In a prior working paper, Pierre and al. have shown how to build a stock selection framework based on the profitability of a firm and its stock price valuation. This Profitability-Valuation framework is derived from the Residual Income Model (hereafter RIM) which is in fact a derivation of the Dividend Discount Model (hereafter DDM). In this context, Pierre and al. show that profitability is necessarely measured using Return On Equity (hereafter ROE) while the valuation metric is necessarely the Price To Book (hereafter PB). As such, screening for stocks using ROE and PB consists in buying stocks that appear cheap from a dividend perspective or, more generally from an earnings perspective. Dividends can, indeed, be replaced by earnings as long as the clean surplus accounting rule that underpins the RIM is observed.
Drawbacks of the dividend or earnings approach to valuation are well known. For example, earnings are a pure accounting measure that can be manipulated because it incorporates non-cash items of the income statement. Another drawback often mentioned by practitioners is that profitability measures based on earnings depend on a firm’s gearing, defined as the amount of debt relative to equity. A company can have an attractive ROE despite having an unattractive Return on Invested Capital (hereafter ROIC). More importantly, a company using financial leverage to enhance its ROE actually makes it more volatile often at the expense of its financial strength (measured by the health of the balance sheet). For these reasons, practitioners in the equity investment community tend to prefer cash-flow based valuation metrics.
The purpose of this working paper is to show that it is perfectly feasable to adapt the Profitatbiliy-Valuation framework so as to hinge it on a firm’s cash-flows instead of earnings. Using cash-flows has several advantages: first of all, it allows us to avoid the debt caveat. Secondly, by using cash-flows when valuing a firm, practitioners adopt a more entrepreneurial attitude towards stock valuation; typically, a private equity firm or any type of firm that wishes to value a potential target will do so by discounting cash-flows instead of earnings or dividends.
The paper is organised as follow. First section recapitulates theoretical and empirical findings in Pierre and al. regarding the link between DDM, RIM, PB-ROE, and how to combine financial screens and fundamental analysis when using the Profitablity-Valuation framework. In the second section, we show how to adapt this approach to cash-flow based valuations measures; links between Profitablity-Valuation screens, fundamental analysis and Discounted Cash-Flow models (hereafter DCF) are also explicitly described. In this section we also show how a cash-flow based Profitablity-Valuation framework is in fact identical to the Economic Value Added (hereafter EVA) which is also known as Residual Cash-Flow and thus comparable to Residual Income.