Company cash flow or earnings is the most popular method for valuing a company as a going concern. The value of the company is based on projections of what its earnings or cash flow is likely to be -- using past trends to predict the future.

Example

In 1972, American Express bought almost two million shares of Donaldson, Lufkin & Jenrette, Inc. ("DLJ") common stock for about $ 30 million. Three years later, when the stock price had declined to about $ 4 million, American Express announced that it would distribute the stock to its shareholders as a dividend.

Two American Express shareholders urged the company to sell the DLJ stock, rather than distribute it as a dividend. They pointed out that if American Express sold the DLJ stock, it could reduce otherwise taxable capital gains by an amount equal to the roughly $ 26 million loss it would incur on the sale of its DLJ stock and thus save approximately $ 8 million in federal income taxes. On the other hand, by distributing the DLJ stock as a dividend, American Express would lose this potential tax saving and would provide no significant tax benefits to its shareholders.

What should the board do? Create real value for shareholders by reducing the company's tax liability or supporting acccounting earnings? (More>>)

Multiple cash flows and discount rates. Although DCF forms the core methodology of the income approach to valuation, FASB recently has recommended an alternative approach in its Concepts Statement No. 7.

Typically, the DCF methodology employs a single set of estimated cash flows and a single discount rate, which attempts to adjust the estimate of future results to reflect the many varied inherent risks and uncertainty. The FASB thinks this approach is overly simplistic.The traditional approach does not adequately capture the uncertainties associated with the projected cash flows themselves. Higher or lower expenses, new competition, government regulation and numerous other factors may affect the project favorably or unfavorably.The number of possible outcomes is virtually limitless. Reducing all of these possibilities to a single projection of cash flows, and then applying a single discount rate, is conducive to serious inaccuracies in present value determinations according to FASB.

Concepts Statement No. 7 introduces the “expected cash flow approach.”It differs from the traditional approach by focusing on explicit assumptions about the range of possible estimated cash flows and their respective probabilities. The following is an excerpt from the Statement which explains the fundamentals of the proposed methodology (see panel on right).

FASB – Statement of Financial Accounting Concepts No. 7 [Excerpt (¶¶ 43-53)] February 2000

43. Accounting applications of present value have traditionally used a single set of estimated cash flows and a single interest rate, often described as “the rate commensurate with the risk.”In effect, although not always by conscious design, the traditional approach assumes that a single interest rate convention can reflect all the expectations about the future cash flows and appropriate risk premium. The Board expects that accountants will continue to use the traditional approach for some measurements. In some circumstances, a traditional approach is relatively easy to apply. For assets and liabilities with contractual cash flows, it is consistent with the manner in which marketplace participants describe assets and liabilities, as in “a 12 percent bond.”

44. The traditional approach is useful for many measurements, especially those in which comparable assets and liabilities can be observed in the marketplace. However, the board found that the traditional approach does not provide the tools needed to address some complex measurement problems, including the measurement of nonfinancial assets and liabilities for which no market for the item exists. The traditional approach places most of the emphasis on selection of an interest rate. A proper search for “the rate commensurate with the risk” requires analysis of at least two items—one asset or liability that exists in the marketplace and has an observed interest rate and the asset or liability being measured. The appropriate rate of interest for the cash flows being measured must be inferred from the observable rate of interest in some other asset or liability and, to draw that inference, the characteristics of the cash flows must be similar to those of the asset being measured. Consequently, the measurer must do the following: (More>>)