“Cash is king” has been one of the most frequently taught lessons throughout the history of our stock market, and it cannot be stressed enough in these times. Indeed, cash flow is the lifeblood of a business and ultimately determines the valuation. How, then, do we gauge the quality of a company from the perspective of cash generation? Here are some of the metrics that we at Urbem find useful to concentrate on.
Free cash conversion rate
This ratio measures how much free cash flow a business can generate out of one dollar of earnings and indicates the quality of the company’s accounting profit. We generally look for a consistently high figure here year in and year out. It would be very rare for a business to deliver a free cash conversion rate above 100% every year over an extended period of time (e.g., a decade). However, it is certainly possible. Some common scenarios include:
1) The company manages to receive cash payment early from its customers
2) The company manages to pay its suppliers late
3) The company can cover some of its staff costs with non-cash instruments (e.g., stock options).
Scenarios 1 and 2 are strong indicators of a solid business model with strong bargaining power. One example of this is the membership model at Rightmove (LSE:RMV, Financial).
CapEx margin
Investors should also be interested in how much capital expenditure is usually required to sustain the operations and expansion at the company. We calculate the CapEx margin as the typical amount of capital expenditure needed to be put back into the business as the percentage of the sales. This way, the metric can be compared with the free cash flow margin.
We look for the CapEx margin to be significantly lower than the free cash flow margin, signaling that the business delivers more cash for its owners than for itself. Take a look at capital-intensive Delta Air Lines (DAL, Financial), for example, which generates a 10.5% CapEx margin and a 7.4% free cash flow margin, as compared to asset-light Domino’s Pizza (DPZ, Financial), which has a 2.4% CapEx margin and an 11.4% free cash flow margin. We thus believe shareholders should be happier with the situation at Domino's, as it keeps less than three cents to itself but allocates more than 11 cents to its shareholders.
Cash conversion cycle
This metric expresses the number of days that it takes for a business to convert its investments in inventory and other resources into cash flows from sales. The lower the figure, the more efficient the company is concerning cash generation.
Aconsistently negative cash conversion cycle is rare but possible. For instance, it can occur if the business manages to pay its suppliers later than when it gets paid from its customers. Two prominent examples of this model are Apple (AAPL, Financial) and Amazon (AMZN, Financial).
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Rightmove and Domino’s Pizza.
Read more here:
- The Compounding Superheroes
- Urbem’s ‘Quality Strategy’ Series: Incremental Return on Equity
- 3 Compounders to Empower the Digital World
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