Why Free Cash Flow (FCF) is Preferred over Earnings in Discounted Cash Flow (DCF) Analysis
In the realm of valuation, understanding the differences between Free Cash Flow (FCF) and earnings is crucial. Both are important financial metrics, but when it comes to Discounted Cash Flow (DCF) analysis, free cash flow (FCF) is generally preferred over earnings to accurately assess a company's intrinsic value. This article explores why FCF is favored and provides insights into the underlying reasons and processes involved in DCF modeling.
The Importance of Cash Flows in Valuation
The primary reason for valuing a company or project through a DCF model is to forecast its future cash flows. Unlike earnings, which can be influenced by various non-cash factors, cash flows represent the actual inflow and outflow of cash. Therefore, when constructing a DCF model, free cash flow (FCF) is often used as a more reliable indicator of the cash available for distribution to investors.
Key Differences Between FCF and Earnings
FCF and earnings are both important financial metrics, but they serve different purposes and are calculated differently. Earnings are calculated on an accrual basis, which includes non-cash items like amortization and depreciation. On the other hand, FCF is calculated on a cash basis, focusing solely on the actual cash inflows and outflows that occur in the business operations and capital expenditures.
Definition of Free Cash Flow (FCF)
Free Cash Flow (FCF) is essentially the cash generated by a company after accounting for the necessary capital expenditures (CapEx) required to maintain or expand its operations. FCF can be thought of as the cash left over after all expenses, including capital expenditures, have been paid. It is calculated as follows:
FCF Operating Cash Flow - Capital Expenditures
Definition of Earnings
Earnings, on the other hand, refer to the net income of a company, which is typically reported on an accrual basis. Net income is the residual amount after subtracting all expenses from revenues. It includes items like depreciation and amortization, which are non-cash expenses.
Why Use Free Cash Flow (FCF) in DCF Analysis
DCF analysis aims to determine the present value of a company's future cash flows. FCF is preferred over earnings for several reasons:
Non-Cash Adjustments: Earnings include numerous non-cash items like depreciation and amortization, which can distort the true cash position of a company. FCF, however, excludes these non-cash items, providing a more accurate picture of cash available to investors. Investment Needs: FCF gives investors a clear understanding of the cash available for reinvestment in the business, dividend payments, or share buybacks. Earnings, while important for evaluating profitability, do not provide this insight. Reduced Manipulation Potential: Non-cash adjustments like depreciation can be manipulated by management, potentially leading to misleading earnings. FCF is less susceptible to such manipulation since it is based on actual cash transactions. Future Cash Contract: By focusing on FCF, DCF analysis provides a clearer picture of the company's future cash generating capacity, which is crucial for valuing long-term assets and projects.Differences in Accounting Bases
The core difference between FCF and earnings lies in the accounting bases they use. Accounting is primarily based on two fundamental methods: accrual accounting and cash accounting. FCF is derived using the cash basis, whereas earnings are calculated using the accrual basis.
Accrual Accounting: This method records revenue when it is recognized and expenses when they are incurred, regardless of when cash is actually received or paid. It is commonly used in financial reporting. Cash Accounting: This method records transactions only when cash is received or paid. It is simpler and more straightforward but less common in financial reporting.Conclusion
In conclusion, while both FCF and earnings play important roles in financial analysis, FCF is preferred in DCF analysis due to its focus on actual cash flow. This provides a more accurate representation of a company's financial health and future cash-generating potential, crucial for making informed investment decisions.