Investing is most intelligent when it is most businesslike.

Cash Flow Vs. Capital Gains

Which would you rather have?  An asset that paid you a check every month?  Or an asset that would simply rise in value until you’re ready to sell it?  There are so many different view points on which takes priority.  But our experience is that they can actually be combined for the best outcome possible.

The problem with only investing for Capital Gains (Buying Low and Selling High) is that you could be wrong.  Even the best get it wrong sometimes.  Many gold lovers have been holding on to a precious metal that hasn’t broke it’s prior high almost a decade ago. The same can be said for silver.

What about cash flow?  Even if our goal is to buy an asset that increases in value over time, we still like to start off by looking at it’s cash flow, or earnings potential.  There are two important reasons why.

  1. Receiving cash flow from your investment creates Cost Basis Reduction. In other words, every dollar we take back off the table puts our investment at a lower risk.  If I spend $100K on a business, but receive $12K back from cash flow, my investment at risk is now $88K.
  2. Cash Flow assets are easier to assign value.  In other words, we can take a very business like approach to understanding how valuable a stock or a property is based on the cash flow it produces.  In contrast, an asset like Gold, or Bitcoin is completely reliant human subjectivity. Market sentiment dictates the price of a non cash flow asset.

When you have a stock that pays you a dividend, or a rental property paying you every year, it eventually reduces your risk to zero.  But that doesn’t mean it’s a full-proof investment.  In fact prior to the stock market crash of 2008, many dividend oriented investors held GM, a company that was losing money hand over fist, and borrowing money just to pay it’s dividend.  Ignorant investors didn’t realize that their principal investment was going down the tubes because they were only focused on getting a check.  But even in this scenario, the dividend did offset their risk.

However, the real value in cash flow is the fact that it gives us a very objective way of measuring the intrinsic value of an asset.  Warren Buffet’s entire approach to valuing a stock is to looking at it’s track record of earnings.  When he can see that a company makes more an more money every year, and that it has some advantage that will keep the money coming, it’s an asset he’s willing to invest in.  Not only that, but he actually uses a formula where he projects earnings 10 years out, factors his minimum rate of return, and comes up with the EXACT PRICE he wants to buy a company for.  Most people don’t even know whether they are buying a stock that’s cheap or overpriced.

Land Lords understand this too.  When it comes to rental property, the name of the game is the CAP RATE.  How long before the cash flow they receive from rental income pays them back on their initial investment.  This isn’t just important for managing risk, but for accelerating growth as well. Real Estate Investors are often able to take out lines of credit against the equity that their tenants are building for them.  This allows them to hold on to the property, while tapping into that equity in order to make more investments.

So we put cash flow first.  We invest for capital gains too, but only under the right conditions.  This usually means a steep discount compared to fair market value of an asset.  But we tend not to hold onto those assets very long, and prefer to funnel the profits into cash flow assets.

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About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

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