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It’s the Cash Flow, Stupid

Economists are sometimes defined as people who don’t believe things work in practice until they can be proven in theory.

One such economist was Karl Marx, who used a remarkably simple theoretical formula to define the practicality of the capitalist system.

Marx’s formula was as simple as:

Capitalism = M-C-M’

Defined, a capitalist starts with Money, converts it into Capital, and ends up with More Money than what he originally started with.

Note that Marx’s formula doesn’t start with Money and ends with Capital. It ends with More Money.

The fact is that if capital can never produce more money – a flow of cash to its owners – then it is worthless.

Such is the importance of cash flows in capitalism.

Who else can vouch for this than the legendary ex-chief of GE, Jack Welch who displayed his own recognition for M’ as the driving force at GE.

In GE’s 1995 annual report, Welch explained that GE was “a company whose only answer to this trendy question, ‘What do you intend to spin off?’ is ‘cash – and lots of it.’

Coming back to Marx, if he had limited his formula for capitalism only to M-C, what purpose could such capital possibly serve?

As Michael Mauboussin and Alfred Rappaport write in their book Expectations Investing:

“Without a monetary return (M’ or More Money) the owners of a firm could not pay for their groceries, opera tickets, Mercedes limousines, and Park Avenue apartments. Without money, they could pay for nothing.”

This view holds true for investors as well.

When you buy shares of a company, you have to visualize a flow of cash somewhere – possibly in the form of dividends and certainly in the form of higher business value that will lead to capital appreciation – some time in the future.

Any other expectation – like beating the market, or making supernormal gains in the short term – will be irrational.

Investing isn’t like collecting art
What value does a piece of art has, however amazing it is?

Its value is set by the whims of other investors, with no anchors, no tangibility, and no meaning.

Art does not produce a stream of cash flows for its owner.

So why is a painting worth millions of dollars and another worth a few hundred?

Well, no calculation on Earth can answer that question. Not even the art collector who paid a million dollars to acquire that piece of abstraction.

The only possible reason for him to pay a million dollars for it is his hope that another art collector will step up to justify today’s selling price at some point in the future.

The process for pricing assets that will never produce a flow of cash to their owners runs parallel to the process for valuing art.

It’s purely speculation.

Why M’ matters?
Ask those investors who speculated in the stocks of dot com companies in 2000, which did not have a single rupee of cash flow to justify their stratospheric stock prices.

Ask those investors who speculated in real estate stocks during 2006-2008.

They will tell you – if they’ve learnt their lessons, why M’ matters – why it is important to invest in companies that generate cash flows and that have the money to reward shareholders with cash flows (dividends).

The truth is that assets that produce cash flows will ultimately return the owner’s investment without depending on the whims of other investors.

Even if those cash flows are some distance in the future, they can be valued by smart
investors using the present value calculation.

In simple terms, financial markets serve as a platform where investors who need cash today can obtain it by selling the present value of future cash flows to other investors who are willing to wait for the cash payoffs (M’, or More Money) from their capital.

The crucial point here is this – If you invest without expecting future cash flows from your investments (stocks), then you might as well collect art or bet on horse races.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

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