Beyond the earnings multiple: cash flow, dilution and the discount rate

explainerPublished 19 October 20262 min readequities

Key points

• Earnings and free cash flow answer different questions. Share-based pay can widen the gap.
• A lower share count raises the claim per share. Issuance does the opposite.
• A higher discount rate lowers the present value of the same expected cash flows. It is not a comment on the business’s virtue.

What is going on

Free cash flow is the cash left after the spending required to keep the business running, on a definition the reader has to take from the filing rather than from a slogan. Return on invested capital compares profit with the capital used to earn it. Leverage raises the equity return when the business earns more than the cost of debt, and it magnifies losses in the other direction. The multiple note already warns that a cheap ratio can be a worsening business. This note does not repeat a tour of price to book.

Why it matters

Suppose, as a worksheet, that a business is expected to pay owners 10 for each of the next three years and then stop, and that the discount rate is 8 percent. The present value is 10/1.08 + 10/1.08² + 10/1.08³, about 25.8. At a 12 percent discount rate the same cash is worth about 24.0. Nothing about the factory changed. The price of time did. If the company then issues shares so that each holder owns less of that cash, the value per share falls again. These cash amounts are not a company.

What to watch

Read dilution, buybacks and the debt schedule in the filing. Treat a single year’s free cash flow as one year. The dividend calculator projects a dividend path you type. It is not a free-cash-flow model.

Risks

Forecasts of cash flow are opinions. The discount rate embeds a risk premium that can be argued. Accounting cash flow can be flattered by delaying payments. This note does not value a named firm.