Instead of evaluating your stocks based on the company’s cash flows, evaluate them based on the shareholders’ cash flows.

How should we value stocks? This is one of the fundamental questions when it comes to investing. Warren Buffett provided a great answer to this question. He said, “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 it may seem simple, many investors (including myself) confuse the cash flows generated by the company with the actual cash extracted from the business.

Although they may sound similar, they are actually very different.

Primary Distinction

The additional cash flow generated by the company is referred to as free cash flow. This is the cash flow generated by the company’s operations minus any capital expenditures paid.

However, not all of the company’s free cash flow is distributed to shareholders. Some cash flows may be used for acquisitions, some may be retained in the bank, and some may be used for other investments, such as buybacks or investing in other assets. Therefore, this is not the cash that shareholders will receive. The cash flow taken out of and paid to shareholders from the business is only dividends.

When valuing stocks, it is important that we base our valuation solely on the cash to be returned to shareholders.

The additional free cash flow not yet returned to shareholders should not be considered when evaluating stocks.

Common Mistakes

Evaluating stocks based on the cash flows generated by the company is a significant mistake, as it may significantly overstate the value of the enterprise.

When using discounted cash flow models, we should not base our valuation on the company’s free cash flow, but rather on the future dividends to evaluate the value of the enterprise.

But what if the company doesn’t pay dividends?

Well, that should apply too. If there are no dividends yet, we need to model only the future dividends to be paid later in the valuation.

Bottom Line

Using the company’s discounted cash flows to evaluate the enterprise may significantly overstate its value. This can be very dangerous as it can be used to justify extremely unfounded valuations, leading to the purchase of overvalued stocks.

To be precise, the valuation of a company should be based solely on how much return it can provide to shareholders.

Nevertheless, the company’s free cash flow is not a useless valuation metric. It is, in fact, the foundation for measuring whether a company is excellent.

A company that can generate strong and growing free cash flow should be able to return increasing dividends to shareholders in the future. The company’s free cash flow can be said to be the “lifeblood” of sustainable dividends.

Of course, all of this also depends on whether the management can make good investment decisions based on the cash obtained.

Therefore, when investing in a company, two key factors are crucial. One is how much free cash flow the company generates, and the other is how well the management performs in allocating new capital.