Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third Edition

CHAPTER 10

From Earnings to Cash Flows

The value of an asset comes from its capacity to generate cash flows. When valuing a firm, these cash flows should be after taxes, prior to debt payments, and after reinvestment needs. When valuing equity, the cash flows should be after debt payments. There are thus three basic steps to estimating these cash flows. The first is to estimate the earnings generated by a firm on its existing assets and investments, a process we examined in the preceding chapter. The second step is to estimate the portion of this income that would go toward paying taxes. The third is to develop a measure of how much a firm is reinvesting back for future growth.

This chapter examines the last two steps. It will begin by investigating the difference between effective and marginal taxes, as well as the effects of substantial net operating losses (NOLs) carried forward. To examine how much a firm is reinvesting, we will break it down into reinvestment in tangible and long-lived assets (net capital expenditures) and short-term assets (working capital). We will use a much broader definition of reinvestment to include investments in research and development (R&D) and acquisitions as part of capital expenditures.

THE TAX EFFECT

To compute the after-tax operating income, you multiply the earnings before interest and taxes by an estimated tax rate. This simple procedure can be complicated by three issues that often arise in valuation. The first is the wide differences ...