Tying free cash flows to market valuation.

AuthorHowell, Robert A.

In a companion piece to his article in the last issue, Robert Howell turns his attention to the importance of free cash flows in determining valuations.

Last month, in this magazine, this author argued in Fixing Financial Statements: Financial Statement Overhaul that the traditional formats of the primary financial statements -- income statement, balance sheet, and cash flow statement -- need major redesign to again be useful for meaningful financial analysis, decision-making and value creation.

Since the fundamental objective of a business is to increase real shareholder value, this means increasing the net present value (NPV) of the future stream of cash flows. Financial statements must, therefore, put much more emphasis on the free cash flows that a business generates. A vivid example of the different impressions one can get from focusing on profits and cash flows is Xerox Corp. (see page 18). Focusing on profits could suggest Xerox is doing well; free cash flows tell another story.

Relating Free Cash Flows To Market Values

A firm's market value reflects the collective judgment of the shareholders' expectations of its future cash flows. If the company produces expected cash flows or expectations remain constant, the market value should remain constant. If cash flows, or the expectations, turn out better, market value should rise; if cash flows or the expectations for them turn down, as with Xerox, value should erode. Recasting financial statements into a much more explicit and clear free cash flow format permits one to at least relate the current period's free cash flows to the current market valuation and reach some conclusions regarding those valuations.

As a starting point, assume that a firm has positive free cash flows of $100 million, and that it will continue to produce that amount in perpetuity. A perpetuity valuation model would capitalize that annuity stream using the firm's cost of capital (assume 10 percent) as the discount rate. Free cash flow of $100 million divided by 0.10 yields an NPV of $1 billion. This $1.0 billion is equal to the "entity value" of the company, and represents the NPV for a stream of $100 million in perpetuity; in essence, it represents the most that should be paid today, to access that future stream of cash flows.

Any debt has to be subtracted from the firm's entity value to determine how much value accrues to the equity shareholders or the equity value. If debt is $200 million, the equity value is $800 million. If the market value exceeds the equity value, the market is "saying" that it expects the free cash flows of the business to improve; if the market value is less, the market expects eroding cash flows.

It is also possible to work in the opposite direction, starting with the company's current market value, adding back any debt; then calculating the rate at which current free cash flows must grow, in perpetuity, to support the current market value. If that required rate of growth is high, say in excess of 10 percent, one has to question how likely that is.

In mid-2001, even after the securities markets had fallen considerably from their early March 2000 highs, companies such as Oracle Corp., EMC Corp., Cisco Systems and Siebel Systems' free cash flows would have had to grow at 14, 18, 18 and 21 percent, respectively -- very unlikely. Since then, all of these companies' market values have dropped further, as could be expected.

Startup and high-growth may be particularly difficult to analyze. Perpetuating negative cash flows would result in a negative value, and calculating a growth rate from a negative starting cash flow to generate a positive market value is...

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