top of page

Everything You Need To Know About The Importance of Cash Flow In Stock Picking

There are several relevant metrics that we can use when evaluating stocks. But one of the best measures is also one of the most frequently overlooked. Below, we’ll look at the importance of cash flow in stock picking and see what the data says.

Cash flow is a superb indicator of the financial health of a business. A company can have huge revenues, but they aren’t profitable if even more significant outgoings exceed them.

Cash Flow Basics

A) Operating cash flow

Operating cash flow is cash received from customers minus operating expenses like salaries, supplies, rent, etc.

B) Investing cash flow

Investing cash flow is cash spent on financial instruments of fixed assets, like machinery, stocks, or securities in other businesses, property, etc.

C) Financing cash flow

Financing cash flow is funds from owners, creditors, investors. These inputs are classified as either debt, equity, or dividend transactions on a cash flow statement.

The Importance of Cash Flow

Aside from detailing the cash-generation ability of a company, cash flow is vital in other ways. For example, investors can use historical cash flows to predict future cash flows. Additionally, it can give investors an insight into the solvency and liquidity of a firm.

Dividend Growth Strategy

Free cash flow can be calculated by taking a (businesses earning + depreciation & other cash charges) minus capital expenses.

To get a free cash flow yield, you take its free cash flow per share and divide it by its stock price. Companies that generate good free cash flows can often increase dividends.

In a similar study, Aberdeen Investment Group also suggests that free cash flow is a quality-value metric tied to premium, long-term returns.

They suggest that because high-quality businesses tend to be “more cash generative,” they can also sustain higher dividend growth and more efficient services debts.

These qualities, Schroders goes on to suggest, persist over the long term, allowing these businesses to grow sustainably.

Cash Flow vs. P/E

Price to earnings (P/E) tends to grab a lot of the investment headlines. However, this metric doesn’t always give a concrete picture of a company’s ability to generate cash. Cash flows help investors understand how much cash a business can generate.

What Investors Should Pay Attention to Cash Flows?

Free cash flow is an essential metric for dividend investors and total returns investors.

For total returns investors, cash flow is a great predictor of stock returns.

How To Action This Information?

The pandemic has pulled into focus the difference between profits and cash flow. Understanding what cash flow is and how to use it to pick stocks is an essential tool for evaluating a company’s financial health. The bigger picture is crucial, but a cash flow ratio can give you an excellent insight into a business’s sustainability and future dividends.

Sign up to today

More free resources on

Alpesh Patel OBE

6 views0 comments


bottom of page