Executive summary of assigned reading

Investors prefer cash flow over earning but the article points out that there are many shortfall is in using standard cash flow measures. There are various definitions of cash flow, some quite incoherent. GAAP does not help either since the whole subject of cash flow itself is so vast, varies from country to country, and possesses complexities and unpredictability that even GAAP with its laws and definitions has just left us with more confusion, inconsistency, and miscategorization.

In response to this complexity of cash flows, many investors resort to EBITDA (earnings before interest, taxes, depreciation, and amortization) and cash earnings (typically defined as net income plus depreciation and amortization). These existed before the GAAP measures, but they have their own major shortcomings.

The question then is: what is the best measure of free cash flow? And the way to answer this is to ask how free cash flow metric will be used.

The article distinguished between four possible uses of cash flow metrics and focuses on the two most popular uses of cash flow in valuations:

a. As the main variable in DCF models

b. In price-to-free cash flow (P/FCF) multiples.

The article focuses on cash flows in multiples-based valuations (b) because this is where the problems are the most evident.

The article defines and provides calculations for free cash flow for yield and states that it is most similar to the U.S. GAAP version of reported cash from operations.

What the paper does in short is to describe the problems with the common flow cash metrics and to provide advice on how to calculate cash flow metrics that overcome these problems. The paper focused on two free cash flow metrics, one for use in multiples (free cash flow to equity holders for yield) and the other for use in multi-period valuations (free cash flow from operations

For discounted cash flow).