Question

Explain how to use cash flow to value a company? What role does the WACC play?

Answer 1

Cash flow can be used to value of the company through various kinds of valuation methods like free cash flow to the equity and free cash flows to the firm.

These are the highly preferred method in order to value a company because cash flows are the lifeblood of a business and the company which have a higher amount of cash flows will be highly liquid and will also command a premium against its peers because the cash flow reflects the ability to deal with the debt repayments and it also reflect that the company is highly liquid to take out its debt it can also undertake various projects on the basis of excess cash it has got in its books.

While calculating the value of a firm using cash flows we need to accumulate all the cash flows to the firm which will not include the expenses like interest payments, because interest is non operating in nature. It is then to be discounted with the weighted average cost of capital in order to arrive at a true valuation of the shares

Weighted average cost of capital is used to discount the cash flows which are receivable to the firm as it is the cost which is required by the company in order to earn those cash flows.