Question

Essay Question

Free cash flow (FCF) is the basis for determining the value of an investment and this is very much so when determining the value of a company. Explain why we can’t rely on Net Income as the basis for valuing a company and how we start with Net Income from the Income Statement eventually arrive at FCF.

Answer 1

For valuing businesses, it is important to focus on cash flows that are generated by the firm and then discount them at the cost of capital to arrive at the value of the firm. Since translation from net income to cash flow involves elimination of many non-cash expenses, so it is not wise to focus on net income as it can be impacted by accouting entries.

From net income, one can move to cash flows by adding back non cash expenses such as depreciation and also taking into account the working capital changes and change in capital expenditures.