by Melanie
In the second instalment of this series, in issue 198/Apr 06, we saw that shares are worth the present value of the future cash they can generate for their owners. We can either look at this cash in terms of the dividends paid out, or in terms of the net cash flowing into the company.

In the mystical world of economic theory, where all capital is created equal and markets are efficient, it actually makes no difference because (a) shareholders’ money is shareholders’ money whether or not there’s been a board resolution to pay it out, and (b) all investors and companies should be assumed to make the same returns and should therefore discount their cash flows at the same rate.

In spite of a few shortcomings (one of which we’ll come to shortly), this theory does at least provide a framework for comparing different companies, whatever they do with their cash. And if you give an analyst a theoretical framework, he or she will give you a 15-page spreadsheet.

After all, if a company is worth the present value of its future cash flows, then why not put together a giant sum, calculating all those cash flows, discounting them back to their present value and totting them all up. These sums are called ‘discounted cash flow’ calculations and they’re all the rage these days (though curiously they were not nearly so popular before the advent of the computer).

Visit The Intelligent Investor for the rest of this article on valuation and to find out more about value investing.

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