Professional investors tend to invest in assets that generate a return or future cash flow. A real estate investor expects cash collected from rent as the expected return for the initial downpayment on a rental property.
The timing around the cash flow breaks down the difference between growth investments and value investments. Value investments tend to generate a positive cash flow right away, while growth investments differ cash flow much further into the future. For stock, the company's profitability determines its cash flow—the moment a company shows it can turn a profit, more investors buy the stock, and the price increases significantly.
Why does Wallstreet reward profitable companies?
A good business makes more money selling a product than it takes to produce the product. A great business makes substantially more than it spends on costs. As a company becomes more profitable, management shows that the business model is no longer burning through money and can create value and free cash flow.
Let's watch a quick video on free cash flow.
The free cash flow to firm or FCFF is the cash left over for the business after expenses and investments are subtracted from revenue.
Revenue - operating expenses - short term investments - long term investments = FCFF
Cash flow we can expect
The free cash flow to equity or FCFE is what we, stock investors, are entitled to after the bond investors are satisfied. FCFF will be the same as FCFE if the company owes no debt.
FCFF - bond interest payments - bond principal payments = FCFE
Typically, companies distribute FCFE to stock investors in the form of dividends. The board of directors decides when to issue out dividends and can increase dividends as the state of the business improves and FCFE increases. Dividends provide us positive cash flow without requiring us to sell our shares.
The board of directors can elect to repurchase shares instead of issuing dividends. The company will buy outstanding shares traded on the market to boost the price per share. As stock investors, we would also benefit from this. Instead of receiving dividends income, the only way to profit is to sell our shares.
A third option is for the company to reinvest the cash back into the business. In this case, we see none of the cash flow but would hope to expect a larger cash flow later from a stronger business.
Understanding the basic criteria of how Wallstreet investors view stocks is important for us an emerging investor. It allows us to minimize speculation and it can give us clues to large market movements. For example, what happens to a stock price after an earnings report?
This lesson is the first in the series of company valuation.