Free Cash Flow, Enterprise Value, and Investor Caution

Abstract

By analyzing actual cash flows in comparison with enterprise values (market capitalization plus debt minus cash), this article documents that the market dramatically undervalues companies. The findings suggest that the equity market has an extraordinarily high discount rate that negates future earnings in the calculus of company value. That is, the discount rate is so high that the vast majority of future cash flows are virtually ignored. The research finds that stock prices do not reflect future corporate earnings. This contrasts with the well-known statement in finance textbooks that “the value of a firm equals the present discounted value of future cash flows.” While the DCF method is normally applied to “estimated” cash flows, it provides a familiar framework with which to test the equity market values against actual cash flows. The authors find that enterprise values are substantially less than the present discounted value of actual future cash flows. A one-dollar increase in actual future cash flows produces only a 75-cent increase in a company?s enterprise value (only 15 cents per dollar of future cash flows when company size is controlled).

The implication is clear: companies are worth far more than the market believes. This provides strong support to the private equity industry. Yes, of late private equity firms have overpaid for acquisitions and may lose their entire investment during the current phase of deleveraging. Yet if private equity firms acquire companies at reasonable prices using less debt, they are likely to create substantial value as a consequence of the fact that companies are so undervalued by the market relative to their cash flows. There are no previous research efforts following the authors’ methodological design based on actual cash flows. Rather, prior research studies have focused on the relationship between forecasted cash flows (by market analysts) and enterprise value. The approach of this article focuses on a different question: the relationship between discounted actual future cash flows and the current market value.

TOPICS: Private equity, equity portfolio management, fundamental equity analysis, statistical methods