Investing Is All About Cash Flows

When you are purchasing stock in a company, you are buying a piece of the business.  You are an owner, as opposed to a creditor that is loaning money to the company.  Whether buying 100 shares or a substantial percentage of a company, you should evaluate the investment as an owner.  Successful companies must generate revenues by selling their goods or services at a higher price than the all-in costs of providing those goods or services.  In the long run, the business must generate both revenues and profits.  It must also turn those revenues and profits back into cash which can be distributed to owners, used to pay creditors, or reinvested in the business.  Not all companies are equally successful at this last step.  They may be generating sales by allowing very lax credit terms, and it may take a long time (if ever) to collect on those sales.  Many companies with rapidly growing revenues have ended up in bankruptcy as a result.  In evaluating a company, you need to look at many factors. Four critical factors are the ability to generate revenues, grow those revenues over time (otherwise you will not keep up with inflation!), generate profits from those revenues, and turn those profits into cash flow.  You cannot pay your bills with net income alone – that requires cold hard cash.

One of the most common ways that analysts and acquirers value companies is to forecast future revenues, expenses, and ultimately cash flow and discount those future cash flows back to the present – called a discounted cash flow (DCF) approach to valuation.  In my early days as an accountant, I often needed to evaluate potential private equity investments and help estimate a value for a family business.  The same approach is helpful in those cases.  Whenever you make an equity investment, you should evaluate the cash you are investing today and compare it to the cash you expect to get out of the investment in the future.  [For more on how analysts value companies see my article with Jerry Pinto and John Stowe – Equity valuation: A Survey of Professional Practice in the Review of Financial Economics 2019.]

After practicing for almost a decade, I completed my doctorate in accounting with a minor in finance nearly 30 years ago.  My decision to pursue the doctorate was to learn more about company evaluation and valuation.  One of my doctoral advisors introduced me to the work of Alfred Rappaport. He had written a book Creating Shareholder Value which presented a very nice model for preparing a discounted cash flow model of valuation. To this day, I use a model based on Rappaport’s original model, and it has served me well over time.  I have also written books about valuation using these models, one of which is currently used to educate CFA’s globally.  In recent decades, Rapaport has collaborated with Michael Mauboussin on investing mode.  They have a new book coming out in September 2021, which I am looking forward to reading.  Mauboussin is one of the greatest minds in investing, and I eagerly read everything he writes.  He recently published a new article, “Everything Is a DCF Model,” which can be downloaded here.

If you are serious about investing in individual stocks, I encourage you to read it!  In the article, Mauboussin articulates a more detailed explanation than I have above as to why cash flows matter for all investors and why DCF models can be used in valuing any company (some with more difficulty than others!).  In my next post, I will talk about the types of cash flows that analysts look at to evaluate a company and use in their DCF models.

Investing Is All About Cash Flows
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