About four years ago, I have written a piece titled “Do you have a No-Brainer Investment?“ as published in i3investor in the link below,
The article above describes the allure of investing in cash generating machines with a portfolio of 10 stocks of mine set up in January 2013. The average return of the portfolio was 113% for a two years and four months period as in May 2015, compared to 16.4% of the broad market during the same period. The excess return was a whopping 97%.
In this article, I expand it to describe on how to scout for these cash generating stocks for investment to build long-term wealth.
What are Cash Cows?
Cash cows are companies that continuously producing plenty of cash (not accounting earnings), after meeting its necessary yearly expenses such as purchasing materials, selling and administration expenses, interest and taxes etc., and including capital expenses in research and development (R&D), purchase of property, plants and equipment (PPE) for further growth of the core business. Companies can utilize this free cash flows (FCF) to do a few things to further increasing shareholder value, such as acquiring profitable companies for growth, pay increasing dividends, buyback own shares when selling cheap, pay down debts, or simply keep the cash in its balance sheet as a safety net during economic downturn.
Free Cash Flow = Cash Flow from Operations - Capital Expenditure
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. Think of companies such as Nestle, Calsberg, Heiniken, BAT, Dutch Lady, Ajinomoto, Panasonic etc. These companies generally have less room for growth, and hence generate more FCF since the initial capital outlay required to establish their businesses has already been made. The younger companies tend to reinvest their cash more aggressively to fuel future growth.
When scouting for cash cows to invest in, the more FCF the company produces the better. A good rule of thumb is to first look for companies with FCF that is more than 5% of its revenue.
It must be noted that cash flows and FCF of a company is lumpy as working capital and capital expenses vary greatly each year. An average annual FCF of a few years should be used.
Consumer products Carlsberg, for example, fits the cash cow mold. Carlsberg’s brand name power and its dominant market share have given it its cash-generating power. The company consistently generated high FCF which even exceeded its reported net income every year. At end-of-year 2008, Carlsberg's free cash flow was RM325 million, or more than 16% of its RM2 billion revenue, and 13% above its net income of RM287 million.
A stock I picked for 2019 as published in i3investor, Magni-Tech Industries has consistent positive FCF every year. Its average FCF of RM47.44 million is 5.3% of its revenue over the last 5 years. Its FCF of RM89.2m for the financial year 2018 is 8.3% of its revenue of RM1.08 billion. Furthermore, its revenue and FCF has been growing at double digits for the last 5 years. Hence Magni-Tech can also be considered as a cash cow in the above definition, and with good growth in the past of more than 10 years. We will use Magni-Tech to illustrate some other traits a cash cow possesses.
Cows That Stand Apart from the Herd: Efficiency and Price
High Efficiency Ratios
A cash cow has an attractive return on equity (ROE). An attractive ROE can help you ensure that the company is reinvesting its cash at a high rate of return, and producing more FCF in the future.
ROE = Net Income / Shareholders' Equity > 12%
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 = Net Income / Total Assets > 7%
A better measure of efficiency may be using the return from the actual capital invested in the core business, rather than the equity, as not all equity is invested in the core business.
Return on invested capital ROIC before tax = Operating Profit, or EBIT / Invested capital > 15%
Invested capital (IC) = Property, plant and equipment (PPE) + net working capital
Yet may be another better measure is to use cash return itself, rather than accounting profit,
Cash return on invested capital (CROIC) = FCF / IC > 10%
All the above benchmark numbers given are arbitrary, but intuitive in the sense that whatever return should be substantially higher the costs of capitals in order to increase shareholder value.
Using Magni as example, taking its fiscal financial results ending 30th April 2018, the ratios as described above are tabulated as below,
ROE = 91366 / 462662 = 20.9% > 12%
ROA = 91366 / 527025 = 17.3% > 7%
ROIC (before tax) = 111521 / 261561 = 32.8% > 15%
CROIC (2018 FCF) = 89208 / 261561 = 34.1% > 10%
CROIC (av 5 years FCF) = 47444 / 261561 = 18.1% > 10%
The above computations show that the return on capitals and cash return on capitals of Magni are superb in the past 5 years, and the company is efficient in utilization the capitals and the FCF it invested in the business and will likely to do the same in the future.
A Low Cash Flow Multiple
Once a cash cow stock is spotted, shall we immediately buy it?
“Investment success does not come from buying good stuff, but from buying well”
First look for companies with a low FCF multiple,
FCF Multiple = Price, or market cap (MC) / FCF
For Magni’s share price on 12th April 2019, together with its latest annual results for 2018,
Market cap = Price * no. of shares = 4.55 * 162732 = 740431
FCF Multiple = 740431 / 89209 = 8.3 < 20
This shows investors pay RM8.30 for RM1 of FCF, which is inexpensive.
Using 5-year average FCF
FCF Multiple = 740431 / 47444 = 15.6 < 20
Inverting the FCF Multiple, we get FCF / MC, or cash yield, CY
CY for Magni in 2018 = FCF / MC = 89209 / 740431 = 12%.
A CY of 12%, paying RM1 and getting a cash return of 12% is much higher than the bank fixed deposit rate, currently of about 4%.
The above valuations in cash form for Magni is inexpensive, or even considered as cheap.
FCF multiples or cash yield are a good starting point for finding reasonably priced cash cows. But be careful: sometimes a company will have a temporarily low FCF multiple because its share price has plummeted due to a serious problem. Or its cash flow may be erratic and unpredictable due to cyclic business nature. So, take care with very small companies and those with wild performance swings.
Cash cows generate heaps of cash. That's certainly exciting, but not enough for investors. If they provide other attractions, such as high ROA, ROE, ROIC and CROIC, and if they trade at a reasonable price, then cash cows are worth investing in, especially for those who are risk averse and require regular incomes from their investments.
Investing in cash cows is just one of the many sound investing strategies. However, whatever strategy one wishes to use, he must have the basic knowledge of how to look at business and its valuation. If you wish to know more about it, you may contact me at