CHAPTER 3
Measuring Cash Flows
Cashflowsarekeyto discountedcash flowvaluations.To
estimate cash flows, we usually begin with a measure of
earnings.Freecashflowstothefirm,forinstance,arebased
on after-tax operating earnings. Free cash flow to equity
estimates,inconstrast,commencewithnetincome.Whilewe
obtainanduse measuresofoperating andnetincomefrom
accounting statements, the accounting earnings for many
firmsbearlittleornoresemblancetothetrueearningsofthe
firms. Weconsiderhowtheearningsof afirm,atleast as
measured by accountants, have to be adjusted to get a
measureofearningsthatismoreappropriateforvaluation.In
particular, we examine the treatment of operating lease
expenses,whichwearguearereallyfinancialexpenses,and
research and development (R&D) expenses, which we
consider to be capital expenses.
Togetfromearningstocashflows,wealsoneedestimatesof
how much firms reinvest back to generate future growth.
Since the accounting definitions of working capital and
capital expenditures are often too narrow for purposes of
computing cash flows, we consider more expansive
definitions of both items.
CATEGORIZING CASH FLOWS
Therearethreewaystocategorizecashflows.Oneistodraw
adistinctionbetweentheequitycashflowsandthecashflows
tothefirm.Thecashflowstoequityrepresentcashflowsto