7.8 Cash Flow-Based Valuations

Overview

Given the limitations of income statement–based methods, it makes sense to shift focus to what ultimately matters in valuation: cash. Whether evaluating a business, a single share of stock, or another investment asset, cash flow—not accounting earnings—is the true driver of financial value. This approach is known as Discounted Cash Flow (DCF) analysis. 

1. Core Concept and Basic Formula

DCF relies on two key estimates:

• Future cash flows or dividends and
• A discount rate (the rate of return required by investors).

The general formula for valuing an asset is:

V = D divided by k 

Where:

• V= value of the asset
• D = expected constant cash flow or dividend
• k = required rate of return (discount rate)

This formula provides a simple yet powerful way to estimate value when cash flow  is stable and long-term.

2. Introducing Growth

In practice, many businesses grow over time, and valuation models must account for this. There are three common assumptions regarding growth:

1. No growth: Payments remain constant.
2. Constant growth: Payments grow at a steady rate (g).
3. Non-constant growth: Payments grow at varying rates, typically high at first and then settling into a stable, lower rate.

With no anticipated growth, the value of the asset will be the expected constant cash flow (D) divided by the required rate of return (k).

When constant growth is assumed, the DCF formula related to the valuation of the asset becomes:

V=D1 divided by k−g (i.e., V=D1 / (k-g)

Where:

• D1= D0 (1+g) is next year’s expected cash flow,
• g = growth rate,
• k = required rate of return (discount rate), and,
• k must be greater than g for the formula to work.

3. Estimating Growth and Discount Rates

Growth expectations depend on a business’s ability to reinvest earnings effectively. If the firm retains part of its earnings instead of paying them as dividends, those retained earnings can drive growth. This concept leads to two important ratios:

• Payout ratio = Dividends / Net Income
• Reinvestment (Plowback) ratio = Retained Earnings / Net Income

Expected growth can be estimated using:

Growth Rate= Reinvestment (Plowback) Ratio × Return on Equity (ROE)

This formula assumes that Retained Earnings generate returns at the same rate as the firm’s current ROE, a reasonable proxy for future growth.

Limitations of Cash Flow-Based Valuation

Despite its widespread use, cash flow–based valuation has its own limitations:

• Forecasting future cash flows is inherently uncertain, especially for companies with irregular or unpredictable earnings.
• The discount rate is subjective and can vary significantly depending on assumptions about risk.
• Growth estimates may not materialize as expected, especially if a business fails to reinvest successfully.

Still, DCF remains among the most robust tools for valuing businesses and securities because it is grounded in actual economic benefits, specifically cash in the hands of investors.

Summary

Discounted Cash Flow (DCF) analysis offers a more fundamental approach to valuation by focusing on future cash flows rather than accounting earnings. It estimates the present value of an investment based on projected cash flows and a required rate of return, making it especially relevant when income statement–based methods fall short. DCF models can incorporate various growth scenarios—no growth, constant growth, or non-constant growth—to reflect business realities more accurately.

Growth projections often rely on a company’s reinvestment practices and return on equity, using ratios like the payout and plowback rates. While DCF provides a powerful framework rooted in economic value, its reliability depends on the accuracy of inputs such as cash flow forecasts, discount rates, and growth assumptions. Despite these challenges, DCF remains a cornerstone of modern valuation due to its focus on actual investor returns.