Cash Cows

Companies that can be "milked" for profit on a continuous basis without much expense on the investors part are called cash cows.  These are fairly large organizations that have strong cash flow and money available to reinvest in their company or support themselves in the event that the economy takes a nose dive.  Shareholders benefit from cash cow companies because they can decide to increase shareholder dividends, or reinvest the money into the company which will boost the returns on the shares even more. 

How to Spot a Cash Cow

Small investors love cash cows!  They will almost always end up with a higher dividend payment from the company they own shares in, or have their returns boosted anyway when the cash cow decides to reinves their additional cash flow to expand the business.

So how can you pick out a cash cow?  They are usually businesses that have been operating for several years, and are dominating within their industry.  They have a strong market share, and the industry itself is difficult for new businesses to start and succeed within.  Most cash cow businesses are slow to grow, but have high profit margins and recurring revenue.

An example of a cash cow company is Procter and Gamble.  Shareholders of Procter and Gamble had great dividends in 2004!

To determine whether or not a company you are considering investing in can be considered a "cash cow", you'll want to use a simple ratio in order to calculate how much free cash flow they have.  Free cash flow is the amount of money a company ha available after paying all of their ongoing expenses as well as money required to expand the assets of the company.  Having free cash flow enables a company to find opportunities to increase the value of shareholders shares.

Free Cash Flow = Cash Flow from Operations - Capital Expenditure

In addition to calculating the free cash flow, you might want to take a moment to calculate various other ratio's for deciding whether or not to invest in a particular company.  The higher the "free cash flow" number in this calculation, the better.  It's common for investors to look for free cash flow that is greater than 10% of the company sales revenue.

Should You Buy the Cash Cow Stock?

If you think you've spotted the cash cow in the "pasture" of stocks, you still need to make some considerations before deciding whether to invest in the stock or not.  You should consider how much investors are willing to pay for $1 of free cash flow- and this can be done by dividing the current stock price by the free cash flow. 

It's true that cash cows generate a lot of cash for the business.  As a smart investor however, you want to check that they have a high return on equity and return on assets, as well as whether they are trading at reasonable prices.  If all of these factors apply, you might want to invest in your cash cow!