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Robert

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Valuation Model

Hi there

Why do we use free cash flow for valuation model and not earnings? Why is there no "discounted earnings model" as this is technically the metric that investors would be interested in... Thanks!

Hi there

Why do we use free cash flow for valuation model and not earnings? Why is there no "discounted earnings model" as this is technically the metric that investors would be interested in... Thanks!

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Hi Anonymous,

Agreeing to the existing answers, I would like to add 1 aspect concerning earnings more specificially.

Since I am regularly working especially with CFOs, I can tell you from first-hand experience that it's each new time surprising again on how much you can alter the picture of your statutory financial accounting (="earnings") into either a positive or negative way. So IFRS/IAS accounting really allows a lot of flexibility in how you depict your financials...

Hope that helps as an additional input on your question!

Robert

Hi Anonymous,

Agreeing to the existing answers, I would like to add 1 aspect concerning earnings more specificially.

Since I am regularly working especially with CFOs, I can tell you from first-hand experience that it's each new time surprising again on how much you can alter the picture of your statutory financial accounting (="earnings") into either a positive or negative way. So IFRS/IAS accounting really allows a lot of flexibility in how you depict your financials...

Hope that helps as an additional input on your question!

Robert

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When valuing a company or an asset you are most interested in the return on any investment. What is this 'return' you care about? What you care about is the cash you get back vs the cash you put in.

EBITDA or earnings does not account for many essential expenses such as interest payments. So to give one example - a highly leveraged company can have both a high EBITDA and low cash flow making it not so desirable as an investment.

Three additional reasons

1. Earnings cannot be used as a measure if you have no revenue (think of biotech firms)

2. FCF is a lot more granular than earnings and allows you to parse apart the various income and expense flows better

3. FCF is an intrinsic valuation - you don't need comparables only need to look at your company in isolation to value it

Hope that helps,
Udayan

When valuing a company or an asset you are most interested in the return on any investment. What is this 'return' you care about? What you care about is the cash you get back vs the cash you put in.

EBITDA or earnings does not account for many essential expenses such as interest payments. So to give one example - a highly leveraged company can have both a high EBITDA and low cash flow making it not so desirable as an investment.

Three additional reasons

1. Earnings cannot be used as a measure if you have no revenue (think of biotech firms)

2. FCF is a lot more granular than earnings and allows you to parse apart the various income and expense flows better

3. FCF is an intrinsic valuation - you don't need comparables only need to look at your company in isolation to value it

Hope that helps,
Udayan

(edited)

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Hi,

Even though enterprises have a purpose in this world to generate profits (or earnings), for an investor the value is determined fundamentally by hard cash released, rather than "paper profits".

Think of investors as very pragmatic people that only care about realist measures; earnings can be thought of a theoretical figure to reflect economic value created, under a commonly agreed accounting framework.

Despite the 2 metrics being tied, you can be profitable without having cash flows (e.g. too much CapEx to grow the business or too much cash tied in receivables) and vice-versa.

Hope it helps!

Best, Francisco

Hi,

Even though enterprises have a purpose in this world to generate profits (or earnings), for an investor the value is determined fundamentally by hard cash released, rather than "paper profits".

Think of investors as very pragmatic people that only care about realist measures; earnings can be thought of a theoretical figure to reflect economic value created, under a commonly agreed accounting framework.

Despite the 2 metrics being tied, you can be profitable without having cash flows (e.g. too much CapEx to grow the business or too much cash tied in receivables) and vice-versa.

Hope it helps!

Best, Francisco

(edited)

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Hello,

I agree with Francesco, you can use both. In addition to all the reasons mentioned by him, DCF is also an easier model to be applied in your cases. Bear in mind that you will have only a paper and a pen to run your analysis, most of the time without real financial reports. That's why most of the times you won't be asked to tak into consideration even the depreciation of the money.

Best,
Luca

Hello,

I agree with Francesco, you can use both. In addition to all the reasons mentioned by him, DCF is also an easier model to be applied in your cases. Bear in mind that you will have only a paper and a pen to run your analysis, most of the time without real financial reports. That's why most of the times you won't be asked to tak into consideration even the depreciation of the money.

Best,
Luca

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Hi there,

first of all, you can definitely use earnings for valuation purposes – that’s what you do when you use a multiple method (eg P/E ratio or EV/EBITDA).

In terms of why you have to use free cash flow when you do a DCF (which is only one of the possible valuation methods), that’s for a very simple reason: according to the DCF valuation model, a company is worth today all the money it will generate through its life, discounting for the time period.

Since earnings include elements such as depreciation which are not real use of money, but simply used for accounting purposes, they are not used because they would not really represent the money generated by the company. In other words, if you use earnings, you would change the previous valuation definition.

Why then the DCF valuation method is based on free cash flow? Because it is an easier way for an investor to define the value of an investment. As an investor, you put cash today in the company, and you want to understand how much in terms of cash the company will generate in the future. Thus this helps to compare apples with apples.

As mentioned at the beginning, though, you can definitely use earnings as well for valuation purposes, if you use a multiple method.

Best,

Francesco

Hi there,

first of all, you can definitely use earnings for valuation purposes – that’s what you do when you use a multiple method (eg P/E ratio or EV/EBITDA).

In terms of why you have to use free cash flow when you do a DCF (which is only one of the possible valuation methods), that’s for a very simple reason: according to the DCF valuation model, a company is worth today all the money it will generate through its life, discounting for the time period.

Since earnings include elements such as depreciation which are not real use of money, but simply used for accounting purposes, they are not used because they would not really represent the money generated by the company. In other words, if you use earnings, you would change the previous valuation definition.

Why then the DCF valuation method is based on free cash flow? Because it is an easier way for an investor to define the value of an investment. As an investor, you put cash today in the company, and you want to understand how much in terms of cash the company will generate in the future. Thus this helps to compare apples with apples.

As mentioned at the beginning, though, you can definitely use earnings as well for valuation purposes, if you use a multiple method.

Best,

Francesco

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Very simply put: because cash is king :D nobody is interested in your earnings if all that cash is tied (e.g. depreciation) and you cannot use it.

Very simply put: because cash is king :D nobody is interested in your earnings if all that cash is tied (e.g. depreciation) and you cannot use it.