MILKING THE CASH COWS
Thinking of milking the cash cows? Actually, you can.
A cash cow refers to a company which has the capacity to produce consistent cash flow, the cash left after deducting expenses. The entity can reinvest that cash in new systems and plants, acquire a company or two, and support themselves should the economy slow down. Also, this company can increase their dividend or reinvest the cash flow to bolster returns.
Most investors prefer cash cow companies since they have sufficient resources to finance its own growth and uphold its value without sacrificing profitability or securing additional capital from shareholders. They can also return the free cash flow to shareholders through larger dividend payments or share buybacks.
They tend to be slow-growing, mature firms that rule their industries. Strong market share and competitive barriers to entry are tantamount to recurring revenues, robust cash flow, and high profit margins. More matured ones, having less room for growth, frequently generate more free cash as the initial capital outlay required to establish their businesses has already been made.
A cash cow can often be a lucrative takeover target. In case a company can no longer use its extra cash to amplify shareholders’ value, it can likely gain buyers who can.
How to determine if a company is a cash cow? Compute its free cash flow by subtracting cash from operations from capital expenditures. The more free cash a firm has, the better. Rule of thumb: look for companies which its free cash flow is more than 10% of its sales revenue.
Once you have spotted a cash cow stock, ask yourself if it is worth buying. For beginners, seek firms with low free cash flow multiple. Divide its stock price (or better, market capitalization) by its free cash flow. That way you can determine how much cash power the share price purchases or how much traders pay for a dollar of free cash flow.
Start with free cash flow multiples to get reasonably priced cash flows. However, a firm will have a temporary low free cash flow multiple as its share prices has plunged due to a severe problem or uncontrollable instances, or the cash flow are unsteady and unpredictable.
Aside from low free cash flow multiples, you can also look at other efficiency ratios. One is the return on equity. You may also check their return on assets to make sure the company is not using debt leverage to artificially inflate their ROE.