Cash Flow is the Bedrock of Equity Valuation
Cash Flow is the Bedrock of Equity Valuation. Equity is the ownership interest in a company. Equity value is the value of a company available to owners through shareholder’s equity, stock or security, assets (like property but excluding liabilities), etc. It includes the enterprise value (an economic value which represents the market value of a business) and all cash and cash equivalents, short and long-term investments, short-term and long-term debts and minority interests, the value of unexercised stock options and securities convertible to equity. Equity valuations are conducted to measure the value of a company given its current assets and position in the market. They are valuable for shareholders and prospective investors who want to know the performance of the company, and what to expect with their stocks or investments in the near future.
Valuation methods based on the equity of a company typically include a thorough analysis of cash accounts, as well as a forecast or projection of future dividends, future earnings (revenue) and the distribution of dividends. ‘Discounted Cash Flow (DCF) Model’ and ‘Cost and Comparable Approach’ are the most popular Equity Valuation models. The concept of cash flow is the basis of all methods of equity valuation. ‘Liquidated and unliquidated assets’ being the keywords here, let’s understand why and how cash flow becomes the bedrock of equity valuation. CHILD LABOUR LAWS IN INDIA
‘Cashflow’, in simple words, is the incoming and outgoing of liquidated assets in a company within the parameters of a time frame. Financing, investments inflow and operations result in cash inflow, while expenses and investments outflow, etc result in cash outflow. Let’s make an attempt to understand how a company attains liquidated assets with the help of a structural example:
Company ‘X’ from April 2014 to March 2015, given Rs. 1crore by Financer ‘Bank B’, Investor ‘Mr. I’ invests Rs. 1crore, Shareholders ‘S1’ and ‘S2’ buy shares worth Rs. 50 lakhs, Rs. 2 crores from Operations (sales), therefore, Total Cash Inflow = Rs. 4.5crores
Further, the same Company ‘X’ by the end of March 2015, Invests Rs. 20 lakhs in Start-up firm ‘Y’, Releases dividends and bonus shares worth Rs. 20 lakhs at year-end, spends Rs. 70 lakhs on employees (training and wages), Rs. 30 lakhs on building maintenance, Rs. 30 lakhs on advertising, Rs. 50 lakhs on taxes, hence, Total Cash Outflow = Rs. 2.2 crores.
Therefore, the Total Cash Flow = Rs. 2.3crores which is also the total liquid assets the company attained in that financial year.
Now, this is how company ‘X’ will have its equity valued holding cash flow as the bedrock-
- DCF Model – The Future Cash Flow (FCF) has to be estimated from the cash flow of the previous year which would be the operating cash flow minus the capital expenditures based on which, the company will estimate investment opportunities. Thus, each financial year’s cash flow will aid in investment. Therefore, as per the above example, Company ‘X’ can decide to invest not more than Rs. 2.3crores in the next say 5 financial years provided the estimate FCF for these 5 years remain at least Rs. 2.3crores.
- Cost and Comparable Approach – The equity values of rival companies in similar businesses is compared and opportunities arise on discrepancies found where say if undervalued, it can buy assets worth up to Rs. 2.3crores and hold them. The value of an asset is derived from the pricing of ‘comparable’ assets, standardized using a common variable such as cash flow.
‘Cash Flow’ is directly responsible for equity valuation since equity would cease to exist without cash flow. ‘Cashflow’ allows a company to accumulate cash. Not only is cash included in equity value, but it also readily helps a company buy unliquidated assets, stocks and securities, etc. It is very important for a company to have cash, unliquidated assets, stocks and securities as equity value on assets (liquidated and unliquidated) that determines the position of a company in the market (positive cash flow will help to pay off liabilities which will only increase the company’s equity value; negative cash flow will act otherwise) as mere profits are not enough to stay in the market.
“We were burning money constantly, faster than was sustainable until we became a buffalo charging off a cliff,” Knitowski recalled after in the 1990s, his first company VoViDa collapsed due to negative cash flow leading to no cash in reserve and thus, no equity value.