As an investor, it pays to follow the cash. If you figure out how a company moves its money, you might eventually find some of that cash flowing into your pockets.

In this series, we'll highlight three big dogs in an industry, and compare their "cash king margins" over time, trying to determine which has the greatest likelihood of putting cash back in your pocket. After all, a company can pay dividends and buy back stock only after it's actually received cash -- not just when it books those accounting figments known as "profits."

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow actually backs up its reported profit. Companies that can create 10% or more free cash flow from their revenue can be powerful compounding machines for your portfolio.

To find the cash king margin, divide the free cash flow from the cash flow statement by sales:

Cash king margin = Free cash flow / sales

Let's take Nike as an example. Over the last four quarters, the footwear giant generated $3.2 billion in operating cash flow. It invested about $335 million in property, plant, and equipment. To calculate free cash flow, subtract Nike's investment ($335 million) from its operating cash flow ($3.2 billion). That leaves us with $2.8 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking Nike's sales of $19 billion over the same period, we can figure that the company has a cash king margin of about 15% -- a nice high number. In other words, for every dollar of sales, Nike produces $0.15 in free cash.

Ideally, we'd like to see the cash king margin top 10%. The best blue chips can notch numbers greater than 20%, making them true cash dynamos. But some businesses, including many types of retailing, just can't sustain such margins.

We're also looking for companies that can consistently increase their margins over time, which indicates that their competitive position is improving. Erratic swings in margins could signal a deteriorating business, or perhaps some financial skullduggery; you'll have to dig deeper to discover the reason.

Three companies
Today, let's look at three companies in the video games industry:

Company

Cash King Margin (TTM)

1 Year Ago

3 Years Ago

5 Years Ago

Activision Blizzard (Nasdaq: ATVI)

24.1%

7.9%

26.9%*

21.1%**

Electronic Arts (Nasdaq: ERTS)

0.6%

(2.9%)

3%

17.5%

Take-Two Interactive Software (Nasdaq: TTWO)

(8%)

5.5%

(3.9%)

(0.7%)

Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months. * Data for year 2007; ** Data for year 2005; both for Vivendi Games prior to merger with Activision.

Activision has more than tripled its cash king margins over the past year, which are now at a whopping 24.1% -- well above our 10% threshold for attractiveness. Electronic Arts, on the other hand, has dropped its cash king margins by almost 17 percentage points in the past five years. Take-Two Interactive's margins have been in the negative over most of the past five years and, with the exception of last year, have steadily declined. Contrast these figures with the sustained fat margins in the big software giants.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

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Jim Royal, Ph.D., owns shares in Activision. Take-Two Interactive Software is a Motley Fool Rule Breakers selection. Activision Blizzard, Nike, and Electronic Arts are Stock Advisor picks. Motley Fool Options has recommended a synthetic long position on Activision Blizzard and the Fool owns shares of Activision Blizzard. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.