Cash Flow vs Total Return:
Back to Old School Investing
by John Valentine, contributions by Genevieve Valentine

I was recently in a client appointment when the client asked “What is the difference between cash flow and total return?” After explaining the differences, the client appeared relieved and satisfied with the explanation at hand, and I was reminded of the importance to explain to clients financial jargon and how these terms apply to their financial experience. To that end, I thought it would be important to share with all of you the answer to the question, “What is the difference between cash flow and total return?”

The objective of building an income portfolio is to generate retirement income (cash flow) for our clients. This is different from looking at the total return of a portfolio or establishing a portfolio for the purpose of achieving capital gains only.We, as a firm, disagree with judging a portfolio by either of these concepts alone.  In addition, a retirement portfolio should be judged by the income (a.k.a. cash flow) generated to pay for a retiree’s lifestyle.

In the 1980s, investors looked for dividend generating investment opportunities because of the poor economic conditions of the 1970s. In addition to living through the recession of the 1970s, most retirees of the 1980s lived through the Great Depression. These investors wanted to be certain that they had consistent cash flow generating investments. In the 1990s, investors (Baby Boomers) cared less about dividend generating investments because of the historical Bull Run. Total return on a portfolio was more important during this decade than monthly cash flow. Investors were busy chasing fashionable growth stocks that reinvested all their profits in the business, instead of paying out a portion in dividends. But following the collapse of the technology bubble and with the current economic condition, investors have again come to appreciate regular cash payments from their equity investments.

Cash Flow

 Cash flow comes from the part of the portfolio where a client draws retirement income. This income is money sent to the individual that can be used for just about anything—golf, dinner, trips (Trips were called vacations when you were working. They’re trips now that you are retired.) In other words, cash flow is the flow of money from a retirement account into the pocket of the client.  Truly defined, income represents the means to perpetuate one’s lifestyle and living standard. It is the summation of cash flow that is paramount and this determines one’s monthly income. Dividing the cash flow generated by the portfolio by one’s income needs is useful in measuring the percentage of income coming solely from dividends and interest. A retiree will use this income to replicate their pre-retirement lifestyle.

 The next question should be, “Where does this money come from?”  Here is an explanation to address that very question.

 When monitoring performance and valuations from a cash flow orientation, we obviously need to look at stock quarterly dividends. Yet, beyond dividends’ current popularity, we also need to explore the other facet of cash flow investing: interest-bearing investments such as bonds and bond instruments. It is essential to realize however, that there is new added risk inherent in these kinds of investments that simply didn’t exist years ago. Rates are so low today that if bond values move sideways or upward, bond investments could lose principal value. As a result, the stock market has made the dynamic shift from a potential appreciation vehicle to a total return vehicle (dividends plus growth or loss). As such, the types of items one should hold in a portfolio have changed to reflect the added risks to bond investments. Even more importantly, one should continue to calculate performance by measuring one’s portfolio growth versus the S&P, but should also focus on the cash flow generated monthly from your portfolio’s investments. (Standard and Poor’s 500 Index is an unmanaged index generally considered as representative of the stock market in general.) The new calculation should be “What amount of cash flow does my portfolio produce through dividends and interest?” (Please take note that an investor may not directly invest in an index.)

 Dividends and Interest

 As mentioned in the “Dividend 101” article in our November 2008 Newsletter, dividends are payouts from a corporation to a shareholder. This payout is cash flow to the investor.

 Similar to how stocks produce dividend payouts, bonds provide interest payouts. The typical bond has an issue price, which is the amount an investor pays to obtain the bond and a fixed coupon rate, which is the interest rate the issuer pays to the bond holder until the date the bond matures.  For example, Investor A purchases a bond for $50,000 dollars with an initial fixed coupon rate of 5%, which pays monthly. This means that the investor will receive $2500 in interest every year from the bond.  Bonds can be bought at a discount, which will increase effective yield or a premium, which will decrease yield.

 Cash Flow Example

For example, let’s consider a $1 million dollar portfolio. With $300,000 invested in stocks yielding 3.5% dividends, the investor earns $10,500 a year. With an additional $400,000 invested in a strategic fixed income portfolio, including ETFs, convertibles, and a variety of bonds yielding 6.7%, the investor earns $26,800 a year. If the remainder of the portfolio generates an additional 1% in interest that adds another $3000 for the year, which brings the total cash flow generated to $40,300 a year (roughly 4% of the $1 million portfolio). If there is even modest growth in the underlying investments, the portfolio has achieved a total return function. The point is that cash flow investing is no longer a simple investment decision. Rather, it has become a performance evaluation metric; focused less on appreciation versus the S&P and more on the underlying cash flow the account generates. After all, this is how an investor supports their lifestyle. (The above information is for illustrative purposes only, and should not be considered a specific recommendation. Rates of return are hypothetical in nature and not indicative of an actual investment. An investor’s results may vary.)

It is important to remember:

The total return of a portfolio is different than the cash flow from a portfolio.

Total Return

Total return is a term used when measuring account or asset performance. Investopedia.com defines total return as, “The actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends and distributions realized over a given period of time”.  In other words, total return is the entire return on a portfolio, which includes income generated from dividends and interest as well as market gains or loss.   

There are different calculations one can use to determine their total return, but one of the easiest formulas is:

(Value of portfolio at the end of the year – Value of portfolio at beginning of the year) + Dividends / Value of portfolio at beginning of the year = Total Return

Let’s put numbers into this equation, so it doesn’t look so foreign:

(125,000 – 100,000) + 500   

              100,000                      =  25% (total return)

 An individual can judge the performance of their investments in many ways. Often times, people simply look at the bottom line of a specific piece of the pie. Did the investment go up, did it go down, and if so, by how much? But there's much more to performance than just a return number on a specific investment. The total return of a portfolio includes all of the pie, not simply one slice. For a more complete picture of a portfolio’s total return, you need to know the components that make up an investment's total return, as detailed earlier: dividends, interest, capital gain distributions, movement of positions as well as how the market itself performed.

Understanding the difference between cash flow and total return is important for investors. Financial jargon can be hard to understand at times, but don’t be afraid to ask your advisor when you don’t understand a term or acronym.  Remember, no question is a stupid question, and often times, you aren’t the only one thinking it.

 The information provided in this article is for educational purposes only and should not be considered a recommendation to buy or sell any security, or of a specific investment strategy. Please consult a financial advisor regarding your specific situation prior to implementing an investment plan.Past performance does not guarantee future results. Investing involves risk, including loss of principle. An investor's shares, when redeemed, may be worth less or more than the original investment price. Common stocks are subject to certain risks, such as an economic recession and the possible deterioration of either the financial condition of the issuers of the equity securities or the general condition of the stock market. There is no guarantee that dividend paying stocks will continue to pay dividends at the same rate or at all in the future. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.