Growth Opportunities, Earning Permanence and the Valuation of Free Cash Flow

Equity Valuation Theory prescribes that free cash flow should not be associated with stock returns because it does not add value. However, free cash flow could become a value-relevant construct in certain contexts. This study considers growth opportunities and transitory earnings as two such contexts and examines the valuation of free cash flows. So, the purpose of this study is the investigation of the effect of growth opportunities and earnings permanence on market valuation of free cash flow. An accounting-based valuation framework is developed where stock returns are regressed on free cash flow interacted with growth and earnings quality proxies, after controlling for book values, dividends, and earnings per share. The data of 64 companies for the period of 2013-2015 in Tehran stock exchange were used. Findings reveal that firms with a positive free cash flow and attractive growth opportunities command a valuation premium from the market. Furthermore, probably 90% free cash flow is found to be positively associated with stock returns when earnings are transitory.