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Thursday, September 10, 2015

Spotting Cash Cows

Before you can spot cash cows, you must understand the true nature of the beast. The good news(?) is that cash cows will never get banned from slaughter. That means, bears can pounce on them at any time. They may get badly hurt, but hardly ever get killed.

A cash cow is a company that generates a lot of free cash flow. That means the cash it generates from its operations comfortably exceeds all its expenses. The actual formula for calculating free cash flow is:

Cash flow from operations – Capital expenditure = Free cash flow

The two items on the left side of the equation can be found from the Cash Flow Statement in Annual Reports. (If you haven’t yet learned how to read the Cash Flow Statement, click on the links at the bottom of this post.)

The lower the capital expenditure, the greater will be the free cash flow. Isn’t capital expenditure necessary for growth? Definitely yes for early-stage companies, which need to chase growth for survival and establish market leadership.

For more mature, stable companies that are sector leaders, high growth may no longer be feasible. They can rely on their existing assets to keep generating profits. Typically, FMCG companies fall in this category.

Aren’t FMCG companies boring and highly priced? Yes to both. But there is a reason for their high price. Due to their large free cash flows, they are usually low-debt or debt-free companies and are able to withstand economic (and market) downturns much better.

Why? Because you will still need to brush your teeth and wash your clothes regardless of the state of the economy and the market.

Read more about how to spot cash cows in this recent article in investopedia.com – and learn whether all cash cows are investment-worthy.

Related Posts

How to read the Cash Flow Statement – Part 1
How to read the Cash Flow Statement – Part 2
A Simple Exercise on Cash Flows
A Solution to the Exercise on Cash Flows

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