Draft:Cash Flow Growth

Cash Flow Growth Definition
Cash flow analysis is necessary to understand a firm and there are various ways to evaluate cash flow. . Cash flow growth is the growth in cash flows of an asset, particularly the free cash flow of firms. Cash flow growth is an important component in valuing an asset. Similar to why we evaluate stock returns rather than stock prices, looking at cash flow growth in addition to the level of cash flow provides significantly more information. Looking at cash flow growth, rather than cash flow level, adjusts for the scale of cash flows. There is also additional information in changes to the level, ie growth, relative to the level itself. Lastly, financial economic theory shows that cash flow growth is a significant determinant of stock returns. Jansen (2021) shows that in the terminal growth stage of valuing of a firm the expected stock return equals the expected cash flow growth.

$$ Cash Flow Growth = (CF_{t}-CF_{t-1})/CF_{t-1} \,$$

Where: $$  CF= Cash Flow \,$$

There are some complications to measuring cash flow growth because, unlike stock prices, free cash flow can cross zero. In order to have a sensible growth rate, a firm must have at least two consecutive years of positive or negative cash flows. Next, because negative values grow inversely without any adjustment, negative cash flow growth rates are multiplied by negative 1. For example, if a firm's cash flow goes from –$10 million to –$20 million, its unadjusted growth rate is (–20 – (–10))/–10 = 100%. However, this is not sensible because the firm's cash flow declined from –$10 million to –$20 million, the cash flow did not grow.

Cash Flow Growth Composition
Cash flow growth can also be decomposed into several informative subsets.

Expected and Unexpected Cash Flow Growth
Observed cash flow growth is the sum of the expected and unexpected cash flow growth.

$$ Cash Flow Growth = E(CFG) + U(CFG) \,$$

Where: $$ E(CFG)= Expected Cash Flow Growth, \,$$

$$ U(CFG)= Unexpected Cash Flow Growth \,$$

Expected cash flow growth may be estimated using a geometric growth from two previous years of positive cash flows

$$ E(CFG)= (E(CF_{t})-CF_{t-1})/CF_{t-1} \,$$

$$ E(CF_t)= CF(_t-1) * (CF_{t-1}/CF_{t-3})^{1/2}  \,$$

Operating and Investing Cash Flow Growth
While operating performance is relatively more important, both operating and investing performance of a firm have significant implications for its asset value. Cash flow growth of a firm can also be shown as: $$ Cash Flow Growth = Operating CFG + Investing  CFG \,$$