The free cash flow majorly determines the rise and fall of stock prices. It is mostly preferred in the determination of stock prices because of its accuracy in presenting the company's earnings base and superior to other valuation methods. Its superiority is derived from the ability to show the companies' potential to invest in shareholder value-improving activities. Also, it supersedes market multiple of comparable firms model because of the hardship of getting equivalent firms. Additionally, the average market ratios of comparable firms are wide. Hence, it isn't straightforward to know the precise location of the firm undervaluation. Finally, free cash flow is beneficial in the valuation of companies that pay little or no dividends and forms a major factor in affecting the demand and supply of the stock market. As noted by Carver (2012 p.5), Microsoft is one of the companies that maintains a high free capital base with high stock prices.
Some stock prices, however, disregard free cash flow valuation due to variation in valuation processes (Zolotoy, 2012 p. 1161) . As such, a firm stock’s price can go up despite the firm lacking free cash flow. The increase in stock prices is prompted by the rise in demand that can be triggered by three factors. First, investors can perceive a decrease in the risk of investing in a company's stocks. Thus, investment in the company assures them high future returns. Secondly, the company can have a high discounting rate. A high discounting rate devalues the present value of the free cash flow. Therefore, it increases the possibility of higher returns on the stock’s value when the discounting rate falls due to factors like reduced inflation. For instance, Dakhlallh (2020 p. 16) provides evidence of family listed firms in Jordan managing their present value to better their chance of increasing future earnings. Finally, investors can predict a future increase in the firms earning base. The growth can be pegged on huge investments that are likely to increase future earning, yet they reduced the free cash flow.
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Interest rates are a fundamental factor in determining the performance of the stock market. A reduction of taxes increases the earnings on the stock. Conversely, the decrease in interest rates decreases the earning on stocks. A case in point is the American stock prices tremendous increased between 1981 and 1998. In the same period, the interest rates reduced from 13.35% in 1981 to 5.83% in 1998 (Kern, 2009) . In essence, any future free cash flow value of a firm can be expressed as a factor of the present free cash flow value. The factor is defined as a discounting rate. Thus, a market valuation of the companies when interest rates are high imposes a higher discounting rate. The high discounting rate reduces the present value of the present free cash flow.
References
Carver, L. (2012). Venture capital valuation . Hoboken, N.J.: J. Wiley & Sons.
Dakhlallh, M. (2020). Accrual-based Earnings Management, Real Earnings Management, and Firm Performance: Evidence from Public Shareholders Listed Firms on Jordanian's Stock Market. Journal Of Advanced Research In Dynamical And Control Systems , 12 (1), 16-27. DOI: 10.5373/jardcs/v12i1/20201004
Kern, A. (2009). How Interest Rates Impact Cash Flow Analysis. Seeking Alpha .
Zolotoy, L. (2012). Earnings Surprise Implicit in Stock Prices: Which Earnings Forecasting Models are Investors Using and What Determines Their Choice?. Journal Of Business Finance & Accounting , 39 (9-10), 1161-1179. DOI: 10.1111/j.1468-5957.2012.02303.x
