekingalpha.com/article/184987-why-i-m-staying-with-verizon

Using Yield-based measures to value stocks: Say Yes to Yield

Say Yes to Yield

1.  Earnings yield

Earnings yield
= Earnings/Price

The nice thing about yields , as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas bond payments are fixed.)

For example:
In late-2003:
Risk-free return from 10-year treasury bond: 4.5%
Earnings yield of Stock with P/E of 20 = 5% (This is a bit better than treasuries, but not much considering the additional risk taken.)
Earnings yield of stock with P/E of 12 = 1/12 = 8.3% (This is much better than the treasury bond. The investor might be induced to take the additional risk.)

2.  Cash return

Cash return
= Free Cash Flow/Enterprise Value
= FCF/(Market capitalization + long term debt – cash)

However the best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E.

To calculate a cash return, divide free cash flow (FCF) by enterprise value. (Enterprise value is simply a stock’s market capitalization plus its long-term debt minus its cash.)

The goal of the cash return is to measure how efficiently the business is using its capital – both equity and debt – to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole company, including the debt burden. An investor buying the whole company would not only need to buy all the shares at market value, but also would be taking on the burden of any debt (net of cash) the company has.


An example of how to use cash return to find reasonably valued investments:
Company A’s
In late 2003,
Market cap = $9.8 billion
Long-term debt = $495 million
Cash in balance sheet = $172 million
Enterprise value = $9,800 + $495 - $172 = $10,100 million or $10.1 billion.

Review its FCF over the past decade
In 2003, FCF = about $600 million

Therefore,
Cash return of Company A = $600/$10,100 = 5.9%

In late 2003:
Yield of 10-year treasuries = 4.5%
Yield on corporate bonds = 4.9% (This is higher but still relatively paltry.)
Cash return of Company A = 5.9% (Looks pretty good. Moreover, this FCF is likely to grow over time, whereas those bond payments are fixed. Thus, Company A starts to look like a pretty solid value.)

Cash return is a great first step to finding cash cows trading at reasonable prices, but don’t use cash return for financials or foreign stocks.
• Cash flow isn’t terribly meaningful for banks and other firms that earn money via their balance sheets.
• A foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally, as the definitions of cash flow can vary widely in other countries.


----

Free Cashflow to Capital

FCF/Capital
=FCF/ Total Capital Employed
= FCF/TOCE
= FCF / (Total shareholders equity + Debt)

The Stock Performance Guide published by Dynaquest Sdn. Bhd. gives data on Free Cashflow (FCF) to Capital.  FCF is the amount of nett cashflow left after paying for re-investment in fixed and current assets. FCF measures the ability of a firm to pay out dividend.

FCF/Capital compares the FCF of a firm with the total capital employed (defined as total shareholders equity & debt). The higher is this ratio, the more efficiently is the firm using its capital.

Cash cows are those companies with FCF/Capital of > 10%.

FCF/Capital is not the same as Cash Return discussed above.

Spotting Cash Cows

Spotting Cash Cows
by Ben McClure (Contact Author | Biography)

Cash cows are just what the name implies - companies that can be milked for further ongoing profits with little expense. Producing plenty of cash, these companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to increase their dividend or reinvest that cash to boost returns further. Either way, shareholders stand to benefit. To help you spot cash cows that are worthy of your investment, we look at what sets these companies apart and offer some guidelines for assessing them.

 

The Cash Cow: An Overview
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. Smart investors really like this kind of company because it can fund its own growth and value.

• A cash cow can reinvest free cash to grow its own business - thereby boosting shareholder returns - without sacrificing profitability or turning to shareholders for additional capital.
• Alternatively, it can return the free cash flow to shareholders through bigger dividend payments or share buybacks.

 

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. (For more on what this means, see The Basics of Mergers and Acquisitions.)

 

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

 

 

(For more on calculating free cash flow, see Free Cash Flow: Free, But Not Always Easy.)

 

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.

 

Consumer products giant Procter & Gamble (PG), for example, fits the cash cow mold. Procter & Gamble's brand name power and its dominant market share have given it its cash-generating power. Take a look at the company's Form 10-K 2004 Annual Report's (filed on Sept 9, 2004) Consolidated Statement of Cash Flows (scroll to sec. 39, p.166). You'll see that the company consistently generated high free cash flows - these even exceeded its reported net income: at end-2004, Procter & Gamble's free cash flow was $7.34 billion (operating cash flow - capital expenditure = $9.36B - $2.02B), or more than 14% of its $51.4 billion sales revenue (net sales on the Consolidated Statements of Earnings). In 2004, PG produced real cash for its shareholders - a lot of it.

 

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.

 

To find PG's free cash flow multiple, we'll look at its stock price on the day it filed its 2004 10-K form, which was Sept 9, 2004. On that day, the stock closed at $56.09 (see PG's trading quote that day on Investopedia's stock research resource). With about 2.5 billion shares outstanding, Procter & Gamble's market value was about $140.2 billion.

 

So, at the financial year-end 2004, PG was trading at about 19 times its current free cash flow ($140.2 billion market value divided by 2004 free cash flow of $7.34 billion). By comparison, direct competitor Unilever traded at about 25 times free cash flow, suggesting that Procter & Gamble was reasonably priced.

 

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

• sometimes a company will have a temporarily low free cash flow multiple because its share price has plummeted due to a serious problem.
• Or its cash flow may be erratic and unpredictable.
• So, take care with very small companies and those with wild performance swings.

 

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)

 

You can find net income (also known as "net earnings") on the income statement (also known as "statement of earnings"), and shareholders' equity appears near the bottom of a company's balance sheet.

 

On this front, PG performed exceedingly well. The company's 2004 net earnings was $6.5 billion - see the Consolidated Statement of Earnings p.35 (p.161 in the PDF) on the 10-K - and its shareholders' equity was $17.28 billion - see the Consolidated Balance Sheets p.37 (p.163 in the PDF). That means ROE amounted to nearly 38%. In other words, Procter & Gamble was able to milk 38 cents worth of profits from each dollar invested by shareholders. (For more on evaluating this metric, see Keep Your Eyes On The ROE.)

 

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). (For more on this topic, see Understanding The Subtleties Of ROA Vs ROE.)

 

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

 

Turning again to Procter & Gamble's 2004 Consolidated Statement of Earnings and Balance Sheets, you'll see that the company delivered an impressive 11.4% ROA (net earnings / total assets = $6.5B / $57.05B). An ROA higher than 5% is normally considered a solid performance for most companies. Procter & Gamble's ROA should have reassured investors that it was doing a good job of reinvesting its free cash flow.

 

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.

 

by Ben McClure, (Contact Author | Biography)

 

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.

 

 

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