In many Discounted Cash Flow models, earnings per share is used as the basis for the equation. Take the net income of a company, divide it by the number of shares outstanding that a company has, input this number into a DCF model and viola, you’ve got the fair value for a stock. Pump the brakes for a second. Let’s really look at the income statement and what it has to do with cash flow.
The Income statement tracks a company’s revenue and subtracts it from the cost of generating that revenue. As companies conduct more business, their revenue and expenses grow as well. The income statement tracks a company’s profitability. Profitability can help gauge the efficiency of a business, and how well it is being managed. The income statement is crucial for understanding the prospects and potential a business has, but it shouldn’t be relied upon as the only way to find a businesses value. Here’s why.
Companies have a choice between International Financial Reporting Standards (IFRS) or their countries accounting standards such as U.S. Generally Accepted Accounting Principles (GAAP). Depending on a company’s adoption of accounting guidelines, they can recognize revenue and expenses differently. Companies that sell products carry inventory. When calculating the value of inventory, businesses can choose between a Last In First Out (LIFO) or First In First Out (FIFO). In order to compare the performance of these companies, we would have to adjust the income statement to reflect either a LIFO or FIFO inventory valuation. Of course, we also know that Amortization and Depreciation are non-cash expenses used to calculate the declining value of intangible and tangible assets. There are also many other assumptions and educated guesses made within the income statement that accountants have to make in order to “smooth out” earnings for a company. All of these factors effect the way the income statement is presented to us investors.
These effects make it difficult to take the earnings reported from a company at face value. It also makes it difficult to compare companies on an even playing field. Earnings for a service based business would look drastically different from a products based business. Two companies in the same industry can have very different income statements if one uses GAAP and the other uses IFRS. We also can’t be naive to the fact that companies have certain agendas when reporting earnings, such as wanting to seem more profitable in order to be acquired by another company or less profitable to avoid acquisition. All of these assumptions and accounting gimmicks makes me very skeptical about taking EPS and plugging it into a DCF model. It would be very difficult to compare companies across industries, sectors and countries in order to find the best businesses to invest in.
If we look at the cash flow statement, we can use free cash flow (FCF) as a better alternative than EPS. I’m not saying that the cash flow statement can’t be manipulated, because it certainly can be. However, I do believe that the cash has less differences between IFRS and GAAP, less assumptions that can be made when recording cash inflows and outflows, no major impact between LIFO and FIFO. This allows us to compare companies more easily than through the income statement. Businesses also invest in their continued growth, and pay for expenses
in cash not earnings. Free cash flow is found by taking a company’s operating cash flow and subtracting its capital expenditures. It takes the cash a company generates through it’s normal business operations and subtracts it by the cash it uses to invest in physical assets. FCF can be used for any type of business and really helps us understand whether a company is generating enough cash to continue its business. It also helps us understand whether companies that need to invest in new equipment are doing so, in order to stay competitive.
When we use FCF in our DCF model, we are actually discounting the future cash flows, not earnings, of a company while evaluating its cash generating ability in order to find a price we would be willing to pay for those cash flows. It only seems logical to me to use the cash flow statement in a model that calculates the present value of cash flows.