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Why is Cash Flow Important?

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There are a number of ways to find stocks that are undervalued. One way is to find firms that show high cash flow or high free cash flow within their financial statements. Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. This is a critical difference that makes Philip Morris such a wonderfully reliable investment, and a steel company such a shaky one.

Let’s say Pig Iron, Inc. sells out its entire inventory of ingots and make $100 million dollars. That’s good. Then again Pig Iron, Inc. has to spend $80 million to keep the furnaces up-to-date. That’s bad. The first year Pig Iron doesn’t spend $80 million on furnaces improvements, it loses business to more efficient competitors. In cases where you have to spend cash to make cash, you aren’t going to get very far.

Philip Morris doesn’t have this problem, and neither does Pep Boys, or McDonald’s. That is why I prefer to invest in companies that don’t depend on capital spending. The cash that comes in doesn’t have to struggle against the cash that goes out. It’s simply easier for Philip Morris to earn money that it is for Pig Iron, Inc.

A lot of people use the cash flow numbers to evaluate stocks. For instance, a $20 stock with $2 per share in annual cash flow has a 10 to 1 ratio, which is standard. A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning a stocks long term. A $20 stock with a $4 per share cash flow gives you a 20 percent return on cash, which is terrific. And it you find a $20 stock with a sustainable $10 per share cash flow, mortgage your house and buy all the shares you can find.

There’s no point getting bogged down in these calculations. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend. Pig Iron, Inc. will have a lot less free cash flow than Philip Morris.

This is primarily sourced from Peter Lynch’s book entitled “One up on Wall Street” published in 1989.

Rich free cash flow situations are good investment for the value investor. The key to finding them is through security analysis and looking where the masses do not. Contact us today, to learn more about how we find undervalued stocks.

At Port Wren Capital, LLC, we specialize in picking specific undervalued U.S. stocks using fundamental analysis developed by Benjamin Graham using a five step process. We have beaten the S&P500, DJIA and NASDAQ benchmarks since we started 5 years ago on our own investments. Discover the difference for yourself. To learn more contact us today.

Published: 8/1/19

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