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Cash Flow Valuation

The valuation of a stock includes the application of many criteria. One of them most often used by investors is cash flow. The cash flow of a company is used to determine its growth progress, if there is such, after the necessary accounting conventions are made.

Cash Flow Definition

Cash flow represents the money a company brings in and applies for the purpose of its activities. This money is for a fixed accounting period, such as a quarter or a year and represents money after all fixed expenditures are deducted.

As a result the term most often used in association with this money is EBITDA, which stands for Earnings before Interest, Taxes, Depreciation and Amortization.

Cash flow gives investors an idea on the real activities of a company.

The deducted interest, taxes, depreciation and amortization distort in one way or another the positive or negative cash flow generated by the activities of the company.

Interest, taxes, depreciation and amortization represent accounting conventions that are used for the purpose of reducing income in order to alleviate the tax burden. They have nothing to do with activities of the company.

Interest can distort a company's operating performance since it is deducted from the income. However, the debt is repaid annually, which leads to different amounts of interest each year.

Taxes can distort a company's operating performance since it is deducted from the income. Additionally, there are very often changes in the tax legislation, which leads to different amounts paid each year.

Depreciation represents the right of companies under the tax legislation to deduct a part of the value of an asset. These deductions should be made over a specified time period and should be in fixed amounts. The schedule that the company should follow has to coincide with the life span of the asset that is being depreciated. For example, company ABC has purchased a machine with a five-year useful life. Therefore, the company can deduct each year one-fifth of the machine's value annually. This is done in order to match the expenses that are incurred with the use of the machine and the income it makes over the five-year time period.

Amortization includes the same concepts as depreciation, but it refers to intangibles. An example of the latter is the goodwill that is gained from the acquisition of a company. The excess that is paid by the company over the shareholder equity represents the goodwill. This cost is what the company can amortize.

Depreciation and amortization are non-cash items. This means that they are expenses that are existent only on paper. They don't involve the payment of cash. However, the amount of the net income of the company is reduced on the book.

Therefore, companies that make large investments in real estate and equipment may show low levels of earnings, since they take advantage of depreciation and amortization. However, such companies may generate high levels of cash flows.

Cash Flow Application

When you use cash flow for company comparison, the companies under consideration should be from one and the same industry or sector.

Finally, cash flow should be part of your company analysis since it eliminates one-time expenses and non-cash charges. Additionally, cash flow is directed toward the actual activities of the company.

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