Damodaran on Valuation

Chapter 3. Measuring Cash Flows

Cash flows are key to discounted cash flow valuations. To estimate cash flows, we usually begin with a measure of earnings. Free cash flows to the firm, for instance, are based on after-tax operating earnings. Free cash flow to equity estimates, in constrast, commence with net income. While we obtain and use measures of operating and net income from accounting statements, the accounting earnings for many firms bear little or no resemblance to the true earnings of the firms. We consider how the earnings of a firm, at least as measured by accountants, have to be adjusted to get a measure of earnings that is more appropriate for valuation. In particular, we examine the treatment of operating lease expenses, which we argue are really financial expenses, and research and development (R&D) expenses, which we consider to be capital expenses.

To get from earnings to cash flows, we also need estimates of 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.