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Focus on Cash Flow not Net Worth

February 15th, 2010 Leave a comment Go to comments

Quick, I have a couple of questions for you.

  1. Do you have a good job?
  2. Do you have good investments?

I asked these questions to a friend, and she said that her job is OK, but that she wasn’t earning as much as she wants. On the investment side, she didn’t know immediately. After finding some of her investment statements, she said that her investments weren’t doing so well, they were down the last quarter.

I think that her response is a common answer. Why do we look at our jobs in terms of cash flow, but our investments in terms of their worth (asset value), but not their cash flow as well? I don’t have an answer to this question. But I am suggesting to you that you should look at your investments in terms of  how much you cash you make from them. 

What Cash?

It’s easy to explain how much you make from your job, you get a “statement” from your employer probably each month or week. The cash from your investments may not be so clear. Here are three ways to look at the cash from your investments:

  1. Free Cash Flow (FCF) – this is money that the company has left over from operations that is available to pay to shareholders, buy back stock, or retain.
  2. Dividends – this is the cash the company pays you periodically out of its FCF.
  3. Interest – this is the cash that a bond pays you periodically.

Why Cash is Important

The public stock markets are filled with excellent companies with good, sustainable businesses that make money and that work hard because they want you to own them. And there are many companies that are not so good.  One of the ways that the good ones can prove to you that they are worthy is by demonstrating their ability to earn money over a long period and share the cash with you through dividends.

Dividends are important because:

  • They demonstrate that the company actually earns money. Some companies do not earn money. You don’t want to invest in these.
  • They demonstrate that the management is looking out for your interests as a shareholder.
  • They demonstrate the sustainabilty of the business model, if the company is able to keep paying them over a long period of time.
  • They offer you an immediate return on your investment that you can do with what you wish.

Build Your Cash Flow

In the end, whatever you invest in will need to create cash. If you are saving for retirement, it matters little what your investments are ‘worth’ if they can’t produce enough cash for you to pay your bills. That’s why tracking your investment cash flows can help you determine your progress along the way, and help to predict if it will provide the money you will need.  

Also, looking at the cash flow of a company can give you good insight into whether it’s a good investment for new money or one that you should continue to hold. It may not happen immediately, but if a company is proficient at increasing cash flow, then the stock price should eventually follow.

Cash Flow Example

I have picked one stock that I have owned for about 4 years. This is a really good example because over that 4 year period, all my purchases (initial, dividend reinvestment) were made at prices higher than the current trading price. So If I sold the stock today I would lose money.

Why did the cash flow increase? Two reasons:

  1. The company increased its cash flow per share. The business improved, this is what you want companies you own to do.
  2. The share count increased. By reinvesting the dividends (even at higher market prices), cash flow increased because you earn more with a higher share count.

Here’s a summary table of what has changed from a cash flow point of view for the following stock:

Realty Income (O) 

         

Realty Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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