Free Cash Flow, Profit Margins, and Turnover

Free cash flow

Strong free cash flow is a hallmark of firms with economic moats, provided that the cash flow comes from ongoing operations and not one-time events. Remember, free cash flow represents the funds left over after a firm has already reinvested in its business to keep it running. It is usually defined as operating cash flow minus capital expenditures (both measures are found on the cash flow statement). If a firm's free cash flow as a percentage of sales is greater than 5%, you've probably found a cash machine and a good basis to dig deeper to see if the company has an economic moat.

Profit margins

There are three main types of profit margins we can measure: gross margin, operating margin, and net margin. These three look at gross profit, operating profit, and net income as a percentage of sales. In a nutshell, margins tell you how much of each type of profit a company is generating per dollar of sales.

Who has the higher profit margins?

It should make sense that companies with economic moats generally have larger profit margins than their competitors. Wal-Mart (WMT) may sell an apple at the same price as a local grocery store. But if Wal-Mart's costs are lower, its profit margins on the sale of the apple will be higher. Likewise, it may cost the same for Harley-Davidson (HOG) and one of its competitors to build a motorcycle, but Harley should be able to sell its bike at a higher price because of its brand. Harley will have the higher profit margin.

A net margin consistently in excess of 15% is a good benchmark that often indicates a company has sustainable competitive advantages. Do keep in mind, however, that margins by themselves are of limited use; you also have to consider the context of turnover and return, which we will discuss shortly.

Turnover

Turnover measures how efficiently a company is using its assets to generate sales. Several types of turnover can be used to measure efficiency, but perhaps the most relevant for our discussion here is total asset turnover, or sales divided by total assets. All else equal, a company with higher turnover than its competitors is more efficient and may have some sort of advantage.

Limitations of turnover

As with profit margins, turnover is of limited use when considered in a vacuum. Rather, it is usually best to compare the turnovers of companies in the same industry. Likewise, turnover should usually be used in the context of profit margin and return.

Margin vs. turnover

Let's use some examples to look at the two ways—margin and turnover—that a company can create high returns for itself.

Thanks to the several types of economic moats it possesses, ABC Software is incredibly profitable, with gross profit margins around 80% and net profit margins around 23%. This means for every dollar of sales it generates, its cost of goods sold is only $0.20. Meanwhile, even after all overhead expenses and taxes, it still generates $0.23 in bottom-line profit per dollar of sales.

But ABC Software does not turn over its assets very effectively, having a total asset turnover of only 0.6. Part of this is because a large chunk of its assets are represented by a giant cash hoard that is not generating anything but mere interest income. As such, its ROA is "only" 14%.

Wide-moat retailer XYZMart is at the opposite end of the spectrum. Its net profit margin is only 3.5%, about one-seventh that of ABC Software. However, it turns its assets over 2.4 times. As a result, its ROA is a little over 8% (3.5% times 2.4).

Of course, companies that can create both high profit margins and turnover can generate exceptionally strong returns. Lifestyle ABC Corp. has 17% net profit margins and asset turnover of 1.64, for an ROA of more than 25%—a testament to the firm's wide economic moat.