How does free cash flow affect organisations’ market value?

Question

How does free cash flow affect organisations’ market value?

Answer

The discussion on the relationship between free cash flow and organisations’ market value represents a substantial part of the finance literature, particularly in terms of investment decision-making processes and valuation. The concept of free cash flow prompts bank experts and stock analysts to consider the precise amount of generated cash by analysing specific operation activities (Al Zaraee and Al-Azzawi, 2014). It is believed that free cash flow affects organisations’ market value when it comes to corporate investment decisions. For instance, a high level of cash flow volatility is represented by lower levels of investment in relation to companies’ capital expenditures. From this perspective, it appears that organisations have failed to use external capital markets to cover cash flow shortfalls (Akumu, 2014). It can be further illustrated that the emergence of exogenous issuance costs is sufficient in the generation of stock market prices, irrespective of the fact that earnings may be independently distributed across organisations. Therefore, it has become important to explore the correlation between free cash flow and organisations’ investment opportunities, which adequately represent their market value. A positive relationship can be demonstrated between free cash flow and the market value of organisations, considering the importance of equity valuation, projected growth and expected rates of return (Akumu, 2014). In this way, free cash flow can dominate companies’ stock returns, implying that the solid support for the relationship between free cash flow and organisations’ market value can yield relevant conclusions regarding companies’ financial performance and future market-related goals (Al Zaraee and Al-Azzawi, 2014). Yet, it can be pointed out that determining organisations’ market value is a quite challenging task due to the influence of a series of factor such as risk of debt and capital expenditures.

References

Akumu, O. C. (2014) [Online] Effect of Free Cash Flow on Profitability of Firms Listed on the Nairobi Securities Exchange. Available at: http://erepository.uonbi.ac.ke/bitstream/handle/11295/75322/Ojode_Effect%20of%20free%20cash%20flow%20on%20profitability%20of%20firms%20listed%20on%20the%20Nairobi%20securities%20exchange.pdf?sequence=3 [Accessed on 26/10/16]. Al Zararee, A. N. Al-Azzawi, A. (2014). The impact of free cash flow on market value of firm. Global Review of Accounting and Finance. 5(2) 56-63.