Using earnings and free cash flow to evaluate corporate performance

Abstract

Corporate valuation is a very central theme to the subject of Finance. Valuation models are of various types based on either the income statement or the balance sheet approaches. Valuation is important in both acquisition and or disposal of assets as going concerns or stand alone investment(s). While there is considerable agreement that the firm's value will be determined by the net present value of the cash distribution it is expected to generate, opinion is however divided as whether to use earnings as supported by practitioners (analysts, investors, managers) or focus on free cash flow supported by modern Finance text books. The focus of this paper was to compare the earnings based measures of corporate performance against that obtained using free cash flow. Using (Beaver, 1966) free cash flow definition, cash flow from operations (CFFO) has been computed and compared with earnings measures of corporate performance. The findings of this research which are expounded under section 4.2 of this paper indicate that there is no significant difference between free cash flow measure of corporate performance and that of earnings especially when the amount of maintenance capital spending cannot be properly segregated. Further this research found that neither average profit after tax nor cash flow from operations (CFFO) approximates to the market return model for stocks quoted at the Nairobi Stock Exchange (NSE) at the time of this study.