Seven Cash Cows That Point the Way to Profit

Email

In uncertain financial times, it's always good to have some actual cash in your pocket – and the next best thing is to have some "cash cows" in your portfolio.

We're not talking commodities here. Rather, we mean cash-rich companies with plenty of "moo-lah" to reinvest in their own growth, or in share buybacks or increased dividends for stockholders.

The expression "cash cow" means just what it sounds like: Something that, once acquired and paid off, can produce consistent cash flow over its lifespan.

As an example, imagine a company with a pool of more than $1 billion in cash on hand. If it does nothing more than invest that $1 billion in an interest-bearing account paying 4.5% a year, it can generate enough interest income to pay 1,000 workers $45,000 per year – year after year after year – without depleting its original cash balance.

That's the perfect definition of a true cash cow.

Six months after the September 2008 market meltdown, Morgan Stanley (NYSE: MS) reported more than $150 billion invested in cash or cash-equivalents, such as three-month Treasury bills – even though they were then yielding a puny 0.09%. That was almost a quarter of its balance sheet, and twice as much cash as it had just a year earlier.

Other corporate giants like American Express Co. (NYSE: AXP), The Coca-Cola Co. (NYSE: KO), Goldman Sachs Group, Inc. (NYSE: GS), 3M Co. (NYSE: MMM) and Merck & Co. (NYSE: MRK) also reported sharp increases in their holdings of cash and easy-to-sell securities in the first quarter of 2009 – liquidity that helped continue growth and maintain profits while many others struggled.

"Although this creates a noticeable drag to our earnings," Morgan Stanley finance chief Colm Kelleher noted at the time, "we believe that maintaining a strong liquidity position is currently the most prudent approach."

Cash-cow companies can reinvest in new systems and plants, pay for acquisitions and support themselves when the economy slows. They have the capacity to pay down existing debt, increase their stock dividends or reinvest the cash to further boost returns – all without sacrificing profitability. And smaller cash cows also can prove to be tempting takeover targets.

However a cash-rich company opts to use its surplus, shareholders stand to benefit. So, obviously, the question for investors becomes, "How can I grab a piece of the action?"

Where to Look for Cash Cows

Finding a company that generates gobs of green sounds exciting on the surface, but that alone isn't enough to make for a solid investment. However, if the stock provides other solid incentives – such as a high return on equity (ROE) and a strong return on assets (ROA), while still trading at a good price – then it's definitely worth investigating.

So, where should you look for cash cows?

Simply put, you're most likely to find them among:

  • Big, well-established companies – those with market caps of at least $250 million.
  • Companies that dominate their industries.
  • Companies that have plenty of free cash flow (FCF) – generally defined as cash left over from operations, minus capital expenditures.
  • And companies that have reasonably priced stocks.

The reasons behind these broad guidelines are simple. First, more mature companies, while they have less room for growth, often generate more free cash flow than newer ones because the initial capital outlays required to establish and grow their businesses have already been made.

Second, money managers increasingly prefer using free cash flow over earnings as an indicator of a company's true health because the calculation is less susceptible to the many discretionary accounting adjustments that can inflate net income.

Third, a high market share and brand-name dominance impede growth by competitors, translating into recurring revenues, high profit margins, and healthy and ongoing cash flow.

Drug companies that have spent decades developing proprietary products with long patent life are a good example. Take Amgen, Inc. (Nasdaq: AMGN), a pioneer in biotechnology manufacturing, which won a 2007 patent-infringement lawsuit that preserved its $7 billion anemia drug franchise. From 2005 to 2009, Amgen's earning per share (EPS) increased from $3.20 to $4.91. First-quarter 2010 financials posted April 21 showed earnings of $1.24 per share on revenues of $3.65 billion. 

Most interesting, Amgen in 2009 increased its cash and short-term investments to $13.442 billion, roughly $13.83 per share, or one-third of the company's total assets. That's up from one quarter in 2008 and one-fifth in 2007. Free cash flow at the end of 2009 rose to $5.763 billion, or $5.93 per share.

What to Look for in a Cash Cow

There are any number of ways to assess a particular stock's potential as a cash cow, but using some of the following criteria can help you narrow the field:

  • Listing on the New York Stock Exchange (NYSE) or Nasdaq.
  • A minimum market valuation of $250 million, although some analysts prefer a $500 million threshold. The $250 million minimum ensures stocks have enough liquidity to make them reasonable investments, while steering you to some quality issues that aren't already household names.
  • A low stock price-to-free-cash flow ratio. Two years ago, after the market collapse, there were plenty of companies around with a ratio of 2:1 or less. Now, you may have to consider a ratio of 10:1 to qualify some of the candidates that meet all the other criteria. 
  • Money in the bank – a balance sheet listing equal to 5% of the company's assets is preferred.
  • Free cash flow greater than 10% of sales revenue – the more free cash a company produces the better!
  • Growing free cash flow of at least 5% of sales over the trailing 12-month period, and in each of the prior three years. This ensures that money from sales is the financial equivalent of a roaring river, rather than a trickling stream.
  • High free-cash-flow yield. This is an indicator of free-cash-flow return relative to share price, calculated by dividing the trailing 12-month period free cash flow per share by the most recent share price. The bigger the ratio, the better, since you want the most cash flow at the lowest possible price. [Note: Some analysts prefer calculating free-cash-flow yield by dividing the company's total free cash flow by its enterprise value (EV) rather than market capitalization, since this accounts for numerous other factors, including debt, preferred shares, etc.]
  • High free cash flow per share. This is cash from operations for the latest reported year, minus the same year's capital expenditures and dividend payments, divided by shares outstanding.
  • A balance sheet showing at least $500 million in cash and equivalents.
  • Returns on equity of 12.5% or more, which will put the corporation in the top third of companies. This is an indicator that all the cash is being reinvested at a high return, and helps prevent sectors with low rates of return on equity across the board from putting lots of marginal companies on your list. Look for a trailing 12-month return on equity that is above average for the company's industry.
  • A current dividend providing a yield of 2.0% or more is nice, but not required. 
  • A healthy cash return – defined as free cash flow plus net interest expense, divided by enterprise value. Evaluating cash return can be a great first step in finding cash cows with reasonable prices, but it may not work that well for financials or foreign stocks. Cash flow is not terribly meaningful for firms that earn money via their balance sheets, and definitions of cash flow can vary widely in other countries. Thus, a foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally.

Most of the above numbers and valuations – or the figures needed to calculate them – can be found on the company balance sheets or the statistical sections of the "stock quotes" summaries on key financial websites such as MSN Money, Yahoo Finance or Forbes.com.

Seven Cash Cows to Start Your Search

Here are seven stocks you can look at as you begin your search for cash cows. Thanks to price increases generated by the market's persistent rally in recent months, not all of them fulfill each of the criteria listed above (most notably exceeding the suggested price-to-free-cash-flow ratio), but all are close – and well worth watching.

Protective Life Corp. (NYSE: PL), recent price $24.15 – This regional life insurance and investment company had estimated year-end 2009 free cash flow of $1.144 billion, or $13.34 a share, providing a free-cash-flow yield of 55.2% and a price-to-free-cash-flow ratio of 1.81. Earnings per share were $3.34, the company had $49 worth of cash on hand per share, a dividend yield of 2.0% and a debt-to-equity ratio of 0.59.

Bank of America Corp. (NYSE: BAC), recent price $18.61 – Despite some much-publicized concerns and a sharp dividend cut in 2009, this banking giant continues to demonstrate cash-cow characteristics. At year-end 2009, BAC had an estimated free cash flow of $156.37 billion, or $15.59 per share, providing a free-cash-flow yield of 83.8%, with $52 per share in cash on hand. On the negative side, the company posted a 2009 loss of 26 cents a share, cut its dividend to just 4 cents for a yield of 0.2% and listed a fairly high debt-to-equity ratio of 2.62.

Constellation Energy Group, Inc. (NYSE: CEG), recent price $37.09 – This Baltimore-based supplier of energy products and services covers the United States, with a focus on the East Coast. At the end of 2009, it had an estimated free cash flow of $6.135 billion, or $30.37 a share, providing a free-cash-flow yield of 81.9% and a price-to-free-cash-flow ratio of 1.20. Earnings per share were $22.07, the company had just over $17 worth of cash on hand per share, a dividend yield of 2.6% and a debt-to-equity ratio of 0.55.

Barnes & Noble, Inc. (NYSE: BKS), recent price $22.33 – Though much of the publishing industry is beset by woes brought on by electronic media, this international bookseller continues to generate substantial cash. At year-end 2009, it had an estimated free cash flow of $414.7 million, or $7.15 a share, providing a free-cash-flow yield of 32% and a price-to-free-cash-flow ratio of 3.10. Earnings per share were $1.11, a dividend yield of 4.5% and a minuscule debt-to-equity ratio of 0.11. The only negative was that cash on hand was just 70 cents per share.

Whirlpool Corp. (NYSE: WHR), recent price $96.09 – This major home appliance maker had a free cash flow of $848.25 million, or $11.31 per share, at the end of 2009, providing a free-cash-flow yield of 11.77%. Earnings per share were $4.34, WHR had $18.45 a share in cash on hand, a dividend yield of 1.8% and a debt-to-equity ratio of 0.79.

PHH Corp. (NYSE: PHH), recent price $24.78 – Despite the well-publicized problems in the housing market, this New Jersey-based provider of mortgage and credit services continues to throw off plenty of cash. At year-end 2009, it had an estimated free cash flow of $1.277 billion, or $23.22 a share, providing a free-cash-flow yield of 93.7% and a price-to-free-cash-flow ratio of just 1.10. Earnings per share were $2.75 and it had cash on hand of $2.72 a share. Minuses include the lack of a dividend and a fairly high debt-to-equity ratio of 3.46.

Zions Bancorporation (Nasdaq: ZION), recent price $27.42 – Like Bank of America, this Utah-based regional bank showed an operating loss for 2009, but its cash-flow numbers remained healthy. With an estimated $1.714 billion in free cash flow, or $10.85 a share, ZION had a free-cash-flow yield of 39.6% and a price-to-free-cash-flow ratio of 2.70. The loss per share was $3.59 and it had cash on hand of $8.67 a share. The only negative besides the loss is a tiny dividend yield of 0.1%.
 
News and Related Story Links:

Join the conversation. Click here to jump to comments…

  1. lee hallock | April 30, 2010

    Good info Thanks

  2. jayaraman L. | April 30, 2010

    the calculation for cash-in-hand for $1billion i.e. 4.5% of interest bearing account to pay up for 1000 employee's in a year. But, a company with a pool of $1 billion of cash-in-hand will not only have 1000 employee's it's 1000 times more than it. Instead it should go for the investment or expansion of his firm to make payment to their workers 100 times more than now and can give opportunities to atleast 1000 employees.

  3. donald kovacevich | May 1, 2010

    these cash cows have already grown.i prefer small cap.

Trackbacks

Leave a Reply

Your email address will not be published. Required fields are marked *


nine − 2 =

Some HTML is OK

© 2014 Money Map Press. All Rights Reserved. Protected by copyright of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including the world wide web), of content from this webpage, in whole or in part, is strictly prohibited without the express written permission of Money Morning. 16 W. Madison St. Baltimore, MD, 21201, Email: customerservice@MoneyMorning.com