Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 16

CASH FLOW ANALYSIS AND EQUITY VALUATIONa

James A. Ohlson

Cash flow analysis is not the right approach to all valuation exercises, but a focus on cash flow does sharpen many aspects of equity valuation. Using cash flow avoids measurement problems encountered in using an earnings-based valuation approach, and the process of valuing a stock can readily be structured around the concept of free cash flow.

Cash flow analysis may be generally viewed as an extension of the dividend discount model framework with cash flow measures substituted for dividend measures. In truth, cash flow analysis has probably been oversold and is not the one right approach to all valuation exercises. The focus on cash flow analysis, however, does sharpen many aspects of equity valuation, and investors and analysts should have a basic understanding of the insights provided by an emphasis on cash flows.

This chapter sets forth a general approach to free cash flow (FCF) analysis, including the justification for using cash flow analysis and some of the practical issues and limitations concerning its application. The chapter also discusses the problems involved in using an earnings-based valuation approach and provides an explanation and example of how to use FCF analysis for stock valuation.