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| | Stable Future Cash Flows (High geometrical mean)
Stable cash flows increase the value of a company. It is clear that it reduces the risks and volatility of the stock price. However we can prove mathematical that a company with stable cash flows also tend to have higher average yearly cash flows in the long term. The explanation is that the geometrical mean of volatile company lower is than the arithmetic mean. We will show this by two examples.
A bond with a coupon rate of 5% will have a arithmetical mean and geometrical mean of 5% as the cash flow is stable. (We assume that there is no credit or interest risk).
The other example is a stock, which has a 50% change of increasing cash flows by 50 percent in a year time and which has a 50% change of decreasing cash flows by 40 percent in a year time. The arithmetical mean of the cash flow of next year is (0,6+1,5)/2 = 1,05 is 5%. However the geometrical mean is sqrt(1,5+0,6) = 0,95 or -5%!! This means a long term return of -5%!!! So although the expected Cash flow of year 1 is +5%, the expected long term cash flow is -5%.
There are two ways to determine whether a company will have stable future cash flows. One is to look at the beta. A low beta is an indication that the stock market believes the impact of economic news is low on the future cash flows of the companies. The other way is to look at the competitive position of the company. Companies with a strong competitive postion and high margins tend to have stable cash flows.
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