Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 431

Where do stockmarket returns come from over time?

In a world of low-yielding investment returns, finding solid investments by wading through various measures, metrics and methods can seem an onerous task. Free cash flow is one of the more reliable indicators for return on your investment. This is especially true when companies focus on allocating cash efficiently among internal reinvestment opportunities, acquisitions, dividends, share repurchases and debt repayments.

Cash flow basics

First, it is important to define what cash flows actually are. Cash flows, the income statement and the balance sheet are the three financial statements needed to assess a business.

A company’s cash flow comes in through sales or cash receipts, for example, and out due to operational expenditures. Cash flows in and out are shown through the quarterly cash flow statements. If the cash outflows are greater than the cash coming in, then it is a cash-losing business.

The cash flow statements also represent how much cash in the bank a business has for that quarter. If the business only has a couple of quarters' worth of cash in the bank, then it may not be a viable business worth investing in.

The income statement, by contrast, represents how much income a business has made through deducting total expenses from total revenues. Meanwhile, the balance sheet represents what assets (land, cash, buildings, machine, equipment, intellectual property, etc.) and liabilities (debt, wages, taxes, etc.) a company might have.

The free cash flow of a business is the cash left over for all financial stakeholders, including investors.

Why is this important?

Take a look at the chart below which is foundational to our investing. It’s the guiding philosophy when looking for companies based on cash flow. It shows the S&P500 index since 1936 with total returns broken into three components: earnings growth, Price/Earnings changes (expansion and contraction) and dividends.

In any period of time, P/E multiples can drive total market returns but their impact fades over time. Investors are left with earnings growth and dividends as the fundamental drivers of long-term equity returns.

Check the long-term numbers on the right of the chart below. The total return from the index over this long time period has been around 10% a year (nominal) on average, of which 3.8% is due to dividends and 4.9% is due to earnings, but only 1.4% is due to multiple expansion and contraction. That is why we focus on the cash flow the business is able to generate. 

Free cash flow as an investment value determinant

Investors can use free cash flow to determine the true value of a business for investment and what returns it may generate in the future. The higher the cash flow in any given year, along with the growth rate of further cash flow, usually means a higher value for the company.

Yet, there are trade-offs in this equation as cash must be invested in the business for growth to happen. The management of any business with free cash flow must determine how much it will pay out to investors today and how much it will invest back into the business to create future growth.

Companies Maximise Returns Through Disciplined Capital Allocation

Source: Epoch; GSFM.

The free cash flow difference

In many respects, free cash flow investors follow the same process as value investors. They use a valuation metric to narrow the investable universe down to a manageable list of candidates. In essence, free cash flow investors uncover value by determining which companies are efficient allocators of capital.

The focus is on the capital allocation decisions instead of the traditional accounting-based financial metrics such as P/E ratios, earnings before interest, taxes, depreciation, and amortisation (EBITDA), and enterprise value (EV). These traditional financial metrics do not tell the full picture of potential returns due to their myriad accruals and assumptions.

Some investors seek companies that have paid out high dividends recently, but such dividends may not be a consistent feature of the investment. In fact, a high dividend payment can often be a sign of distress within a company and its stock price will fall. It is best to view company dividends in line with the consistency of free cash flow.

Every good company needs a sound capital allocation policy. Reinvestment of cash into the business should only happen when the return on capital is greater than the company’s average cost of capital. If not, then the cash should be used to buy back shares, pay dividends and pay down debt.

Company cash flow examples

Most technology companies were able to maintain or increase their dividends and share repurchase programs throughout the pandemic. Microsoft is a good example as the company continues to generate strong levels of free cash flow and increased its dividend in September 2020 and September 2021. The company also maintained its share repurchase programme through the pandemic. Microsoft has been transitioning to an enterprise software-as-a-service company with a strong adoption of its Office 365 platform and it is pushing this model into more of its offerings. The focus on perpetual subscriptions rather than one-time licensing sales will improve the consistency and growth trajectory of cash generation which has been strong in the work-from-home environment.

Another example to highlight is MetLife, a U.S. based global life insurance company.  MetLife raised its dividend in April 2020 at the start of the pandemic and again in April of this year.   While the company temporarily paused share repurchases during the early part of the pandemic, they did reinstate the buyback programme in Q3 of 2020 which has continued into this year.  The company has a strong regulatory capital position, pays an attractive dividend, and has a policy to use excess free cash flow for debt reduction and share repurchases. Growth for the company will reflect the rate of market expansion in the U.S. as well as the more dynamic opportunities to offer insurance and financial products in developing regions outside the U.S.

On the other hand, movie theater operator Cinemark is an example of a company we exited after determining that the business impact from the pandemic was very material which clouded the outlook for dividend sustainability.  We sold the position over concerns that the US could experience theatre shutdowns of an indeterminable length which would put pressure on the cash flows of the business.

When assessing any investment, it’s important to remember that cash is still king.

 

Damien McIntyre is CEO of GSFM, a sponsor of Firstlinks and distributor of the Payden Global Income Opportunities Fund in Australia and New Zealand. This article contains general information only. Please consider financial advice for your personal circumstances.

For more papers and articles from GSFM and partners, click here.

 

RELATED ARTICLES

Deep dives make better investment decisions

banner

Most viewed in recent weeks

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Latest Updates

Retirement

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

Shares

Boom, bubble or alarm?

After a stellar 2025 to date for equities, warning signs - from speculative froth to stretched valuations - suggest the market’s calm may be masking deeper fragilities. Strategic rebalancing feels increasingly timely.

Property

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Economy

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Shares

Is the iPhone nearing its Blackberry moment?

Blackberry clung on to the superiority of keyboards at the beginning of the touchscreen era and paid the ultimate price. Could the rise of agentic AI and a new generation of hardware do something similar to Apple?

Fixed interest

Things may finally be turning for the bond market

The bond market is quietly regaining strength. As rate cuts loom and economic growth moderates, high-quality credit and global fixed income present renewed opportunities for investors seeking income and stability. 

Shares

The wisdom of buying absurdly expensive stocks (or not!)

Companies trading at over 10x revenue now account for over 20% of the MSCI World index, levels not seen since the dotcom bubble. Can these shares create lasting value, or are they destined to unravel?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.