Question

Why do you think so much emphasis is placed on cash-flow-based stock evaluations, especially the "free cash flow model"?

Answer 1

Free cash flow model is appropriate to use when:-
(1) the firm doesn't pay dividends at all or pays out fewer dividends than dictated by its cash flow,
(2) free cash flow tracks profitability,
(3) the analyst takes a corporate control perspective.

Free cash flow is an almost certain signal that the firm is in good financial health. A firm cannot free cash flow by borrowing more money or by creating fictitious accounting entries. For free cash flow to be present the operations have to be efficient and the firm has to be creating value. The presence of free cash flow therefore is a huge positive signal. The absence may not be considered to be a sure shot negative thing. When companies are in their growth phase, they need cash. Hence, in such scenarios the present day free cash flow may be negative. However, it is expected to be much better in the future.

While on the other hand, dividend discount models use dividends as a proxy for the firm’s operating performance. The underlying logic is that a firm can continue to pay dividends in the long run only if its underlying business is stable and prosperous. Multiple cases in the stock market have shown that this need not necessarily be the case. Firm’s can borrow money and keep on paying dividends and mask the fact that the underlying business is rapidly deteriorating. Alternatively, firms could have robust business models and may need cash to invest in them and hence may feel that paying out dividends is sub-optimal utilization of cash. The correlation between dividends and underlying performance is just that, a correlation! Dividends are neither the cause nor the effect of good performance. It just happens to be the case that a lot of good businesses tend to pay dividends too! Dividends are just used to distribute the wealth. They are in no way, signals that wealth has been created by the company.

The dividend discount models assume that the investors have no control over the payout policy of the firm whatsoever. This is true for the case of the minority shareholder. Hence, it is said that as far as the minority shareholder is concerned, dividend discount models may be the best tools for valuing a firm. This may not be the case when potentially bigger shareholders come into picture. Bigger shareholders find the free cash flow approach much more suitable for their needs. Thus free cash flow approach is said to have the perspective of a big ticket acquirer.

Thus, free cash flow as a metric, provides a much deeper insight into the workings of a firm and consequently so much emphasis is placed on free cash flow model.