>> Now I feel pretty strongly that EBITDA is not a good measure of cash flow.
Because unless you adjust for these changes in working capital,
then EBITDA is just as easy to manipulate as earnings is.
What we're going to do in the next video is a case where we'll highlight some of
these drawbacks of EBITDA, and
I'll show you when it's not a great measure of cash flow.
And then, one more point on this.
You often hear people talking about cash is king, implying that you should only
look at cash from operations or EBITDA as a proxy for cash from operations,
and not even look at earnings, because it's too easy to manipulate.
Well, there's actually been a lot of academic research that's
looked at this question of earnings versus cash flow.
And it finds that earnings are a better predictor of future cash flows than
current cash flow from operations.
The reason is that earnings is trying to measure the creation of value.
It's trying to answer the question, are you able to price your product of service
high enough to cover all the costs of doing business?
If so, you tend to get high cash flows in the future,
even if it turns out you don't happen to have high cash flows this period.
Where as cash from operations can be much more susceptible to timing effects,
which is something we'll look at in the next video.
But the good news is, you don't have to choose one or the other.
You get both earnings and cash flow from operations.
And academic research is very clear that if you put both measures in together,
you get the best predictions of how a company's going to do in
the future in terms of its future cash flows.
>> I bet that accounting professors did the research to show that earnings is
better than cash flow.
Is that really the case in the real world?
>> Yes, it was mostly accounting researchers that did this research.
But is there anything wrong with that?
The data that they looked at, though, came from real companies looking at long time
series of data from 1962 to the present, and it's a very robust result that
earnings are a better predictor of future cash flows than current cash flows.
But again, the research emphasizes the best prediction
comes from including both measures together.
The last topic of this video is that I want to briefly talk about free cash flow.
Now this is more of a finance topic, where they use free cash flow a lot.
But since we've been talking about cash flows, and
these finance approaches generally pull cash flow numbers
out of the financial statements, I wanted to briefly give you some cautions
that you should have in dealing with free cash flows.
When people talk about free cash flow,
they generally mean operating cash flow minus cash used for long term investments.
There's valuation models out there that show if you forecast out of companies'
free cash flows, discount them back to present value, you'll get a measure of how
much the company should be worth, what it stock price should be.