Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
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Throughout finance, one rule always holds true. The general belief is that the value of any asset or security is exactly equal to the discounted present value of all the cash flows that can be derived from it in future periods.
Using this principle, one can easily value securities like debt. This is because they have a finite existence. The cash flows derived from them can be easily predicted. However, equity valuation is not so simple. Equity represents a partnership in the business. As such, it represents an attempt to value cash flows which are uncertain and unpredictable.
In this article, we will try to understand the concept of equity valuation in more detail.
In finance, valuation is a process of determining the fair market value of an asset. Equity valuation therefore refers to the process of determining the fair market value of equity securities.
The whole system of stock markets is based upon the idea of equity valuation. The stock markets have a wide variety of stocks on offer, whose perceived market value changed every minute because of the change in information that the market receives on a real time basis.
Equity valuation therefore is the backbone of the modern financial system. It enables companies with sound business models to command a premium in the market. On the other hand, it ensures that companies whose fundamentals are weak witness a drop in their valuation. The art and science of equity valuation therefore enables the modern economic system to efficiently allocate scare capital resources amongst various market participants.
As discussed, on a micro level, equity valuation is beneficial for the entire stock market ecosystem. However, how does it benefit an individual to study and apply the principles of equity valuation?
Well, markets receive information every moment and make an attempt to factor the financial effect of this information in the stock price. Individual estimates of the effect vary and as such different people may come up with different stock prices. Therefore, there can be a difference between the market value of a company and what investors call its true or “intrinsic value”
Investors, stand to gain a lot of money if they are able to correctly identify this difference. The second richest person in the world, Warren Buffett has made his fortune correcting and applying the art of equity valuation. In fact, the theory of equity valuation has been heavily influenced by the work of Warren Buffett and his mentor.
Equity valuation is followed differently by different individuals. As such, there is no set pre-defined standard process. Instead, equity valuation consists of 4 or 5 broad categories of steps that need to be followed. The procedures maybe different but the objectives are always the same. Every person conducting equity valuation, must in one way or another account for these parameters:
The process of equity valuation is thus long, subjective and difficult to understand. However, for those who do master this art, the rewards are enormous.
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