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.

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.

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