Trying Free Cash Flows to Market Valuations

Trying Free Cash Flows to Market Valuations
“In a companion piece to his article in the last issue*, Robert Howell turns his attention to the importance of free cash flow in determining valuations”
1. Introduction
Financial statement overhaul traditional format need major design à useful for meaningful financial analysis, decision-making, and value creation.
“Financial statement needs to put more emphasis on the free cash flow that a business generates”

2. Relating Free Cash Flows to Market Values
A firm’s market value reflects the collective judgment of the shareholder expectation in the future cash flow. If the expectation cash flow constantà Market value constant, is the expectation cash floe is betterà Market value should be raise, if the expectation cash flow is turn downà Market value is erode
“Management should regularly undertake those process to their own firm; Invertors should do the same to each infestation “
“ it is possible to directly relate a business’s free cash flow to its market value, financial statement should make this connection easy (today do not)

3. Managing for Free Cash Flows and Shareholder Value Creation
Management fundamental responsibleà increase shareholder valueà by increasing the NPV of the future system of cash flow.
There are there ways:
Increase cash earning by growing the business]
Reduce investment (managing working capital and fixed and other assets more tightly)
Financial management has two element
Managing the mix of capital to minimize the firm’s WACC
Using fee cash flow, or free cash flow after interest payment and debt service, to increase company future value.
“The ultimate financial management challenge is to use free cash flows to invest in new business opportunities that build shareholder value”

4. Xerox Corp. Profits vs. Cash Flows
This is example of how potentially misleading accounting profits can be…
Early 1999, stated that year 1998 is an excellent year à stock price climbing from $42 to $64
Throughout 1999, Xerox reported bad news “softness in its significant Brazilian market, a profit warning for the third quarter that stunned Wall Street, then another warning and large earning shortfall for the fourth quarter. à year end the stock price $20
May 2000 à the stock price fall to $5
“basically Xerox did was attribute more its leasing transaction to current (e.g., ’98 and ’99) revenues and profits than its should have” –because the added revenues booked only increased its receivable ad had no beneficial effect on cash flow --
5. Metrics to Monitor Free Cash Flows and Value Creation
Traditional financial statement analisis just focused on measures of “profitability” and “risk”.
Profitability fuccused à ROA and ROE
Risk measures à Liquidity and Solvency
“ROA often overstated, ROE also in most cases the resulting calculation is over stated”
ROA suffers for two account:
It fails to recognize the flow characteristics of working capital
Having fewer resources tied up in working capital is better in that it reduces the amount of cash required to support growth and improves ROIC
“Solvency measures are the times-interest earned ratio and various debt-to-capital ratios”
“if the company lax\ck adequate free cash flow to cover its debt service, it is insolvent, regardless of what ratios say”


6. Summary
Free cash flow has to be the focus of major financial statement overhaul and may be directly related to current market valuations to determine if the current free cash flows support current market values