Net Income and EBITDA as Proxies for Cash Flow in Valuation

Using other measures of earnings like net income, EBIT, EBITDA, or CFO in the discounted cash flow model would give a wrong estimate of a company’s value.

Net income inappropriately:

• Includes the effects of non-cash charges like depreciation that should be added back to compute cash flow available to equity holders.
• Ignores cash inflow from net borrowings.
• Ignores cash outflow from FCInv and WCInv.

EBIT inappropriately:

• Does not reflect the cash taxes paid by the firm.
• Ignores the effects of FCInv and WCInv.
• Does not account for the contribution of the depreciation tax shield.

Question

Which of the following reasons most likely makes net income a poor measure of earnings in the discounted cash flow model?

1. It does not reflect the cash taxes paid by the firm. 
2. It does not account for the depreciation tax shield.
3. It includes the effects of non-cash charges like depreciation.

Solution

The correct answer is C. 

Net income is a poor measure of earnings in the discounted cash flow model because it includes the effects of non-cash charges like deprecation. Depreciation should be added back as it is a non-cash expense.

A is incorrect. Net income reflects the cash taxes paid by the firm. This is a reason why EBIT is a poor measure of earnings in the discounted cash flow model.

B is incorrect. Net income reflects the depreciation tax shield as depreciation is deducted when computing net income. https://mommabe.com/ This is a reason why EBIT is a poor measure of earnings in the discounted cash flow model.

Reading 24: Free Cash Flow Valuation

LOS 24 (h) Evaluate the use of net income and EBITDA as proxies for cash flow in valuation.