Long Term Investing is about Future Cash Flow

Ultimately, in long term investing, fundamentals and cash flow are paramount for an investor (an investor is a business owner).

Years ago, a hockey game between the Boston Bruins and Edmonton Oilers had been paused for some technical issues with the stadium lights. To kill some time, the announcers started interviewing people including the Edmonton Oilers, Wayne Gretzky, undoubtedly the world’s greatest hockey player at the time. The announcer stated that Gretzky wasn’t the biggest guy in the league, or the strongest, or the fastest or the toughest, yet he was regarded as the greatest hockey player in the world. So, how then did Gretzky explain his own genius? Gretzky simply replied:

“I don’t go where the puck is; I go where the puck is going to be!”

In a simple one liner, Gretzky confirmed that his success did not come from chasing the puck. Instead it came from staying one step ahead and by anticipating where the puck would likely go next.

Thus, it is important to look at the future potential of a stock or investment instead of focusing solely on past performance. Long term investing is about looking from the perspective of a business owner at a company’s fundamentals and cash flow.

Cash Flow

In finance, cash flow (CF) is the term used to describe the amount of cash (currency) that is generated or consumed in a given time period by a business. It has many uses in both operating a business and in performing financial analysis. In fact, it’s one of the most important metrics in all of finance and accounting.

Every investment is the present value of all future cash flow.

Many investors are lured by short term performance. They are interested in finding the latest, hottest, top performing stocks and investments driven by the financial entertainment media. However, investors who buy those top performing investments today may not necessarily enjoy the same returns in the future. In investing, it’s essential you approach buying stocks like a business owner.

Cash flow is not the same as net income (or profit).

While cash flow describes the movement of money into and out of your business, profit is the surplus of money your business has after you’ve subtracted the revenue from your expenses.

The inflow and outflow of cash into and out of a company reflects the health of that company’s operations. That’s why it’s important as an investor (business owner) to be able to understand a company’s fundamentals and cash flow.

Cash flow is more dynamic in concept then profit – as it measures the movement of money – then profit, which simply demonstrates how much money you have left over after your expenses have been deducted. Even a profitable business can fail if a business doesn’t have a healthy cash flow.

Without a healthy cash flow, profit is meaningless.

Many successful companies (like Amazon, Twitter, Uber and Yelp) actually existed a long time without profits, but no company can survive without a healthy cash flow. For small to mid-cap companies, profit is still important, but cash flow is vital.

If you don’t have cash on hand, you can’t pay for your company’s basic needs like rent, employee salaries, electricity or equipment. If you don’t have enough cash on hand to replenish inventory or pay operating expenses, you will become unable to generate new sales. If you can’t afford operating expenses, your company will eventually fail. That’s why cash flow is such an accurate predictor of an investment or company’s success.

Cash Flow From Operating Activities

The operating activities reflects how much cash is generated from a company’s products or services. Positive (and increasing) cash flow from operating activities indicates that the core business activities of the company are thriving.

Cash Flow From Investing Activities

Investing activities include any purchase or sale of an asset, loans made to vendors or received from customers or any payments related to a merger or acquisition is included in this category. In short, changes in equipment, assets, or investments relate to cash from investing.

Cash Flow From Financing Activities

Cash flow from financing activities shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. Some examples are: issuance of equity (shares), payment of dividends, issuance of debt (e.g. bonds) and repayment of debt.

Free Cash Flow

One of the most important financial number is free cash flow (FCF). It is the cash flow available to all the creditors and investors in a company, including common stockholders, preferred shareholders, and lenders.

You can calculate FCF, if not provided, quickly. FCF = Operating cash flow – capital expenditures (aka. CAPEX). Simply, capital expenditures on the CFS is the line item “Purchase of Property, Plant and Equipment” (PPE). the PPE expenditure is the “maintenance amount” of running a business. Though it says “purchase”, this includes repairing, renewal and/or maintenance of the companies assets.

No company can survive without a healthy cash flow.

Generally, you want to see a steady increase in cash flow from operations. If this number is growing (while debt being in control) at a rate of 10% or more annually.

However, past performance cannot guarantee future results. In other words: don’t assume that an investment is going to continue to perform well in the future simply because it’s done well during a specific time period in the past.

Two of the key ingredients for success in investing is understanding that cash flow is king and your a business owner when you purchase a company’s stock.

References:

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