Cash Cow Companies (and How to Find Them)

A cash cow company is one that has enough annual income to more than over its expenditures. A cash cow is usually a mature company with a large market share. The company has already put in the capital and hard work to become successful, and it mostly focuses on fine-tuning that success each year rather than making large changes. For an investor, a cash cow stock can provide very healthy, consistent dividends without high risk of loss. Even though the capital appreciation of the stock may be low, this promise of income while the stock is held is promising. There are a number of calculations that can help you spot a cash cow.

Free Cash Flow

The first important factor to consider is the company's free cash flow. This is the major factor that will indicate whether it is indeed worthy of the "cash cow" name. To calculate free cash flow, subtract capital expenses from cash flow due to operations. It is important to only consider operational cash flow and not cash flow from investments and assets. Operational cash flow is the true measure of the earning power of the company and its brand.

Cash Flow Multiple

Once you know a company's cash flow, you should compare it to the price of a share in the company. The goal with this calculation is to determine how much bang you can get for your buck. Divide the price of a share of the company's stock by its cash flow. All things being equal, the company with the lower multiple will be a better buy. For example, if a company can provide $200 million in annual cash flow for only $5 a share, it is more valuable than a company that can provide $200 million in cash flow for $10 per share. 

Efficiency Ratios

Finally, it is wise to measure how well a company uses its annual cash flow to generate equity, assets and healthy returns. A company which does not accomplish this ends up simply paying cash to investors without improving the financial standing of the company itself. There are a number of measures of efficiency, but the two basic measures are Return on Equity (ROE) and Return on Assets (ROA).

ROE can be calculated by dividing a company's net income by the average shareholders' equity. This tells you how effectively investments into the company are being turned into profit; ideally, this profit is then returned back to shareholders in part. Another part of the profit should be used to build assets. To calculate ROA, simply divide the annual net income by the total assets of the organization. The resulting ratio indicates how well a company puts its holdings to work. For example, a company that has five factories should use those factories as collateral to build a sixth if the market is ripe. By failing to use assets to build more assets and more profit, a company will halt its growth. Even a strong cash cow with a large market share can end up losing money quickly if it does not grow.

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