As an investor, you know that 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, as we try 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 past four quarters, the footwear giant generated $3.2 billion in operating cash flow. It invested about $335 million in property, plants, and equipment. To calculate the 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%, a figure that makes 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, since doing so is an indication 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 discount-travel industry:

Company

Cash King Margin (Trailing 12 Months)

1 Year Ago

3 Years Ago

5 Years Ago

Priceline.com (Nasdaq: PCLN)

23.5%

16.3%

6.6%

5.1%

Expedia (Nasdaq: EXPE)

20.7%

12.7%

30.7%

42.9%

Orbitz Worldwide (NYSE: OWW)

11.0%

1.7%

16.3%

0%*

Source: Capital IQ, a division of Standard & Poor's.
*For fiscal 2005.

Priceline offers cash king margins well above our 10% threshold for attractiveness, and it gives us the kind of steady growth in margins that we like to see. But although Expedia's current margins also look good, they have fluctuated over the past five years and have fallen by more than 22 percentage points from five years ago. Likewise, Orbitz's cash king margins have slipped by more than 5 points from three years ago, but they're well up from more than half a decade ago. In a tough industry, Priceline and Expedia have managed to turn a lot of their sales into free cash, and Priceline in particular looks as if it's doing the right things to thrive.

The cash king margin can help you find highly profitable businesses, but it should be only the start of your search. The ratio does have its limits, especially for rapidly growing small businesses. Many such companies reinvest all of their cash flow into growing the business, and they're left with 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 no shares in any company mentioned. Nike is a Motley Fool Stock Advisor recommendation. Priceline.com is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.