Cash Flow Measures - Earning

Overview

A second possible measure of cash flows to be discounted are the company's earnings. This is straightforward to measure, in fact, it can be taken directly off the company's financials.

The problem with earnings is that it is not technically a cash flow. The generally accepted accounting principles mandates the matching principle, which states that the expenses should be reported in the same period as the revenue generated from those expenses.

As an example, a company spends money manufacturing a product. That money is recorded as an asset (inventory), and only when the company sells the product, does it become an expense (as cost of goods sold).

The matching principle has some benefits. First and foremost, it is a simple way to check whether a company is spending more to produce a product than what it is collecting as revenue from the sale of the product.

Second, the matching principle does a fairly good job of measuring the assets of the company, in the sense that those assets can be converted to cash at some later date.

However, by its very nature, the matching principle alters the dates of the cash flows that occur. The expense to manufacture a product occurs earlier than the sale, and timing of a cash flow is a critical component of its worth.

Needless to say, using earnings as a back of the envelope measure for calculating a discounted cash flow value is not bad.