Free Cash Flow, Enterprise Value, and Investor Caution

Journal of Private Equity, Vol. 13, No. 4, pp. 42-50

https://doi.org/10.3905/jpe.2010.13.4.042

Posted: 21 May 2019

See all articles by Harlan D. Platt

Harlan D. Platt

Northeastern University - Finance and Insurance Area

Sebahattin Demirkan

George Mason University - Department of Accounting

Marjorie Platt

Northeastern University - Accounting Group

Date Written: May 1, 2010

Abstract

By analyzing actual cash flows in comparison with enterprise values (market capitalization plus debt minus cash) we document that the market dramatically undervalues firms. The findings suggest that the equity market appears to have an extraordinarily high discount rate which negates future earnings in the calculus of firm value. That is, the discount rate is so high that the vast majority of future cash flows are virtually ignored.

Our research finds that stock prices do not reflect future corporate earnings. This finding contrasts with the well known statement in finance textbooks that "the value of a firm equals the present discounted value of future cash flows." In fact, we find that enterprise values are substantially less than the present discounted value of future cash flows. A one-dollar increase in future cash flows produces only a 75 cent increase in a firm's enterprise value (only 15 cents per dollar of future cash flows when company size is controlled).

Market support for our findings appears ever day in the business press. For example, the following quote from Bloomberg.com of December 8, 2008 speaks precisely to our findings: Cheapest Stocks Since 1995 Show Cash Exceeds Market By Michael Tsang and Alexis Xydias Dec. 8 (Bloomberg) – "Stocks have fallen so far that 2,267 companies around the globe are offering profits to investors for free. That's eight times as many as at the end of the last bear market, when the shares rose 115 percent over the next year. "The Bank of New York Mellon, for example, on that day December 8th had a market capitalization of $31.71 billion, debt of $35.83 billion, and cash of $75.50 billion. In this case, the market has an infinite discount rate on any and all future cash flows.

The implication of our work is clear: companies are worth far more than the market believes. This provides strong support to the idea behind the private equity industry. We realize that 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 our 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. Our approach focuses on a different question – the relationship between discounted future cash flows and the current market value as posited by financial theory.

Keywords: Enterprise Value, Actual Cash Flow, Cash Flow, Valuation

JEL Classification: G30

Suggested Citation

Platt, Harlan D. and Demirkan, Sebahattin and Platt, Marjorie, Free Cash Flow, Enterprise Value, and Investor Caution (May 1, 2010). Journal of Private Equity, Vol. 13, No. 4, pp. 42-50, https://doi.org/10.3905/jpe.2010.13.4.042, Available at SSRN: https://ssrn.com/abstract=1397708

Harlan D. Platt (Contact Author)

Northeastern University - Finance and Insurance Area ( email )

Boston, MA 02115
United States
617-373-4740 (Phone)
617-373-8798 (Fax)

Sebahattin Demirkan

George Mason University - Department of Accounting ( email )

Marjorie Platt

Northeastern University - Accounting Group ( email )

360 Huntington Ave.
Boston, MA 02115
United States

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