[byrneseyeview]

So the only thing you can back your life on is the cashflow. You can't just manufacture cash.

Yes, you can. Read up on Enron's repo agreements. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter -- it was underhanded, but it still showed up as operating cash flow. They did this for t-bills, Nigerian barges, and everything in between. Cash flow quality is higher than earnings quality, but it is by no means perfect.

[furiouslol]

The DCF model adjusts to this situation perfectly.

They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter

So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis.

When I say you can't just manufacture cash, I'm talking about free money with no strings attached. In your Enron example, there is a string attached - they have to buy it back in the future, so there is a projected cash outflow in the future. No company can manipulate the books to inject $100 million from the thin air. That $100 million has to come from somewhere - from debt, equity investment, asset sales etc.

Earnings is so unreliable. Eg. this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11. A DCF model would value this company correctly as bankrupt while an earnings model would not be able to value this company correctly.

[byrneseyeview]

So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis.

But you don't see it! All they have to do -- all they did -- was repo a little more at the end of the next quarter. RJR did this with cigarettes a while back: they offered discounts and 100% refunds to customers who bought just before the end of the quarter, and they ended up with extra cash for their 10-Q even though these actions hurt the business.

A few other scenarios a cash flow analysis misleads you on:

* Gradual liquidation: if a company sells off its inventory and equipment over time, it can show positive, growing cash flow (and a rapidly growing cash flow as a proportion of capital!) even though the business is falling apart.

* A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.

this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11

If the debt is normal debt, that shows up on the balance sheet, and the interest payments. If it's a zero-coupon bond, it shows up in the income statement but not the cash flow statement (although the tax effect shows up in both).

The point of earnings is to show what kind of value has been added to the business over time. We might call this Platonic version Earnings. Cash flow is a better way to approximate Earnings when companies are manipulating their earnings, but not when they're manipulating both. In the long run, given a perfect accounting system, DCF will equal Tangible Book + Discounted Earnings. Since accounting is imperfect, and a business can be manipulated to appear better than it really is by any measure that people actually use to value companies, picking just one kind of valuation is folly. I use free cash flow, but I use it judiciously -- I try to make it as much like Earnings as possible.

[furiouslol]

they offered discounts and 100% refunds to customers who bought just before the end of the quarter, and they ended up with extra cash for their 10-Q even though these actions hurt the business.

DCF deals with this. They get upfront cash but since these actions hurt the business, it hurts cashflow in the future. So it's not like as if they got off scot-free with this strategy. Like I said, DCF requires that you have really good estimates about future cashflows. If you say But you don't see it!, then you are not making good estimates.

Note: My point is not that DCF will give you a 99.99% accurate valuation. No model will since all models depends on the accuracy of the inputs. My point is that given the amount of knowledge you have about a particular company, the DCF model provides the best framework to reaching a fair valuation.

A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.

It is not deceptive. If the company does that, you just assume their future cashflow from operations will decline from the aging planes.

While other valuation models are useful in supporting your initial valuation calculations, DCF is the fundamental block.