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Chapter 4

Chapter 4. Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School. What you will learn from this Chapter.

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Chapter 4

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  1. Chapter 4 Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School

  2. What you will learn from this Chapter • What is meant by cash flow from operations • What is meant by cash used in investing activities • What is meant by free cash flow • How discounted cash flow valuation works • Problems that arise in applying cash flow valuation • Why free cash flow may not measure value added in operations • Why free cash flow is a liquidation concept • How discounted cash flow valuation involves cash accounting for operating activities • Why “cash flow from operations” reported in U.S. financial statements does not measure operating cash flows correctly • Why “cash flows in investing activities” reported in U.S. financial statements does not measure cash investment in operations correctly • How accrual accounting for operations differs from cash accounting for operations • The difference between earnings and cash flow from operations • The difference between earnings and free cash flow • How accruals and the accounting for investment affect the balance sheet as well as the income statement • Why analysts forecast earnings rather than cash flows • How a valuation model is a model of accounting for the future

  3. Terminal Investment / Ongoing Investment

  4. Free Cash Flow to Equity • This is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment.Calculated as:   FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment • FCFE is often used by analysts in an attempt to determine the value of a company.  This alternative method of valuation gained popularity as the dividend discount model's usefulness became increasingly questionable.

  5. Free Cash Flow the Firm • This is a measurement of a company's profitability after all expenses and reinvestments. It's one of the many benchmarks used to compare and analyze financial health. • A positive value would indicate that the firm has cash left after expenses. A negative value, on the other hand, would indicate that the firm has not generated enough revenue to cover its costs and investment activities.

  6. DDM • The dividend discount model (DDM) is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. • In other words, it is used to value stocks based on the net present value of the future dividends. The equation most always used is called the Gordon growth model. It is named after Myron J. Gordon, who originally published it in 1959. • The variables are: P is the current stock price. g is the constant growth rate in perpetuity expected for the dividends. r is the constant cost of equity for that company. D1 is the value of the next year's dividends. There is no reason to use a calculation of next year's dividend using the current dividend and the growth rate, when management commonly disclose the future year's dividend and websites post it.

  7. Income plus capital gains equals total return • The equation can also be understood to generate the value of a stock such that the sum of its dividend yield (income) plus its growth (capital gains) equals the investor's required total return. Consider the dividend growth rate as a proxy for the growth of earnings and by extension the stock price and capital gains. Consider the company's cost of equity capital as a proxy for the investor's required total return. • Income + Capital Gain = Total Return • Dividend Yield + Growth = Cost Of Equity

  8. DDM • The Problem of Forecasting Advocates of the dividend discount model say that only future cash dividends can give you a reliable estimate of a company's intrinsic value. Buying a stock for any other reason - say, paying 20 times the company's earnings P/E today because somebody will pay 30 times tomorrow - is mere speculation.

  9. Advantages / Disadvantages of DDM Advantages Easy concept : Dividend are what the shareholders get, so forecast them Predictability : Dividends are usually fairly stable in short run so dividends are easy to forecast (in short run) Disadvantages Relevance : Dividend payout is not related to value at least in short run Dividend payout ignore the capital gain component of payoff Forecast Horizons Typically required forecast for long periods When DDM works (when payout is permanently tied up to the value generation in the firm. For example, when a firm has fixed payout ratio (Dividend/ earnings)

  10. Advantages / Disadvantages of DDM • Dividend usually are not necessarily tied to value creation ( A FIRM CAN BORROW TO PAY DIVIDENDS). • Dividend are distribution of value, not creation of value. • Dividend conundrum • Payoff (Dividend plus Terminal price) are insensitive to dividend component. • The failure of the dividend discount model is remedied by looking inside the firm to the features that create value – the investing and operating activities. Discounted cash flow analysis does just that

  11. C1 C3 C4 C5 C2 I4 I1 I2 I3 I5 C3-I3 C1-I1 C4-I4 C5-I5 C2-I2 1 2 3 4 5 Cash Flows for a Going Concern Free cash flow is cash flow from operations that results from investments minus cash used to make investments. • Cash flow from operations (inflows) • Cash investment (outflows) • Free cash flow • Time, t

  12. The Discounted Cash Flow Model (DCFM)

  13. Terminal Value and Continuing Value • DCM requires forecasting over an infinite horizon. If we are to forecast for a finite horizon, we will have to add a horizon for the value of free cash flow after a horizon. This value is called continuing value. • Terminal value is value we expect the firm to be worth at time T and terminal payoff to selling the firm at T. • The continuing value is the value omitted by calculation when we forecast only up to T rather then infinity. CV is a device by which we reduce an infinite horizon forecasting problem.

  14. The Continuing Value for the DCFM A. Capitalize terminal free cash flow B. Capitalize terminal free cash flow with growth Will it work?

  15. DCF Valuation: New York State Electric and Gas

  16. Simple Valuations • Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware ! A simple DCF valuation for NY State Electric and Gas, 1996 Another simple valuation where g is a growth rate

  17. Wal-Mart Stores, Inc. (Fiscal years ending January 31. Amounts in millions of dollars.) 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations 536 828 968 1,422 1,553 1,540 2,573 3,410 2,993 Cash investments 627 541 894 1,526 2,150 3,506 4,486 3,792 3,332 Free cash flow (91) 287 74 (104) (597) (1,966) (1,913) (382) (339) Dividends per share 0.03 0.04 0.06 0.07 0.09 0.11 0.13 0.17 0.20 Price per share 6⅞ 8½ 10⅝ 16½ 27 32½ 26½ 25⅞ 24⅜ The DCFM: Will it work for Wal-Mart Stores?

  18. Why Free Cash Flow is not a Value-Added Concept • Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses • Value received is not matched against value surrendered to generate value - except for long forecast horizons Note: a firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partially a liquidation concept Note: analysts forecast earnings, not cash flows

  19. Advantages Easy concept: cash flows are “real” and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: free cash flow does not measure value added in the short run; value gained is not matched with value given up. free cash flow fails to recognize value generated that does not involve cash flows investment is treated as a loss of value free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments. Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals. Discounted Cash Flow Analysis: Advantages and Disadvantages • When It Works Best • When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate.

  20. Statement of Cash Flows: Dell Computer

  21. Reported Cash Flow from Operations Reported cash flows from operations in U.S. cash flow statements is after interest: Cash Flow from Operations = Reported Cash Flow from Operations + After-tax Net Interest Payments After-tax Net Interest = Net Interest x (1 - tax rate) Net interest = Interest payments – Interest receipts Reported cash flow from operations is sometimes referred to as levered cash flow from operations

  22. Reported Cash Flow in Investing Activities Reported cash investments include net investments in interest bearing financial assets (excess cash): Cash investment in operations = reported cash flow from investing - net investment in interest-bearing securities

  23. Calculating Free Cash Flow: Dell Computer, 2002 Reported cash flow from operations 3,797 Interest payments 31 Interest income* (314) Net interest payments (283) Taxes (35%) †99 Net interest payments after tax (65%) (184) Cash flow from operations 3,613 Reported cash used in investing activities 2,260 Purchases of interesting-bearing securities 5,382 Sales of interest-bearing securities (3,425) 1,957 Cash investment in operations 303 Free cash flow 3,310 *Interest payments are given as supplemental data to the statement of cash flows, but interest receipts usually are not. Interest income (from the income statement) is used instead; this includes accruals but is usually close to the cash interest received. †Dell’s statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial Statement footnotes.

  24. Forecasting Free Cash Flows • It is difficult to forecast free cash flows without forecasting earnings. First forecast earnings and then make adjustments to convert earnings to cash flow from operations. Follow the following steps: • Forecast earnings • Forecast accruals (the difference between earnings and cash flow from operations in the cash flow statement) • Calculate levered cash flow from operations (Step (i) - Step (ii)) • Calculate unlevered cash flow from operations by adding after-tax net interest • Forecast cash investments in operations • Calculate forecasted free cash flow, C - I (Step (iv) - Step (v))

  25. Forecast 2000 2001 2002 Earnings 1,666 2,177 1,246 Accrual adjustment 2,260 2,018 2,551 Levered cash flows from operations 3,926 4,195 3,797 Interest payments 34 49 31 Interest receipts (158) (305) (314 ) Net interest payments (124) (256) (283) Tax at 35% 43 (81) 9 0 (166) 99 (184) Cash flow from operations 3,845 4,029 3,613 Cash investment in operations (401 ) (482) (303) Free cash flow 3,444 3,547 3,310 Forecasting Free Cash Flow: Dell Computer

  26. Features of the Income Statement 1. Dividends don’t affect income 2. Investment doesn’t affect income 3. There is a matching of • Value added (revenues) • Value lost (expenses) • Net value added (net income) 4. Accruals adjust cash flows Accruals Value added that is not cash flow Adjustments to cash inflows that are not value added

  27. The Income Statement: Dell Computer

  28. The Revenue Calculation Revenue = Cash receipts from sales + New sales on credit  Cash received for previous periods' sales  Estimates of credit sales not collectible  Estimated sales returns and rebates  Deferred revenue for cash received in advance of sale + Revenue previously deferred

  29. The Expense Calculation Expense = Cash paid for expenses + Amounts incurred in generating revenue but not yet paid  Cash paid for generating revenues in future periods + Amounts paid in the past for generating revenues in the current period

  30. Earnings and Cash Flows Earnings = [C - I] - i + I + accruals = C - i + accruals • The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals.

  31. Earnings and Cash Flows: Wal-Mart Stores

  32. Accruals, Investments and the Balance Sheet Accruals and investments are put in the balance sheet Shareholders’ equity = Cash + Other Assets - Liabilities Earnings Cash from Operations Accruals Free cash flow Cash from Operations Investments

  33. The Balance Sheet: Dell Computer

  34. The articulation of the financial statements through the recording of cash flows and accruals Net cash flows from all activities increases cash in the balance sheet Cash from operations increases net income and shareholders’ equity Cash investments increase other assets Cash from debt financing increases liabilities Cash from equity financing increases shareholders’ equity Accruals increase net income, shareholders’ equity, assets and liabilities

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