

Cash Flow

What it is:

Cash flow is simply the cash expected to be generated by an investment, asset or business. 

How it works (Example):

As an investor, you buy a dividend-paying stock. You purchase the stock for $10 and the company pays you a $0.50 dividend each year. $0.50 is cash flow to you. You have valued the stock at $10 based on the stream of annual cash flows you receive each year. If the dividend drops to $0.25, the stock will be worth less to you, and if the dividend increases to $0.75, the stock will be worth more.

On a company level, assume a business had a good year and was able to increase the amount of cash flow it generated. It made more than it paid out. The company can either keep the cash to reinvest in future business prospects, or it can distribute the cash to its investors. Anyone who wants to put a price on the company as a whole will see the cash flow it generates and assign a value based on those cash flows.

A Cash Flow Statement is required to be filed with the SEC by every publicly-traded company. By examining it, an investor can track the sources of cash and the uses of cash throughout the covered time period.

Why it Matters:

Cash flow should be the #1 priority for every investor. Any asset should eventually generate cash to pay back the capital that the investor has invested.

The value of any asset can be determined in three steps: 1) Estimate the future cash flows the asset will generate for you; 2) Pick an appropriate discount rate to account for the risk you're assuming by investing in the asset; and 3) Calculate the present value of the cash flows from #1 by discounting them to today's dollars using #2. 

It is important to note that having temporary negative cash flow is not always a bad thing. If a company is spending more cash than it earns because it is building a more efficient manufacturing plant, for example, the investment should pay off later when the plant generates products that are turned into cash. On the other hand, if a company has negative cash flow because it's overpaid for acquisitions or made other poor investments, then the long-term benefits may never materialize.

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