CASH BASED VALUATION TECHNIQUES
By Robert E Katz, MComm CA (SA)
he ascendancy of shareholders in most developed countries
has led more and more managers to focus on value creation
as the most important metric of corporate performance. Both
earnings and cash flow valuation techniques are widely used
in practice. Whilst neither method is so flawed that they
cannot be relied upon, over time it has come to be recognised
that cash flow valuation techniques result in more accurate
and reliable results than earnings based techniques. Only
in very rare situations can earnings be deemed a surrogate
for cash, therefore the question of which technique to use
will usually apply. The key to effective valuation remains
unchanged: choosing the right methods for estimating critical
variables and understanding the real nature of value creation.
Discounted cash flow, Free cash flow, Predicting future
income, Adjusting for risk, Cost of equity,Value, Price
Earnings, Multiple, Operating cycles, Credibility &
“There is nothing so dangerous as
the pursuit of a rational investment policy in an irrational
world”. John Maynard Keynes.
In general, there are two approaches to
valuation. The first, being discounted cashflow valuation,
relates the value of an asset to the present value of expected
future cashflows generated by that asset. The second, the
capitalised earnings approach, is where a stream of maintainable
earnings is capitalised at a price/earnings multiple to
arrive at equity value. In theory, both methods are capable
of producing the same estimates of intrinsic value, but
in actuality, there can be significant differences in outcomes,
depending upon which method is adopted (Francis, Olsson
& Oswald, 2000:7).
Both earnings and cash flow valuation techniques
are widely used in practice. Whilst neither method is so
flawed that they cannot be relied upon, over time it has
come to be recognised that cash flow valuation techniques
result in more accurate and reliable results than earnings
It is useful to acknowledge from the outset
that valuation is an imprecise science. All valuations,
be they cash or earnings based, involve an educated guess
whereby analysts peer into an uncertain future and attempt
to predict what a company might be worth (Lee, 2003:4).
The purpose of this essay is to investigate
both earnings and cash flow valuation techniques so as to
Both earnings and cash flow valuation techniques
involve two fundamental tasks:
These basic observations on value imply
that valuations are forward looking i.e. they look to future
income flows, only using past income flows as a means of
corroborating the forecasts.
It is now recognised that the most relevant
form of income to be predicted is the entity’s ability
to generate cash, in particular ‘marginal free cash’
Adjusting for risk requires an assessment
to be made of the market price of risk i.e. the compensation
required by investors for taking on the risk, rather than
investing in risk free investments. The Capital Asset Pricing
Model (hereafter CAPM), which calculates the cost of equity,
is most commonly used for making this assessment for discounted
cashflow (hereafter DCF) valuations. Although CAPM is potentially
flawed, no universally acceptable technique has emerged
to replace it (Black, Wright & Bachman, 1998:29-32).
3. CASH BASED
3.1 The free cash flow method
A company’s value is driven by its ability to generate
cash flow over the long term. Furthermore, a company’s
cash-flow generating ability (and hence its value creation
ability) is driven by long-term growth and returns that
the company earns on invested capital relative to its cost
of capital (Copeland, Koller & Murrin, 2000:131).
Free Cash Flow (hereafter FCF) is the net
cash generated from operations after taking into account
the cash reinvested to fund future growth. It is the primary
source of cash available to repay the suppliers of debt
and equity and to compensate them for risk, and thus it
is the key component of value creation (Copeland,et al.
The present value of the expected free
cash flows from the asset results in the value of that asset.
The discount rate when discounting cash flows is always
the cost of capital, which is the weighted average of cost
of equity and cost of debt, using target market weightings
(Brealey & Meyers, 2003:531).
The FCF method encourages a move from an
accounting basis of evaluating an entity’s performance
to a more economic one. Management time and effort can be
focused on the four actions that create value:
of the Free Cash Flow Methodology
A number of adaptations of the basic FCF
methodology theme have been developed. These models feature
similar advantages and limitations. The main advantage is
that they are conceptually sound and can be applied to most
companies. The disadvantage is that they require explicit
forecasting of future cash flows and discount rates (Lee,
2003:5). Some of these variations are:
The CVA approach was popularised by Professors
Eric Ottosson and Fredrik Weissenrieder of the Department
of Economics, Gothenburg University, Sweden. Ottoson &
Weissenrieder (1996) describe the approach as one which
makes a distinction between the uses to which cash is put,
being either strategic or non-strategic. The authors believe
that a focus on strategic investments will give managers
a better chance to form the future of their companies.
3.4.1 Nominal versus Real Valuation
One of the first decisions in DCF analysis, especially for
valuations of companies outside the United States, is the
basic decision of whether to do valuations in nominal or
in real terms. In theory, using nominal cash flows and nominal
discount rates will produce the same value, but when inflation
rises above 10 percent, DCF valuations start falling apart
in nominal terms because they become extraordinarily sensitive
to small changes in assumptions. The solution is to use
real valuation or perform the valuation in a more stable
currency, for example the US Dollar (Damodaran, 2000:5).
A company’s value has two separate
components. The first is the PV of future cash flows during
an explicit forecast period, and the second is the PV of
future cash flows beyond the explicit forecast period. This
second component is called the company’s terminal,
or continuing value.
The relative importance that a company’s
terminal value assumes in a company’s total value
is largely determined by the length of the forecast period
contained in the DCF model. The forecast period is dependent
on the forecast risk inherent to the industry. Recently,
in an 8 year forecast period for a typical company in the
tobacco industry, the continuing value typically represented
56 percent of the total value of the company; for sporting
goods, the continuing value represented 81 percent. For
a typical high-technology company, continuing value typically
represented 125 percent of total value, which means that
the PV of the FCF for the first 8 years of the company’s
life would have been negative. All the value of the company
would derive from the expected cash flow beyond the first
8 years (Lee, 2003:5).
for Risk – The Cost of Equity:
Estimating cost of equity requires three
inputs: the risk-free rate, the equity risk premium, and
beta. For the risk-free rate, the common practice is to
use short-term government security rates. For setting a
risk premium, the standard practice is to use a historical
risk premium. For beta, the most common approach is to regress
stock returns against market returns. Unfortunately, all
three of these practices can provide misleading answers.
Short-term government security rates
Since investors are looking ahead, they
want to know what the ‘risk-free’ rate is over
the length of time used for the forecasted cash flows.
For an investment to be risk free, the
exact return over the life of the investment must be known.
A 6 month treasury bill would not be risk free for the purposes
of considering an 8 year cash flow. It would not be risk
free because the investor would have to reinvest it at the
end of each 6 months period at a currently unknown rate.
In this case the appropriate risk free rate would be an
8 year zero coupon government bond rate (Damodaran, 2000:5).
Many people, who use the CAPM to come up
with the cost of equity, prefer to use historical premiums.
They use historical data on share and bond returns over
a past period; determine the average return made on shares
and on a risk free asset over the period, and take the difference,
which is the historical risk premium.
How the historical risk premium is computed
matters. The result depends on several factors: what historical
period is used and what type of investment is defined as
the risk-free rate.
Historically, using as long a time period
as possible is desirable, which is a little counterintuitive.
Since the market risk premium is a random variable, a longer
time frame (which encompasses a stock market crash, expansions,
recessions, two world wars and stagflation) is a better
estimate of the future than a short, more recent time frame
(Copeland, et al. 2000:217).
A different way of thinking about the risk
premium is to estimate an implied equity premium, i.e. letting
the market decide what the premium is. If analysts have
ready access to the following:
The current level of the ALSI;
The expected dividends next year for
the entire index;
The expected growth rate in earnings
and dividends over the next five years; and
If the growth rate is expected to be stable,
the value of the share can be written as the basic Gordon
The only unknown in the above equation
is the required rate of return. The required rate of return
is the implied cost of equity. One of the advantages of
the implied equity premium is that it can be estimated for
any market in the world. Historical data is not needed (Damodaran,
Beta measures the risk of a share relative
to a diversified portfolio. Most services estimate betas
for emerging market companies using the local index. These
betas mean very little if the shares are to be included
in a portfolio that includes non-local shares. To be meaningful,
the beta of these companies ought to be estimated not against
a local index but against a global index.
An even more troubling problem with beta
is that the betas for emerging markets can be completely
The largest and safest companies could
look riskiest; the smallest and riskiest companies could
look safest. This phenomenon is caused by index domination.
The weighted average beta for all shares is one. In Brazil
for example, Telebras (Telecomunicacoes Brasileiras) which
comprises 50% of the Bovespa share index, recently had a
beta of 1.11.In the index, eight other shares had betas
greater than one and 169 had betas below one.
Some of the solutions to the regression
beta problem are:
Choosing a more relevant index e.g.
The S&P 500;
Using a measure called the ‘relative
standard deviation’, whereby each company’s
standard deviation of share prices is divided by the market
average. A number for relative volatility that looks very
much like a beta is produced; and
Estimating beta from the bottom up
i.e. taking a weighted average of unlevered betas from
other similar companies and levering up using the company’s
debt to equity ratio. This approach offers greater precision
by substituting the average beta for the sector in which
the company operates for the regression beta (Damodaran,
Because accurately estimating the company’s
cash flows and choosing the appropriate discount rate is
difficult, DCF analysis is often abandoned in favour of
valuation by multiples. Valuation by multiples entails calculating
particular multiples for a set of benchmark companies and
then finding the implied value of the company of interest
based on the benchmark multiples. Although many studies
incorporate this approach, no multiple is uniformly accepted
as the one on which to base valuation (Lie & Lie, 2002:44/45).
Earnings valuation approaches capitalise
a maintainable earnings stream at a multiple so as to arrive
at an equity value. Earnings valuations techniques include
market multiples such as Price Earnings, Forecasted Price
Earnings, Enterprise Value over Sales, Enterprise Value
over EBITDA and Enterprise Value over EBIT (Lie & Lie,
The most popular earnings based valuation technique is the
Price Earnings Multiple or P/E Ratio. The P/E ratio approach
assumes that the company will be worth some multiple of
it future earnings in the continuing period (Copeland, et
The P/E multiple is driven largely by the
cost of capital and the growth rate of earnings. Holding
the cost of capital constant, the P/E ratio is primarily
a function of the expected growth rate in earnings. High
P/E companies are expected to grow their earnings quickly
relative to today’s earnings (Lee, 2003:9).
In its relative form, where firms are ranked
on the basis of the ratio of P/E ratio to expected growth,
the rankings will provide a measure of relative value, if:
The length of the high-growth period
is the same for all firms; and
All firms are of equivalent risk (Sharpe,
If these assumptions are not fulfilled,
a direct comparison of the ratio of P/E to expected growth
may not be justified because a higher risk firm should be
expected to have a lower P/E ratio than another firm with
the same expected growth rate but much less risk. Similarly,
the P/E ratio for a firm where high growth is expected to
last 5 years will be lower than the P/E ratio for a firm
where the same high growth is expected to last 10 years.
There are a number of reasons why the P/E ratio is used
so widely in valuation:
It is simple to compute for most shares
and is widely available, making comparisons across shares
It is an intuitively appealing statistic
that relates the price paid to current earnings.
The multiple is simple to apply as
a valuation tool; and
It can be a proxy for a number of
other characteristics of the firm including risk and growth
to be Used
Merrill Lynch & Company views the hierarchy
of earnings as being shaped like a pyramid. From the top,
sales tends to be more stable than earnings before interest,
taxes, depreciation and amortisation (EBITDA); EBITDA tends
to be more stable than earnings before interest and taxes
(EBIT); EBIT tends to be more stable than cash flow; cash
flow tends to be more stable than operating earnings per
share (hereafter EPS); and operating EPS tends to more stable
than reported EPS. As one comes down the income statement,
earnings become more variable and unpredictable. Analysts
should focus on the bottom of this pyramid i.e. reported
EPS and look for signs of variability, even though the company
would want analysts to focus on the top of the pyramid.
Analysts should look at the variability of earnings, and
variability is masked as one moves up the income statement
because the trend as one moves up is toward greater stability.
The cyclicality of earnings is not nearly as important as
the variability of earnings (Bernstein, 2002:51,53).
The “Quality of earnings” directly
affects the valuation of a company and the accounting treatment
associated with inter alia revenue and costs recognition
directly affects the quality of earnings. Therefore to avoid
accounting discrepancies under current GAAP, analysts must
carefully examine the accounting choices a company makes
when constructing its financial statements and assess the
effect of those choices on its reported earnings quality
The definition of a “comparable”
firm is essentially a subjective one. The use of other firms
in the industry as the control group is often not a solution
because firms within the same industry can have very different
business mixes, risk and growth profiles. There is also
plenty of potential for bias. To the extent that companies
operate in several industries, the high subjectivity involved
in choosing comparable companies could render this method
impractical (Damodaran, 1996:304).
When markets make systematic errors in
valuing entire sectors, using the average P/E ratio of these
shares will build that error into the valuation (Damodaran,
Alford (Lie & Lie, 2002:47) studied
the effects of the choice of comparable companies on valuation
accuracy when the P/E multiple is used and found that comparable
companies chosen on the basis of industry yielded the smallest
estimation of error when valuing companies by use of the
with High Intangible Value
Companies with a large part of their value
in intangible assets, such as high-technology companies
and companies with substantial research and development
activities, may be particularly hard to value because a
large portion of their value derives from uncertain future
growth opportunities. A further complication with such companies
is that their high research and development expenses reduce
current earnings and in such a case, current earnings may
be a bad predictor of value.
Dot-com companies are typical examples
of the above as most of their value is tied to their potential
to become major players in the future. Multiples are not
suited for valuing these companies and analysts should resort
to valuing the vast real options embedded in these companies’
assets (Lie & Lie, 2002:51/52).
Graham (1995:209) concluded that a large
part of the discrepancies between carefully calculated formula
values and their market prices can be traced to the growth
factor, not because formulae underplay its importance, but
rather because the market often has concepts of future earnings
changes which cannot be derived from the companies past
4.3.6 Comparisons of P/E Ratios
Comparisons are often made between P/E ratios in different
countries with the intention of finding undervalued and
overvalued markets. It is clearly misleading in these cases
to compare P/E ratios across different markets without adjusting
for differences in the underlying variables such as interest
rate differentials and expected growth (Damodaran, 1996:299).
P/E ratios are not meaningful when the EPS are negative.
While this can be partially overcome by using normalised
or average EPS, the problem cannot be eliminated entirely
PREDICTIONS OF CASH FLOWS
Earnings and cash flows, though related, measure fundamentally
different things. Cash flow measures inflows and outflows
within a time period, regardless of the state of the operating
cycle. Earnings measure inflows and outflows from operating
cycles that the company has completed within a time period,
regardless of when the cash flows occur.
Predicting the future from the past is
always a risky thing. In the case where the company is neither
growing nor shrinking the scale of its operations, cash
flow and earnings reflect the same results. When the company
is scaling up or down, earnings reflect the operating cycle
that the company may replicate in future, while cash flows
mix this operating information with information about investment
and divestment (O’ Brian, n.d. :).
Some of the pitfalls of using earnings to predict future
cash flows are:
The company may not replicate its current
business activity in the future. It may change strategic
direction, pursuing new or different product markets;
Accounting numbers in most major economies
are not adjusted for the effects of inflation. For short
operating cycles in low-inflation economies, the time
lags for most revenue and costs are not substantial, and
therefore inflation creates only minor distortions; and
Earnings involve a great deal of judgment.
Judgment enters for example in defining when operating
cycles are complete and in identifying costs with sales
(O’ Brian, n.d. :).
Cash flows are more credible than earnings because they
involve less judgement. They are, on the other hand, less
relevant than earnings in measuring replicable operating
performance. This leaves us with the classic accounting
conundrum: we want both relevance and reliability, but no
single number provides both.
The best number for forecasting future
cash flows is the one that credibly conveys the results
of replicable operating cycles. Earnings measure the results
of operating cycles, but involve judgement, which reduces
their credibility. Cash flows involve less judgment, but
do not measure the results of operating cycles (O’
Brian, n.d. :).
The P/E ratio and other earnings multiples,
which are widely used in valuation, have the potential to
be materially misused. This method, whilst not fundamentally
flawed that it cannot be relied upon, has major shortcomings.
A failure to adjust for differences in the fundamentals
can lead to erroneous conclusions based purely upon a direct
comparison of multiples (Damodaran, 1996:315).
Rarely will earnings and cash flow depict
the same result. It is in these cases only that earnings
can be deemed a surrogate for cash, and earnings based valuation
techniques can be used in conjunction with cash based techniques
so as to cross correlate results. In all other cases, the
DCF method is superior to earnings based methodologies.
The value of a company is a function of
the company’s cash flows, its expected growth, the
length of the growth period and the cost of capital. Naïve
attention to accounting earnings will often lead to value
destroying decisions. Investors, who use the DCF approach
to valuation, focusing on increasing long-term cash flow,
ultimately will be rewarded by higher share prices (Copeland,
et al. 2000:87).
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