As you know, in CFA Curriculum, discounting all future FCFF and terminal value gives us firm value, then we get equity value by deducting market value of company’s debt from its firm value. Dividing equity value by the number of shares gives us the share value. However, when reading equity analysis reports from some securities companies, I notice that after they calculate the firm value, in addition to deducting debt, they also add back cash. Only then they divide the figure by the number of shares to get the share value. The action of adding back cash is different from what I learn from CFA curriculum. So my question is that is this practice correct? It seems rational to me. What practice should I follow (add cash back or not) because it really makes a difference when you add cash back to get the equity value. Please help me with this. Thank you very much.
As Yoda says, “You must unlearn what you have learned.” What happens in practice (or in real life, or in common sense) has no place in the CFA exam. Do what the curriculum says. If you start applying your own practice to the exam, you will most certainly fail.
Hi, thank you for the comment. Of course I am going to follow strictly the CFA content when doing the exam. My question is for real life practice. I’ve just entered an investment fund and been confused of the difference between what I learned and what people in the industry are doing.
There are many established “norms” in the financial industry, and this (adding cash to FCFF) could be one of them… at least for some people. From an analysis standpoint, recognize that FCFF focuses on the cash flow statement. It borrows elements from the I/S, but at the end of the day FCFF is very much CFO-oriented. That is, show me what the firm’s core, recurring activities are. Hanging on to cash is definitely not one of them. When adding cash to FCFF, you’re bringing in an extraneous item from the balance sheet which, in most cases, is a fleeting (short-lived) item. If you’re consistently generating cash and sitting on it, market pressures will force you to return some of the pie back to investors (e.g. AAPL). IMO, adding cash is not realistic because a firm’s ability to hang on to cash cannot be sustained. The whole goal of obtaining a realistic FCFF is to ascertain a realistic equity value. By adding cash, you’re being less conservative, and are probably ascribing more value to the firm when you shouldn’t be. Just my two cents.
Hi Aether, I think your points are spot on. I really agree with you. Thank you very much.