Financial Reporting

Stock valuation involves estimating the worth of a company,one of its operating units,or its ownership shares.

Pro forma financial statements of a business,prepared by a credit analyst,would include constructing worst-case scenarios that incorporate alternative assumptions about sales,costs,competitor behavior,etc.

Business valuation involves estimating the intrinsic value of a company,or one of its operating units.

Fundamental valuation uses basic accounting measures to assess the amount,timing,and uncertainty of a firm's future operating cash flows or earnings.

Cash flow assessment plays a central role in analyzing the credit risk of a company.

Lenders compare their cash flow projections for a company to the firm's future dividend commitment as stated in the firm's dividend policy.

When determining the discount rate to apply to a firm's expected future cash flows,analysts should select a rate that reflects the risk (or uncertainty)associated with these cash flows.

In theory,the abnormal earnings approach and the free cash flow approach never produce the same valuation estimate.

The cost of capital,expressed in dollars,reflects the level of earnings investors demand from the company as compensation for the risks of investment.

Operating cash flow minus cash outlays to replace existing operating capacity is free cash flow.

The "free cash flow valuation approach" expresses current stock price as the discounted present value of expected future distributable cash flows.

The amount available to finance planned expansion of operating capacity,reduce debt,pay dividends,or repurchase stock is distributable (or free)cash flow.

In applying the discounted free cash flow valuation model,the discount rate used is the average cost of capital.

One popular approach used to estimate a firm's equity cost of capital is the capital asset pricing model,which expresses the equity cost of capital as the sum of the return on a riskless asset plus an equity risk premium multiplied by the company's systematic risk.

A simplified version of the discounted free cash flow valuation model assumes a zero-growth perpetuity for future cash flows.This assumption is best applied to growth companies with stable cash flow patterns.

If a company is currently generating a free cash flow of $10 per share,which is expected to continue indefinitely,and if the discount rate is 10%,the estimated share price would be $100.

The details of free cash flow valuation are important only for stock analysts and investors.

Earnings are a proxy-imperfect but the best we have-for free cash flow.

The FASB believes that the most useful predictor of future cash flows is accrual accounting earnings.

Accrual accounting produces an earnings number that smoothes out the unevenness in year-to-year cash flows,and provides an estimate of sustainable annualized long-run future free cash flows.