Profit doesn’t always equal cash flow. But, cash flows are the basis for investment valuation.
Increased sales don’t always mean increased profits. If a company you want to invest in increased its sales, it may not lead to increase in profits.
When it comes to cash generated by a company, and to many it is surprising, not every time profits (net income) equal actual cash flows. The reasons are varied. Things such as depreciation, accounts receivable and payable, and inventories make for actual differences between profits and cash flows.
When it comes to sharing profits with investors, such as paying dividends, companies can only do so with the cash they have, not with a line on the income statement called ”net income.” No cash, no dividends. (Note that cash can be borrowed as well, so it doesn’t always come from profits.)
Indeed, many analysts will determine the value of stocks by the dividends the companies pay, or will pay in the future. Values of many other assets are also derived from cash flows generated.
Even when a company reinvests earnings, and pays no dividends, there are other ways to value that company, but the assumption is that the investment will eventually generate cash flows for the investors. And the expectation of higher cash flows in the future will raise its stock price now.
Cash flows are king. No cash flows, no business, and no investor profits.
The fact is, when you buy a stock, you become an owner of a piece of a company. As an owner, you want to eventually receive income (cash) from your investment.
Of course, many stockholders will sell before receiving dividends and make capital gains. However, if it was assumed that the company will never pay a dividend, then its value would only be equal to what its assets can be sold for (liquidation value).
To become an educated investor, you need to know some basics of investment accounting. Even if you’re a trader relying on technical analysis, you may eventually want to invest your trading gains for the long term.
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No money, no business
Many valuation methods rely on actual cash flows generated rather than net profit figures. Cash flows are the key. In the long-term, a lack of positive cash flows is likely to lead to liquidation or sale of a business.