Stock Value: Future Cash Flows Are Key

Imagine you’re thinking about buying a house. What truly determines its value? Is it just the bricks and mortar standing there today? Not really. A big part of what you’re paying for is what that house will provide you in the future. Will it offer comfortable living for your family? Can you rent it out for income? Will its location become more desirable over time, increasing its resale value? These are all future benefits, or future cash flows in a way, that influence how much you’re willing to pay for that house right now.

The same core idea applies to valuing common stocks. When you buy a share of stock, you’re not just buying a piece of paper. You’re buying a tiny ownership stake in a company. And what is the value of owning a piece of a company? It comes down to what that company is expected to generate in the future. Specifically, it’s about the cash the company is expected to generate over time that could potentially come back to you as a shareholder.

Think of it like this: a company is like a money-making machine. It takes in resources, uses them to create products or services, and then sells those to customers, generating revenue. After paying its expenses, what’s left over is cash flow. This cash flow is the lifeblood of the company. It can be reinvested to grow the business further, used to pay down debt, or, importantly for shareholders, distributed as dividends.

When we talk about valuing stocks based on future cash flows, we’re essentially trying to estimate how much cash this “money-making machine” is expected to generate for its owners in the years to come. This might seem like gazing into a crystal ball, and in some ways, it is an estimation game. However, analysts and investors use various tools and techniques to make informed projections about a company’s future revenues, expenses, and ultimately, its cash flow.

Now, you might be thinking, why future cash flows and not past performance? While looking at a company’s history can be helpful to understand its track record, the stock market is fundamentally forward-looking. Investors are not paying for what a company did yesterday, but for what they believe it will do tomorrow and in the years after. Think of planting a seed. You’re not paying for the seed itself, but for the potential tree it can become and the fruits it might bear in the future. Similarly, with stocks, you’re investing in the future potential of the company to generate cash.

To make this future cash flow concept practically useful for valuation, we need to consider one more crucial element: the time value of money. A dollar today is worth more than a dollar tomorrow. This is because you could invest a dollar today and earn a return on it, so in the future, you’d have more than just that dollar. There’s also inflation, which erodes the purchasing power of money over time. Because of this time value of money, future cash flows are worth less today than the same amount of cash received right now.

Therefore, when we value a stock based on future cash flows, we don’t just add up all the expected future cash flows. Instead, we “discount” them back to their present value. Discounting is essentially the reverse of compounding interest. It’s a mathematical process that accounts for the time value of money, recognizing that future cash flows are worth less today. The further into the future a cash flow is expected, the more it’s discounted.

So, the fundamental principle behind valuing common stocks based on future cash flows boils down to this: the intrinsic value of a stock, what it’s truly worth, is the present value of all the future cash flows that investors expect to receive from owning that stock. This includes dividends and potentially the cash flow generated from selling the stock in the future. By estimating these future cash flows and discounting them back to today, investors can arrive at an estimate of what a stock should be worth, helping them make informed decisions about buying or selling. It’s all about looking ahead and understanding the potential for a company to generate value over the long term.