Cash flow return on investment (CFROI) is a valuation model that considers the current state of liquidity flow, with the yield needing to exceed the company’s internal hurdle rate for the security’s price to be attractive to investors. CFROI has proponents and detractors, with some believing it only identifies factors that determine the market price. The internal rate of return for the issuer is higher than the hurdle rate if the yield exceeds the cost of debt financing, and assuming the return to investors remains satisfactory, there will be no problem moving those stocks on the stock exchange.
Also known as a CFROI, a cash flow return on investment is a type of valuation model that operates with the understanding that the investment price is not determined based on the performance of the entity that issued the security, but on the current state of liquidity flow. The idea is that this yield must exceed the company’s internal hurdle rate for the security’s price to be attractive to investors and profitable to the issuer. As with most types of investment theories, CFROI has a number of proponents, as well as others who don’t believe this particular financial theory is the most viable strategy when it comes to making investment decisions.
To understand how the concept of cash flow return on investment works, it is necessary to define what is meant by hurdle rate. This is simply the amount of return that must be exceeded or exceeded to justify the price of a good or service. As it relates to the investment business, the hurdle rate is the minimum amount of return that an investor will consider fair if he decides to buy the stock. For a business, the rate defines the minimum amount of profit it must make from the sale of securities to make the effort worthwhile.
From this perspective, the CFROI is basically an internal rate of return for the company issuing the security. If this internal rate of return is higher than the hurdle rate, it means that the yield exceeds the cost of debt financing involved in issuing the shares and the share price is at a level acceptable to the issuer. Assuming the return to investors remains at a consistently satisfactory level, there will be no problem moving those stocks on the stock exchange.
While many people believe that a cash flow return on investment strategy makes sense and can be used to explain how the stock market sets prices in some cases, others believe that the strategy identifies only a set of factors that determine the price that the market will bear. For investors who believe this to be the case, there is an obvious need to consider factors that are beyond the control of the issuer. For example, the movement of shares offered by competing companies would be important in determining the current price of the stock as well as the general state of the economy. Proponents of a cash flow return on investment approach point out that these external factors are explained by their impact on the internal rate of return experienced by the issuer, meaning that they are in fact considered on the front end, rather as part of a simultaneous set of relevant circumstances.
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