The only true way to know that an investment is worthy of your capital is to measure the cash that it produces. You might have savings (such as gold or silver) that produce no cash flow for you, but when analyzing an investment you need to be very aware of its cash flow potential.
If all else is equal, the investment with the larger, more dependable cash flow is better than the next possible investment. However, most people quickly forget about this seemingly obvious metric in favor of a good growth potential story. This trap destroys many would-be investors.
For an example let’s look at the stock market craze of the late 1990’S. The story that captured the imagination of the country was that the internet was going to revolutionize the world to such a degree that old metrics of value no longer applied. Any company with a .com at the end of its name was considered pure gold. Most of these companies had little to no actual earnings, but they had an incredible story about how they would be the next big thing. Of course we know what happened. Reality struck and these companies did not actually produce any profit and the internet bubble popped.
We saw a similar thing next in the real estate bubble of the 2000’s. People were so excited about the appreciation of the housing market that they would buy a house with the plan to hold it a couple months and then sell it for a huge profit. And then this market suffered a bust as well. The problem here was the same, these properties had risen above the price that could be supported by a typical renter. So they were being bought on the hope that the market would keep going up and they could sell it to “the greater fool”.
And that worked for a while. If you got in and out early, you made a profit. Of course, most people got in late. The problem is that all of these people were gambling because the appreciation was not based on rising cash flow, but instead on the assumption that markets would just keep going up simply because they had gone up.
Here’s a powerful tip. When you start hearing how “the rules have changed”, it’s time to get out of the investment in question. The rules don’t change, but the investing masses always want to believe they have when a financial environment is riding to the moon. Every investment depends on cash flow to make it worthwhile and if the cash flow isn’t there and won’t be anytime soon, then the investment will soon face a crash.
Now, it can sometimes be a good, even spectacular, investment to be early into an opportunity which doesn’t yet have cash flow. These are always more risky. An example of this would be to be an early investor in a start-up company. If you were one of the first investors in Microsoft, you would not have had the cash flow to warrant your investment. However, you might have known the people involved, understood clearly how the product would bring value to the market place, had a strong conviction that this dream would come to fruition, and understood exactly how this plan would lead to future cash flow! Only then would it have been a great investment. But for each such successful venture, there are many who fail.
This is Part 4 in the series Investment Due Diligence. To continue with this series, click on Pt 5. To use this as a growth tool to better understand your own calling, you might start by reading Part 1, Pt 2 and Pt 3.