Cash Cow Stocks: Great for Long-Term Investing

A cash cow is generally defined as a company that turns 5-10% of its sales into cash. Good businesses that can turn sales into true free cash flow usually have a competitive advantage that strengthens their future. Warren Buffett is a fan of cash cows. He and Charlie Munger always say they want earnings that turn into cash, not more factories or inventory. They want cash cows, as most value investors do.

What Makes a Cash Cow Special?

1. Less risk – In general, companies that do not have to spend heavily for growth make for safer long-term plays. Much of the risk in a business comes from timing and competition. In competitive markets where few companies are cash cows – think automotive manufacturing – the timing and opening of new factories creates a significant business risk. Companies that do not have to make large capital expenditures naturally have lower risk.
2. Faster capital turns – Businesses should be viewed as small compounding machines. Businesses that can turn sales into free cash flow can reinvest more readily into more product. Think about Walmart in its early days; the company could purchase merchandise, make a small 4-5% profit on the sale, and then reinvest the capital the next week for new merchandise. Fast capital turns allowed Walmart to grow faster than the competition.
3. Future dividend growth – Dividends have to be paid with cash – Deere & Company (DE) shareholders probably do not want a tractor as a dividend payment. By definition, cash cows generate excess cash not necessary to run the business, meaning more cash can be returned to shareholders without negatively affecting the business’s future.

Metrics and Attributes to Watch

A cash cow can be spotted with two financial ratios:

1. CROIC – Look for companies with a high cash return on invested capital. A higher return on invested capital means the company can generate more cash with less cash investment going forward.
2. Free cash flow yield – The free cash flow yield is the amount of free cash flow a company generates divided by the total value of the company. A company that generates $250 million in free cash flow with a market value of $2.5 billion has a free cash flow yield of 10%.

Also focus on the type of business and how it makes money. Here are some common attributes of a cash cow stock:

• Intangible product lines – Equifax (EFX) is a great example. The company has a database on consumer spending and credit history which it monetizes by selling the information to individuals and businesses. Equifax reports are not capital-intensive; you don’t need a factory to pump out credit reports. In the past 12 months, Equifax turned 18% of its sales into free cash flow.

• Repeated sales – Companies that have repeated sales to their customers turn more of their sales into cash. Starbucks (SBUX) and Philip Morris International (PM) are companies with repeated sales patterns that bring a steady flow of cash to the business. The same is true of Coca-Cola (KO). Businesses that become a habitual part of a customer’s day bring more cash flow with more regularity. Companies like Boeing (BA) have much more cyclical and infrequent sales patterns, which leads to uneven cash flows over time.

• Franchised capital expenditures – McDonalds (MCD) essentially “outsources” its capital expenditures. While it does own some stores, its franchisees pay for much of the company’s growth. Its real product is intangible – the brand, systems, and support that make McDonald’s a powerhouse in fast food. Companies that can outsource the capital intensive parts of their business make for incredible cash cows. In the last 12 months, McDonald’s turned 16% of its revenues into pure cash flows.

Hunting Down Cash Cows

It doesn’t take very long to get a “feel” for what makes a company a cash cow. Soon enough, you’ll be able to recognize from the brief description of the company on sites like Yahoo Finance or MorningStar whether or not a company fits the mold of a cash cow stock.

Are you a cash cow investor? Are there any stocks in your portfolio that fit the definition for a cash cow?