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

FCF ANALYSIS FOR STOCK VALUATION

So, having come full circle from FCF analysis and its difficulties through earnings analysis and its distortions, the idea is that FCF analysis can be used to get at a company’s value and thus its stock value. This approach should not be used to replace traditional equity valuation techniques but, rather, as a supplement: a good starting point for trying to understand a company’s current market value and possibly whether its stock is overvalued or undervalued. A simple but fairly comprehensive FCF analysis can be conducted in five discrete steps.

Estimate Current FCF

The first step is to estimate the current FCF. Many analysts think that if they want to estimate a company’s FCF, they need to look at the cash flow statements; however, the cash flow statements are not needed. The best answer to the problem of how to estimate the current FCF is to define FCF as NOPAT minus the change in the book value of invested capital:

NOPAT uses a bottom-up, rather than top-down, approach that starts with net income. Then, any adjustments for foreign currency translation need to be made to get comprehensive income. Next, any interest incurred on debt, net of interest earned on cash and marketable securities, is added; as a practical matter, this net interest can be imputed on the basis of an estimated average after-tax cost. Trying to find the net interest after ...