Is Priceline.com a Cash King?

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 four companies 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."

Today, let's look at priceline.com (BKNG -0.47%) and three of its peers.

The cash king margin
Looking at a company's cash flow statement can help you determine whether its free cash flow 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. A sustained high cash king margin can be a good predictor of long-term stock returns.

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. In the four quarters ending in December, the restaurateur generated $6.97 billion in operating cash flow. It invested about $3.05 billion in property, plant, and equipment. To calculate free cash flow, subtract McDonald's investment from its operating cash flow. That leaves us with $3.92 billion in free cash flow, which the company can save for future expenditures or distribute to shareholders.

Taking McDonald's sales of $25.5 billion over the same period, we can figure that the company has a cash king margin of about 14% -- a nice high number. In other words, for every dollar of sales, McDonald's produces $0.14 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.

Four companies
Here are the cash king margins for four industry peers over a few periods.

Source: Capital IQ, a division of Standard & Poor's.

Priceline blows away our 10% threshold for attractiveness with cash king margins of nearly 33% and has shown strong growth over the last five years. Expedia also far exceeds our threshold with margins of nearly 25%. While Expedia hasn't shown the same growth, it's the only one of the listed companies that offers a modest dividend, with a 0.8% yield. Orbitz's margins are much lower, at 7.7%, and have declined by nearly two percentage points since last year. However, Orbitz's margins have grown by nearly six percentage points from five years ago.

Priceline has shown some impressive growth over the last few years, and its involvement in international markets has helped protect it from the decrease in consumer spending resulting from the recession. In fact, it has even managed to compete effectively with Ctrip.com on its home turf of China in the race for market share among the growing middle class, and managed to negotiate a partnership that allows them both to access a portfolio of 235,000 hotels worldwide through Booking.com.

Priceline has also been aggressive in responding to challenges from its domestic competitors. Soon after Expedia spun off TripAdvisor, Priceline purchased travel search engine Kayak, which gave it access to valuable consumer data and may help prevent Expedia, TripAdvisor, and Orbitz from grabbing too much market share

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. Conversely, the formula works better for slower-growing blue chips. 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.