assets. One can estimate the investment value of shares by forecasting
and valuing these expected cash flows.^5
More generally, the value of any asset—stock, bond, real estate, or
any other property—is determined by the discounted value of all ex-
pected future cash flows. Future cash flows are discountedbecause cash
received in the future is not worth as much as cash received in the pres-
ent. The reasons for discounting are (1) the innate time preferencesof most
individuals to enjoy their consumption today rather than wait for to-
morrow; (2) productivity, which allows funds invested today to yield a
higher return tomorrow; and (3) inflation, which reduces the future pur-
chasing power of cash received in the future. A fourth reason, which ap-
plies primarily to the cash flows from risky assets such as equities, is the
uncertaintyassociated with the magnitude of future cash flows.
Sources of Shareholder Value
For the stockholder, earnings are the source of future cash flows. Earn-
ings, profits, and net incomes are the cash flows that remain after the
costs of production are subtracted from the sales revenues of the firm.
The costs of production include labor and material costs, interest on
debt, corporate taxes, and allowances for depreciation.
Firms can create value for shareholders by using their earnings in a
number of ways. The first and historically the most important is this one:
- Payment of cash dividends
Earnings that are not used for dividends are called retained earnings.
Retained earnings can be used to create value in the following ways:
- Retirement of debt
- Investment in securities or other assets or acquisition of other
firms - Repurchase of the firm’s own shares (which is known as a buy-
back) - Investment in capital projects designed to increase future profits
If a firm retires its debt, it reduces its interest expense and there-
fore increases the cash flow available to shareholders. If a firm buys as-
sets, the income from these assets is available to pay future dividends
98 PART 2 Valuation, Style Investing, and Global Markets
(^5) There might be some psychic value to holding a controlling interest in a firm. In that case, the
owner values the stock more than minority shareholders value it.