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 McDonald's as an example. Over the last four quarters, the restaurateur generated \$6.0 billion in operating cash flow. It invested about \$1.9 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment (\$1.9 billion) from its operating cash flow (\$6.0 billion). That leaves us with \$4.1 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of \$23.8 billion over the same period, we can figure that the company has a cash king margin of about 17% -- a nice high number. In other words, for every dollar of sales, McDonald's produces \$0.17 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 restaurants:

Company

Cash King Margin (TTM)

1 Year Ago

3 Years Ago

5 Years Ago

Buffalo Wild Wings (Nasdaq: BWLD)

2.7%

1%

0.7%

1.3%

Panera Bread (Nasdaq: PNRA)

10.1%

11.8%

2.8%

4.5%

BJ's Restaurants (Nasdaq: BJRI)

1.3%

1.9%

(11.8%)

(7.0%)

Panera Bread is the only company of the three that meets our 10% threshold for attractiveness, and its cash king margins have climbed substantially from a few years ago. Buffalo Wild Wings has lower cash king margins, while BJ's Restaurants offers the lowest margins of the three, but it has also improved its margins markedly from three years ago. For swiftly growing chains such as these three, the cash king margin understates a company's profitability. So it's probably better to use net income as a measure of profitability rather than free cash, since each company plows a huge amount of its operating cash flow back into growth.

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.

Want to read more about Buffalo Wild Wings? Add it to My Watchlist, which will find all of our Foolish analysis on this stock. You can also add Panera Bread and BJ's Restaurants or any other stock you like.

Jim Royal, Ph.D., owns shares in McDonald's but not in any other company mentioned here. Panera Bread is a Motley Fool Stock Advisor recommendation. Buffalo Wild Wings is a Motley Fool Hidden Gems selection. McDonald's is a Motley Fool Income Investor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.