Valuation Guru Aswath Damodaran says a single year’s free cash flow (to equity or the firm) actually has more noise in it, and is less informative about a company’s operating health than a single year’s earnings.
In his latest blog on October 25, Damodaran said it pains him, as a cash flow advocate, to say “if your game is pricing stocks, I see little benefit from replacing traditional multiples (like PE and EV to Ebitda) with free cash flow-scaled pricing measures.”
Damodaran said the logic that analysts use for the use of free cash flows is simple and seems compelling.
It is: If the value of a business is the present value of its expected cash flows, it seems reasonable to also argue that free cash flow that a business generates is a better measure of its value than the accounting earnings.
“In sum, there is nothing inherently better about using free cash flows instead of earnings in a pricing setting, and you can argue that the additional volatility and loss of perspective that comes with free cash flow numbers yields worse pricing,” he said.
That said, Damodaran believes cash flow will never be widely used as a basis for pricing, than for intrinsic valuation.
“First, the reason that investors like to price companies, using multiples, is because they have frames of reference on these multiples, i.e., a sense of what a typical number should like in a sector. With PE ratios, their long history of usage has left investors with frames of reference that they can use, rightfully or wrongfully, in pricing stocks, but with Price to FCFE ratios, there is no such reference frame,” he said.
Besides, given how free cash flow to equity (FCFE) is computed, with the netting out of reinvestment and incorporating debt cash flows, it will always be a more volatile number than earnings, with much of the additional volatility telling little about the current earnings power, Damodaran said.
The good news, Damodaran said, is that the distribution for price to FCFE resembles the distribution for PE ratios. The bad news: An investor is replacing a multiple where he lose almost half the firms in the sample, with PE ratios. Price to FCFE is even more flawed multiple, in which one cannot calculate more than 63 per cent of publicly traded companies, he said.
“Put simply, if you start with a peer group of 25 firms, you may end up with a final sample of 10 firms or less, if you are pricing with a price to FCFE multiple. Moreover, price to FCFE ratios show more divergence than PE ratios,” he said.
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