Element of Return on Investment

Within the last 30 years, there has been a shift in emphasis from valuation based on accounting income to valuation based on cash flow.  Many people now make statements like "cash flow is all that matters".  The reason for this emphasis on cash flows is that accounting earnings, per say, cannot buy anything.  Accounting earnings are mere constructs based on accruals of revenues and expenses, which have only a rough correlation with actual cash flows.  Cash flows, on the other hand, represent the actual dividends and distributions to the investor (which may be either positive or negative).  To the extent accounting earnings fail to reflect actual cash flows, they are not useful in assessing value and, consequently, return on investment.

Empirical studies support this view.  For example, some changes in accounting rules have had no effect on cash flows, but have caused material change in reported income.  In such cases (where the change in reported earnings had no correlation with the change in cash flows), research on publicly owned corporations shows that the stock prices are essentially unaffected.  This is evidence that investors do not rely on reported earnings when assessing the value of an asset.  It is the cash flow that contains the information necessary to assess value.

Robert Schmitz
Robert Schmitz Corporate Real Estate Advisors