Cash Flow Statement Value

Cash flow based valuation techniques (DCF analysis): High Subjectivity

The reason value investing emphasizes the balance sheet and income statement is that to resort solely to the cash flow statement can be deceptively simple.

Cash flows alone disguise important metrics. Cash is not exactly the bottom line. True, cash flows drive value, but some portion of cash flows will be needed to reinvest in capital resources necessary to sustain business production and results.

Thus to arrive at a cash flow figure by adjusting net income for noncash expenditures is only a partial step. Step two is to further adjust that figure by probable future cash commitments to capital expenditures.

Step 1: Adjust earnings for noncash charges
Suppose a company generates net income of $1 million. Part of the expenses recorded to generate the $1 million consisted of net noncash charges of $200,000. Cash flow is thus $1.2 million. That is step one.

Step 2: Free cash flows
Then this figure must be adjusted to reflect the amount the company will need to disburse in cash to maintain its property, plant and equipment at levels sufficient to sustain business productivity. Suppose this figure is either $0.1 million or $0.3 million. Adjusted, cash flows are now either $0.9 million or $1.1 million. This is the bottom line figure, and may be called free cash flows. (Buffett calls it owner earnings to designate that these are the free flows of results allocable to the common stock.)

Too often analysts fail to take this additional step of adjusting for the probable costs of required reinvestment. It would be more accurate for these analysts simply to stick with the net income figure. After all, the noncash charges to earnings that produce the net income figures are at least, in part, intended as a proxy to estimate such required reinvestment.

In this example, the bookkeeping allocation of noncash charges of $0.2 million may be as reasonable an estimate of required cash reinvestment as the separate estimates of either $0.1 million or $0.3 million. But zeroing in on this figure is a crucial value investing exercise.

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF