What is a Cash Cow?
A cash cow is a business unit, product line, or investment that has a return on assets (ROA) greater than the market growth rate. The idiom refers to the idea that it produces 'milk' (profit) long after the cost of the investment has been recouped.
How Does a Cash Cow Work?
For example, let's assume that Company XYZ has five divisions, one of which makes widgets. The widget division manufactures and sells 85% of the widgets in the United States and has an ROA of 30%. The widget business, which is very mature, grows about 5% per year. In this scenario, Company XYZ's widget division is a cash cow. The low growth of the market means little investment is needed, and the high ROA indicates that profits in the division should be high -- higher than what is needed to maintain market share (this, incidentally, is why the excess cash generated by a cash cow doesn't need to be, nor should it be, reinvested in the cash cow).
Cash cows usually have large market shares in mature industries. The higher market share often implies or translates into the ability to produce at a lower cost, and for them, there is usually little reason to spend money on capturing more market share. It is possible, however, for a cash cow to dry up if competitors capture enough additional market share.
Why Does a Cash Cow Matter?
Cash cows generate steady, reliable cash flows that often fund their own growth and the growth of a company's other business units. They can also generate the cash companies need to pay dividends or finance other endeavors. Importantly, they are often the reason lenders are willing to lend money to a company -- that is, the cash cow is the source of the lender's assurance that the company can service the debt. Thus, cash cows enable companies to leverage themselves in pursuit of other high-return opportunities.