The Beginners Investing Guide - Buy Like Buffett

The Beginners Investing Guide - Buy Like Buffett

The Beginners Investing Guide

The Beginners Investing Guide

February 1, 2011 By Mark 3 Comments

This is the third entry in the beginners guide to investing. In previous weeks we took a look at the role that the balance sheet and income statement play in investing decisions. This week we will take a look at the third and final financial statement which is the statement of cash flows.

Cash Flow Statement Definition

The cash flow statement is a summary of all the cash inflows and outflows that a company has from operating and non operating activities. Basically it’s focus is on how a company is utilizing its cash. The cash flow statement will show you how quickly a company is going through cash. This is known as negative free cash flow or its cash burn rate.

Warren Buffett is a big fan of the cash flow statement because it shows the amount of free cash flow available. This is the cash available to owner’s. If someone bought a company, they would have access to all of the free cash flow available on the cash flow statement. Free cash flow is defined as follows.

Cash Flow From Operations – Capital Expenses (CapEx) = Free Cash Flow

Capital expenditures are the funds that are used by a company to acquire tangible assets like plants, property, and equipment.

Look at some of Buffett’s largest investments and you will see a common theme taking place.

• Coca Cola generates $9 billion dollars in free cash flow.
• Proctor & Gamble generates $13 billion dollars in free cash flow.
• Johnson & Johnson has $14 billion dollars in free cash flow.

Warren Buffett loves companies with large amounts of free cash flow.

Measuring Free Cash Flow

You can compare a company’s stock price to the amount of free cash flow using the price to cash flow ratio.

Price to Cash Flow = Share Price/Cash Flow per Share

You can find this calculation on Yahoo Finance.

The higher the multiple of free cash flow to price, the more expensive the company. The lower the multiple of free cash flow to price, the cheaper the company.

There are exceptions however. If a company is growing at an astronomical growth rate, they may elect to use cash from operations to fuel growth. This would make the free cash flow look lower than it really is. That’s why it is important to pay attention to the cash inflows of a company. A company with high amounts of cash inflows could be considered a cash cow and may just need a different management team if this doesn’t equate to significant growth or large amounts of free cash flow.

Now you have a primer on all three financial statements and how they relate to investing. The purpose of this guide is to help make you become a better investor. The more informed you are as an investor, the greater your chances of making money investing.

Wikio