Cash Flow Valuation

As many legendary investors have stated, when you buy stocks, you buy a piece of a business. And as such, it's a good idea to know something about the business. For most retail investors, you can't buy power to even partially control these companies, so you're essentially buying the quality of the business as it is or will be. Someone who buys a business may see a failing company, but have big ideas on how by buying he could turn it around. Not so when investing in corporations.

No all you can do as an investor is buy and sell, make money on dividends and make money on capital appreciation. As with anything you are trading, your goal is to buy at a discount and/or sell at a premium. Since you have no idea really what the market will be buying at a premium in the future (if you did, you would not need research to make money), the only thing you can know is the current trading value of the equity and what it is truly worth. That second piece is the trick.

In valuing businesses, a very common method, perhaps even the standard method, is by looking at the cash flow. The value of the Caterpillar plant isn't what it cost to build it, as the balance sheet says, but what kind of money will accrue due to what happens at that plant in the future. Now cash flow is a lot of things and the bottom line on a cash flow statement is the change in cash which is frankly not very useful. There's operating cash flow with it's several components, investing cash flow, and financing cash flow. Generally, free cash flow is used, and this has a standard definition of operating cash flow less capex, but there are variations. Some call EBITDA cash flow, cash flow metrics are calculated using only the operating cash flow without the capex adjustment. There's free cash flow to the firm and free cash flow to the equity. Warren Buffet uses something similar he calls owner earnings.

Cash flows from the future (once you pretend to know what they'll be) must be discounted at a rate of return. Since different companies have different levels of risk, you must evalute this piece as well. This blog is meant as a brief intro to future blogs looking at varying pieces of a puzzle that combine to give my thoughts on what goes into a comapny valuation. There is no single place in the annual report to find the answers, because the only current number that really benefits you is the cash on hand, which is rarely much and usually has bondholders who would get it first anyway. Everything else gets it's value from the cash it produces in the future.