Calculating Free Cash Flow to the Firm: Method #2: Cash Flow From Operations
February 12, 2025
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The whole objective of equity valuation is to find mispriced securities. Investors can make abnormal profits when they find securities which are lower than their intrinsic worth trading in the market. However, the concept of mispricing and intrinsic value is misunderstood to say the least. What the average person considers as mispricing is at best a narrower concept, an estimation of what mispricing truly is. In this article, we will explore in detail the concept of mispricing.
The average person considered mispricing to be a two layered concept. This means that they believe that there is a given market price and then there is the intrinsic worth of the security i.e. the two layers. They believe that the true intrinsic worth of the security can be calculated with precision and mispriced securities can be discovered.
However, this is not the truth. Since the whole subject of valuation is an imperfect science, the true intrinsic worth of a security can never be found out for sure. At best, we can get approximations. Human error will always be present. A better analyst may provide a more accurate estimate of the intrinsic worth of the security. However, it will still be an estimate and not the intrinsic worth itself.
Hence, finding mispriced securities is about understanding the three layers i.e. the quoted market price, the estimate of intrinsic value and the intrinsic value itself. Hence, there will actually be two gaps which need to be taken into consideration before making an investment decision.
Since there are three layers present and the difference between any two layers forms a gap, there will be two gaps present. The details regarding these gaps are as follows:
Now, since we are aware that there are actually two types of gaps present, we must understand how professional investors mitigate the risks arising from these gaps. The usual mitigation plans are as follows:
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