| | | Even then, why discount cash flows and not earnings - after all, Buffett says earnings. And Buffett's idea was inspired by a dividend discount model. So, why not dividends?
The truth is that everyone is somewhat right on this matter when looking at the long term, as the cumulative earnings, free cash flows, and net distributions ultimately converge in the long run. Whether we discount profits, free cash flows, or net distributions, we find a kind of equality among the formulas. The only difference between these measures is a matter of timing, and this is what this theory provides as a tool: depending on the type of situation a company is in, one measure may be slightly more relevant than another, or, in other words, offer more ease in future projection and evaluation.
A company that will be dissolved in the next 2 or 3 years can be well assessed using all three measures, even though estimated profits can provide an idea of what will be recovered in cash and potentially distributed to shareholders. A mature company with relatively stable growth can be evaluated based on either an accrual or cash basis, assuming it doesn't yet pay out a significant dividend, for instance. On the other hand, a growing company may record negative free cash flows for several years, which forces an analyst to look far into the future to make an assessment. In fact, they should project until the point they believe the company will generate positive free cash flows to calculate a future continuing value that will represent more than 100% of the present value of the cash flows.
It goes without saying that this projection far into the future is speculative, more so than a value calculated using accrual accounting, as the latter recognizes the operations and events in the period during which the operations were conducted and the events occurred. More value can be captured in a closer horizon than with the cash flows.
There are some ideas circulating that using cash flows is a better approach because it is impossible to manipulate cash, whereas accrual accounting relies on estimates. As a result, analysts should not place full confidence in these figures. On the other hand, some may admit that cash accounting serves as a measure of investment and disinvestment. For example, a company can reduce its investments and increase its free cash flows, which might be a sign that the management is uncertain about where to further invest, potentially indicating slower growth in future profits. The reality is that financial statements are prepared by accountants with the intention to be analyzed together, as they are all interconnected. Focusing solely on one while ignoring the others is akin to reading just one chapter of a book, making it challenging to comprehend the complete story.
Hope it helps a little.
Good investing,
Will |
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