Valuation: Measuring and Managing the Value of Companies, 5th Edition

I just finished this book: Valuation: Measuring and Managing the Value of Companies, 5th Edition. This book is quite advanced, but it provides me alternate method in calculating free cash flow for banks.

The book suggests that we can use equity cash flow as alternate to free cash flow. There are few ways of calculating equity cash flow.

First

[Equity Cash Flow] = [Net Income] − [Changes of Equity] + [Other Comprehensive Income]

Net income represents the earnings theoretically available to shareholders after payment of all expenses, including those to depositors and debt holders. However, net income by itself is not cash flow. As a bank grows, it will need to increase its equity; otherwise, its ratio of debt plus deposits over equity would rise, which might cause regulators and customers to worry about the bank’s solvency. Increases in equity reduce equity cash flow, because they mean the bank is issuing more shares or setting aside earnings that could otherwise be paid out to shareholders. The last step in calculating equity cash flow is to add other comprehensive income, such as net unrealized gains and losses on certain equity and debt investments, hedging activities, adjustments to the minimum pension liability, and foreign-currency translation items. This cancels out any noncash adjustment to equity.

Second

Another way to calculate equity cash flow is to sum all cash paid to or received from shareholders, including cash changing hands as dividends, through share repurchases, and through new share issuances. Both calculations arrive at the same result. Note that equity cash flow is not the same as dividends paid out to shareholders, because share buybacks and issuance can also form a significant part of cash flow to and from equity.

Third

Of course, you can also calculate equity cash flow from the changes in all the balance sheet accounts. For example, equity cash flow for a bank equals net income plus the increase in deposits and reserves, less the increase in loans and investments, and so on.

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2 thoughts on “Valuation: Measuring and Managing the Value of Companies, 5th Edition

  1. To understand the use the free cash flow to equity formula, one must understand the components of it and how it differs from dividends. A company’s net income is also referred to its earnings. A company pays some of the earnings out to investors in the form of dividends and the amount retained is used for future growth. The formula for cash flow to equity starts with the company’s earnings. Capital expenditures is substracted to account for the amount needed for assets used for growth. The next variable, change in working capital, is subtracted to account for an increase in capital needed for short term operations. Lastly, net borrowing is added, or subtracted if negative, to account for any capital received from taking new debt, or lost due to repayment of debt. These factors all resolve to the amount available to equity, or shareholders.

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