Cash flow

Finance academics and practitioners have pointed out distinctions of the use of cash flows with that of accounting numbers for valuation of equity with their use of the of the former for valuation, and the latter for reporting and controlling purposes. They have justified the use of the methods and approaches under the principle that cash flows consider the time value of money while the accounting numbers do not.

On the premise that the Cash flow has been the basic building block of the Discounted Cash Flow (DCF) model used for valuation, practitioners of the field and even some theorist displayed the obvious flexibility and versatility although not without limitations. One limitation perceived from the use of cash flow is the discipline imposed on the person estimating the cash flow especially those cash flows in the distant future. One would readily see that given the difficulty of forecasting far into future, a declining rate of growth in cash flows must be assumed beyond some future year to address the uncertainty. Given the therefore that valuations are extremely sensitive to these growth rate which is required to be assumed to go indefinitely, such exercise could become a good ground for patently optimistic analyst to say that the later growth rates could still be reliable. On the other hand therefore, the choice of the growth rate can therefore be made for personal reasons beyond what reasonable assurance dictates under the circumstances. Along this line therefore the search for better alternative for stock or equity valuation would always be wonderful and profitable areas for researchers given the possible dent of the credibility of DCF valuations.

Having recently reassessed the role of cash flow in valuation, academics and practitioners have recognized the Residual Income Model (RIM), an accounting based valuation technique, as an alternative technique or method to discounted cash flow methods. This RIV does offer many advantages over the cash flow methods.