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Also known as CFROI, a cash flow return on investment is a type of valuation model that operates with the understanding that the price of the investment is not determined based on the performance of the entity that issued the security, but on the current status of cash flow. The idea is that this return must exceed the internal hurdle rate of the corporation in order for the price of the security to be both attractive to investors and lucrative for the issuer. As with most types of investment theories, CFROI has a number of supporters, as well as others who do not find this particular financial theory to be the most viable strategy when it comes to making investment decisions.
In order to understand how the concept of cash flow return on investment works, it is necessary to define what is meant by a hurdle rate. This is simply the amount of return that must be exceeded or hurdled over in order to justify the price of a good or service. As it relates to investing activity, the hurdle rate is the minimum amount of return that an investor will consider equitable if he or she chooses to acquire the security. For a business, the rate defines the least amount of profit it must make from the sale of securities in order to make the effort worthwhile.
From this perspective, the cash flow return on investment is basically an internal rate of return for the business that is issuing the security. If that internal rate of return is higher than the hurdle rate, that means the return is exceeding the cost of debt financing that is involved in issuing the shares, and the price of the shares is at an acceptable level for the issuer. Assuming that the return to investors is remaining at a consistently satisfactory level, there will be no problem moving those shares on an exchange.
While many people find that a cash flow return on investment strategy is logical and can be used to explain how the stock market sets prices in some instances, others feel that the strategy only identifies one set of factors that determine the price that the market will bear. For investors who feel this is the case, the need to consider factors that are outside the control of the issuer is apparent. For example, the movement of shares offered by competing companies would be important in determining the current price of the security, as well as the general state of the economy. Supporters of a cash flow return on investment approach point out that these external factors are accounted for by their impact on the internal rate of return experienced by the issuer, meaning they are in fact considered on the front end, rather as part of a concurrent set of relevant circumstances.
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