Question

The essence of chapter 7 (Birgham 2020) and establishing the value of a stock is that company has the ability to generate free cash flow, or it has the potential to generate free cash flow in the future. With that assumption, the level of free cash and the speed of the growth of the free cash flow is the primary driver of the company's stock valuation . The question at hand is if you believe this evaluation method explains the rise and the fall of a stock price? (Of course, as you provide a response, it must be supported by supporting research, either from your assigned readings, external material, articles, current events, financial news and so on). Can you give examples? What about those companies that see their stock prices go higher despite lack of free cash flow or regardless of their free cash flow assumptions? What explains their rise in price? And finally, what is the connection of interest rates to free cash flow? Why do stock market valuations get impacted by the impact of interest rates on free cash flow? (Of course, this last portion is a very relevant topic in our current environment as interest rates have been very volatile).

Answer 1

Yes, the evaluation method of using free cash flows most certainly and to a large extent explains the rise and fall of stock price. The intrinsic value of a stock is the present value of its future cash flows. The reason why stock prices keep changing is because of developments like changes in macro and micro economic conditions, rise or fall of interest rates, and other such developments that will have a direct bearing on a company’s free cash flow. For example when a drug company like Pfizer announces the launch of a new medicine or a new drug the company’s stock prices increases initially because there will be a positive impact on the company’s free cash flow. Later the prices stabilize because the stock price has factored in the impact of the increase in free cash flow due to launch of the new drug. Stocks of certain companies see their prices go higher despite lack of free cash flow or regardless of their free cash flow assumptions. This can be explained by the presence of bullish market sentiments for these stocks. Investors favor some stocks due to their attractive growth in their revenues, profits and EPS. This leads to increase in their stock prices. However the increase will not be sustainable as a company with no free cash flow will be forced in future to either issue fresh equity or to borrow additional money leading to additional interest burden. Stock market valuations get impacted by the impact of interest rates on free cash flows. First of all change in interest rates will affect the discount rates at which the free cash flows are discounted to arrive at their present value. Secondly change in interest rates will affect interest expenses and this directly affects net income which is used to compute free cash flows.

References:

https://www.morningstar.in/posts/38391/free-cash-flow.aspx

https://seekingalpha.com/article/137623-how-interest-rates-impact-cash-flow-analysis