Analysis of Asset Allocation

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Fundamental Analysis: Cash Flow
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Since earnings can be influenced by income items that are not a part of the operations, cash flow are more and more used to measure the health of a company. But we will see that the cash flow is not only a flow of cash.

The cash flow is the net income with non cash expenditures (such as depreciation) added back.

Depreciation is added back because it doesn't involve a disbursement of money, it's just a book entry that represents the approximate loss in value of tangible long term assets.

Of course a lot of cash flows (at different levels) has been developed together with their respective ratios.

The most common ones are:

Cash flow per share = (Net Income + non cash adjustments) / Common stock shares outstanding

where non cash adjustments are depreciation and deferred taxes.

As the P/E, the cash flow can be compared to the price:

Price cash flow per share = price/cash flow per share

This ratio can be analyzed like the P/E.

Free cash flow is defined as the cash flow of which you subtract the capital expenditures and the dividends paid to the shareholders. Free cash flow can be also compared to price.

Free cash flow is an important figure because it depicts a company that is growing within its means. If you look at the market, it is surprising to see how few companies have free cash flow and how many of them continue to pay dividends. In the long term, a company without free cash flow will have difficulties to pay dividends.


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