How should we value a stock? That’s one of the basic questions when investing. Warren Buffett answers this question extremely well. He says:

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

While seemingly straightforward, a lot of investors (myself included) have gotten mixed up between cash flow that a company generates and cash that is actually taken out of a business.

While the two may sound similar, they are in fact very different.

Key difference

Extra cash flow that a firm generates is termed free cash flow. This is cash flow that the company generates from operations minus any capital expenditure paid. 

But not all free cash flow to the firm is distributed to shareholders. Some of the cash flow may be used for acquisitions, some may be left in the bank, and some may be used for other investments such as buybacks or investing in other assets. Therefore, this is not cash that a shareholder will receive. The cash flow that is taken out of the business and paid to shareholders is only the dividend. 

When valuing a stock, it is important that we only take cash that will be returned to the shareholder as the basis of the valuation.

Extra free cash flow that is not returned to shareholders should not be considered when valuing a stock.

Common mistake

It is a pretty big mistake to value a stock based on the cash flow that the company generates as it can severely overstate the value of a business.

When using a discounted cash flow model, we should not take free cash flow to the firm  as the basis of valuation but instead use future dividends to value a business.

But what if the company is not paying a dividend?

Well, the same should apply. In the case that there is no dividend yet, we need to account for that in our valuation by only modelling for dividend payments later in the future.

Bottom line

Using discounted cash flow to the firm to value a business can severely overstate its value. This can be extremely dangerous as it can be used to justify extremely unwarranted valuations, leading to buying overvalued stocks.

To be accurate, a company should be valued based only on how much it can return to shareholders.

That said, free cash flow to the firm is not a useless metric in valuation. It is actually the basis of what makes a good company.

A company that can generate strong and growing free cash flows should be able to return an increasing stream of dividends to shareholders in the future. Free cash flow to the firm can be called the “lifeblood” of sustainable dividends.

Of course, all of this also depends on whether management is able to make good investment decisions on the cash it generates.

Therefore, when investing in a company, two key things matter. One, how much free cash flow the firm generates, and two, how good management is in allocating that new capital.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.