When it comes to investing, obviously making money is key and the best way to make money is to find the most profitable company set to generate huge amounts of cash in the future. More cash usually leads to a higher stock price and a fatter bank balance means there is potential for dividend checks, windfall payouts, or other shareholder returns.
It is difficult trying to find these elusive companies, but through a combination of historic ratios and analyst predictions, I believe that I may have found several that are set to power forward with plenty of cash for the future.
As a starting point, I began searching for companies that had a good profit margin, in particular, an earnings-before-interest-and-tax margin of around 20%, which indicates a good flow of cash in to the company’s coffers. Secondly, using historic figures, I started looking for companies that had achieved a five-year average return-on-shareholder-equity greater than 15%, to highlight the companies that had consistently delivered a good return on shareholder capital.
Lastly, I searched through analyst predictions and reports to whittle down the remaining candidates looking for companies that were predicted to improve their gearing ratio by at least 50% over the next three years. For example, a company’s net debt to shareholder equity ratio should fall by 50% over the next three years, indicating improving free cash flow, fiscal prudence, and balance sheet strength.
Note: for the purpose of this piece, gearing is total debt divided by shareholder equity.
First up is luxury jewelry producer Tiffany & Co. (NYSE:TIF). Tiffany & Co. (NYSE:TIF) has achieved a 15.9% return on shareholder equity on average during the past five years — a consistent, high level of return. In addition, the company’s earnings-before-interest-and-tax margin during 2012 was 18.7%, indicating a strong level of cash generation.
|Company||EBIT margin, FY 2012||ROE 5-YR average|
From a gearing perspective, Tiffany & Co. (NYSE:TIF)’s wide profit margin and strong return on equity mean that the company’s level of gearing is projected to fall rapidly over the next few years. According to estimates, the company is expected to reduce its gearing by around 30% every year for the next five years, which should lead to a higher share price and more returns over the next few years.
Next up, biotechnology
Next is biotech company Merck & Co., Inc. (NYSE:MRK). Merck & Co., Inc. (NYSE:MRK) has recently fallen out of favor with investors after a poor first quarter but the company is still generating a lot of cash and producing a good return on shareholder equity. Over the past five years, Merck has produced an average return-on-equity of 16.6%, partly down to the company’s wide EBIT margin, which came in at 22.2% of revenue during 2012.
|Company||EBIT margin, 2012||ROE 5-YR average|
With such a wide EBIT margin, Merck & Co., Inc. (NYSE:MRK) has a strong cash flow and analysts predict that the company’s gearing level will turn negative (move into a net cash balance) this year. Indeed, the company’s wide profit margin means that even after losing the exclusive manufacturing rights to some of its key drugs, it is still set to churn out cash for the next few years, which will open the door to additional stock repurchase programs like the $5 billion buyback that the company has recently announced.