In the previous episodes we have discussed the preparation of the statement of cash flows. And unfortunately we have seen that the indirect method, that's quite an exercise. And it seems to be a very strange, roundabout way to come up with a number that is clearly seen in our balance sheets. And here we have to come back to the big question. We study accounting with one big goal in mind. Would like to apply the findings of this discipline that, for us, are important in our valuation procedures. And here, we are back to the idea of valuation. And, although we talked about that in great detail in our corporate finance course, but now it's time to remind of you of the fact that valuation deals not only with cash flows, but also cash flows that are available for investors. Investors I put, not investment but for investors. So unless this cash flow does not reach investors, both debt investors, lenders, and equity investors, stockholders, that is not the amount that is used in a valuation. And now the question is how can we find the proxy for this cash flow that is available for investors. Well, some of that we do know, we know that net income under GAAP, under accounting procedure, strictly speaking is not equal to cash flow. Well there are special cases when it's close to that and we can say that special cases, when net income is about the same as cash flow. But this is when there is no change in working capital, so no adjustments. Remember, cash flow from operations. And not only that, we can also say the depreciation expense is equal to the replacement cost of depreciated assets. So, basically, if these two things they hold, then we can say that net income is an okay proxy for cash flow. But we know that in general, this is a poor, so we can say that in general, net income is a poor proxy. Again, I'm putting that here just to remind you of that, because that's an important thing, and oftentimes people, when they work with various financial statements when they extract these numbers, they sort of not forget about that but set that aside. Now what can we do, what other approaches we can use here? Well, lets see what people normally use. Well In valuation, normally people use free cash flow. What is free cash flow? Well, this is net operating income, before replacement costs, and then less total investment. So the idea is as follows. We made some money, and then, from this amount, we subtract investment that is plowed back into the company. And then, everything else is available to the suppliers of capital. So that's consistent with the general idea in valuation that we have to deal with these cash flows. Well, again, we can re-write that, that this is cash flow operations that is net operating income plus adjustments, less Cash flow for replacement, and then cash flow for new Investment. Now, here for the first time comes the point that, remember, it seems very straight-forward to everyone to see, well, we do have the statement of cash flows. Why don't we use that In our valuation? The key story is that in the statement of cash flows, the cash flows that go for replacement of depreciated assets and that of the new investment, they are mixed up together and that creates a problem. So we have to, that is why that when we use the indirect method we can really see what goes for what. And although that was a cumbersome, hard and roundabout method, but that pours some light on what goes on here. Well, we can say that again if delta in working capital is 0 and then depreciation is the same as replacement, then we can rewrite this equation and say that the free cash flow is approximately net operating income less cash flow for new investment. And that is what normally is used. Well, here we have to make two special observations before wrapping up this episode. Well, number one is that cash flow from operations often times is not the same as it's reported In the statement of cash flow. And that is because of the different treatment of interest. And we will discuss that in just a few minutes. And then, another thing here is that it seems that instead of all that, we can use a standard dividend approach for valuation. Again, I will remind you of that in the next episode. But remember when we in corporate finance about how we value equity, we said that this is the sum of the present values of all future dividends. And it seems to be clearly a much more direct way. So now we will study all these things and then, with respect to that, we'll say, why bother about proxies? Well, in the next episode we will study all these two things. And we will that unfortunately that must be kept in mind.
