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
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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
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4-3
Terminal Investment / Ongoing Investment
For a terminal investment:
I0
Initial Investment
1
2
Investment Horizon: T
3
T -1
T
0
Terminal Cash Flow
C F1
C F2
C F3
C FT-1
C FT
C ash Flow s
For an investment in equity:
P0
Investment Horizon:
When stock is sold
Initial Price
1
2
3
d1
d2
d3
T-1
T
0
Dividends
McGraw-Hill/Irwin
Selling Price at T +
Dividend (if sold at T)
dT-1
P T+d T
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4-4
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.
McGraw-Hill/Irwin
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4-5
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.
McGraw-Hill/Irwin
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4-6
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.
McGraw-Hill/Irwin
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4-7
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
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4-8
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4-9
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.
McGraw-Hill/Irwin
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4-10
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)
McGraw-Hill/Irwin
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4-11
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
McGraw-Hill/Irwin
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4-12
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
C1
C2
C3
C4
C5
I1
I2
I3
I4
I5
C1-I1
C2-I2
C3-I3
C4-I4
C5-I5
3
4
5
Time, t
1
McGraw-Hill/Irwin
2
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4-13
The Discounted Cash Flow Model (DCFM)
Cash flow from
operations (inflows)
Cash investment
(outflows)
Free cash flow
C1
C2
C3
C4
C5 --->
I1
I2
I3
I4
I5
C1  I1
C2  I2
C3  I3
C4  I4
C5  I5 --->
________________________________________________
Time, t
1
2
3
4
--->
--->
5
V0E  V0F  V0D
V0E 
C I
C1  I1
C I
C I
C VT
 2 2 2  3 3 3  T T T 
 V0D
F
F
F
F
 TF
VOF
McGraw-Hill/Irwin
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4-14
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.
McGraw-Hill/Irwin
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4-15
The Continuing Value for the DCFM
A. Capitalize terminal free cash flow
C T 1  I T 1
CVT 
ρF 1
B. Capitalize terminal free cash flow with growth
C T 1  I T 1
CVT 
ρF  g
Will it work?
McGraw-Hill/Irwin
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4-16
DCF Valuation:
New York State Electric and Gas
______________________________________________________________________________
New York State Electric and Gas Corp.
(Amounts in millions of dollars except per share data)
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Cash from operations
602
460
381
403
379
499
533
531
534
Cash investments
207
191
211
301
243
302
216
160
212
Free cash flow
395
269
170
102
136
197
317
371
322
1.090
1.188
1.295
1.412
1.539
1.677
1.828
1.993
362
226
131
72
88
117
173
186
Discount factor (1.09)t
PV of cash flows
Total PV of cash flows
1,355
Continuing value1
3,578
PV of CV

F
V1987
Value

of
1,795
the
firm
3,150
Book value of debt and
preferred stock
E
V1987
2,290


860
Value of equity
Value per share (55.733
shares)
Dividends per share
15.43
2.00
22 43
Price per share
1
Continuing value =
McGraw-Hill/Irwin
$322
.09
2.02
28 87
2.06
2.10
26
29
2.14
2.18
32 12
30 43
2.00
25 87
1.40
21 85
1.40
19
= $3,578 million
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4-17
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
F
V1996

C1996  I1996

F  1
322

.09
$
3,578 million
Book Value of debt
$
1,875 million
E
V1996
$
1,703 million
Value per share on 69.67 million shares
$
24.44
Price per share, 1996
$
21 5 8
Another simple valuation
F
V1996

McGraw-Hill/Irwin
322
1.09  g
where g is a growth rate
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4-18
The DCFM:
Will it work for Wal-Mart Stores?
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
McGraw-Hill/Irwin
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4-19
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
McGraw-Hill/Irwin
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4-20
Discounted Cash Flow Analysis:
Advantages and Disadvantages
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.
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.
McGraw-Hill/Irwin
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4-21
Statement of Cash Flows:
Dell Computer
Fiscal Year Ended
------------------------------------------February 1,
February 2,
January 28,
2002
2001
2000
-----------------------------------
Cash flows from operating
activities:
Net income
$ 1,246
Adjustments to reconcile net
income to net cash provided by
operating activities:
Depreciation and amortization
239
Tax benefits of employee
487
stock
plans
Special charges
742
(Gains)/losses on investments
17
Other
178
Changes in operating working capital:
Accounts receivable, net
222
Inventories
111
Accounts payable
826
Accrued and other liabilities
(210)
Other, net
(123)
Non-current assets and
62
liabilities
-----Net cash provided by
3,797
operating activities
-----Cash flows from investing
activities:
Investments:
Purchases
(5,382)
Maturities and sales
3,425
Capital expenditures
(303)
-----Net cash used in investing
(2,260)
activities
------
$
2,177
240
929
$
1,666
156
1,040
105
(307)
135
194
(80)
56
(531)
(11)
780
404
274
(394)
(123)
988
416
(75)
82
-----4,195
-----3,926
------
------
(2,606)
2,331
(482)
-----(757)
(3,101)
2,319
(401)
-----(1,183)
------
------
Supplemental Statement
Of Cash Flows Information:
Interest paid
Investment income, primarily
interest
McGraw-Hill/Irwin
31
314
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49
305
34
158
4-22
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
McGraw-Hill/Irwin
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4-23
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
McGraw-Hill/Irwin
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4-24
Calculating Free Cash Flow:
Dell Computer, 2002
Reported cash flow from operations
Interest payments
Interest income*
Net interest payments
3,797
31
(314)
(283)
Taxes (35%) †
Net interest payments after tax (65%)
Cash flow from operations
Reported cash used in investing activities
Purchases of interesting-bearing securities
Sales of interest-bearing securities
Cash investment in operations
Free cash flow
99
(184)
3,613
2,260
5,382
(3,425)
1,957
303
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.
McGraw-Hill/Irwin
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4-25
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:
i. Forecast earnings
ii. Forecast accruals (the difference between earnings and cash
flow from operations in the cash flow statement)
iii. Calculate levered cash flow from operations (Step (i) - Step
(ii))
iv. Calculate unlevered cash flow from operations by adding
after-tax net interest
v. Forecast cash investments in operations
vi. Calculate forecasted free cash flow, C - I (Step (iv) - Step (v))
McGraw-Hill/Irwin
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4-26
Forecasting Free Cash Flow:
Dell Computer
Forecast
Earnings
Accrual adjustment
Levered cash flows from
operations
Interest payments
Interest receipts
Net interest payments
Tax at 35%
Cash flow from operations
Cash investment in operations
Free cash flow
McGraw-Hill/Irwin
34
(158)
(124)
43
2000
1,666
2,260
2001
2,177
2,018
2002
1,246
2,551
3,926
4,195
3,797
49
(305)
(256)
(81)
90 (166)
3,845
4,029
(401)
(482)
3,444
3,547
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31
(314)
(283)
99
(184)
3,613
(303)
3,310
4-27
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
McGraw-Hill/Irwin
Adjustments to cash inflows
that are not value added
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4-28
The Income Statement:
Dell Computer
Net revenue
Cost of revenue
Gross margin
Fiscal Year Ended
------------------------------------------February 1,
February 2,
January 28,
2002
2001
2000
----------------------------------$ 31,168
$ 31,888
$ 25,265
25,661
25,445
20,047
---------------5,507
6,443
5,218
----------------
Operating expenses:
Selling, general and
administrative
Research, development and
engineering
Special charges
Total operating expenses
Operating income
Investment and other income
(loss), net
Income before income taxes and
cumulative effect of change in
accounting principle
Provision for income taxes
Income before cumulative
effect of change in accounting
principle
Cumulative effect of change in
accounting principle, net
Net income
McGraw-Hill/Irwin
$
2,784
3,193
2,387
452
482
374
482
-----3,718
-----1,789
(58)
105
-----3,780
-----2,663
531
194
-----2,955
-----2,263
188
-----1,731
-----3,194
-----2,451
485
-----1,246
958
-----2,236
785
-----1,666
-
59
-
-----1,246
------
$
-----2,177
------
© The McGraw-Hill Companies, Inc., 2003 All rights reserved.
$
-----1,666
------
4-29
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
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4-30
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
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4-31
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.
McGraw-Hill/Irwin
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4-32
Earnings and Cash Flows:
Wal-Mart Stores
____________________________________________________________________________
Wal-Mart Stores, Inc.
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)
Net income
628
837 1,076 1,291 1,608 1,995 2,333 2,681 2,740
Eps
.28
.37
McGraw-Hill/Irwin
.48
.57
.70
.87
1.02 1.17 1.19
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4-33
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
McGraw-Hill/Irwin
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4-34
The Balance Sheet:
Dell Computer
Fiscal Year Ended
_______________________
February 1,
2002
-------------
February 2,
2001
-------------
ASSETS
Current assets:
Cash and cash equivalents
Short-term investments
Accounts receivable, net
Inventories
Other
$
Total current assets
Property, plant and equipment,
net
Investments
Other non-current assets
3,641
273
2,269
278
1,416
-----7,877
826
4,373
459
-----Total assets
$ 13,535
-----LIABILITIES AND STOCKHOLDERS EQUITY
Current liabilities:
Accounts payable
Accrued and other
Total current liabilities
Long-term debt
Other
Commitments and contingent
liabilities (Note 7)
Total liabilities
Stockholders equity:
Preferred stock and capital in
excess of $.01 par value;
shares issued and outstanding:
none
Common stock and capital in
excess of $.01 par value;
McGraw-Hill/Irwin
$
5,075
2,444
-----7,519
520
802
-
$
4,910
525
2,424
400
1,467
-----9,726
996
2,418
530
-----$ 13,670
------
$
4,286
2,492
-----6,778
509
761
-
-----8,841
------
-----8,048
------
-
-
5,605
4,795
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4-35
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
Beginning stocks
Flows
Ending stocks
Cash Flow Statement – year 1
Ending Balance Sheet –
year 0
Cash from operations
Cash from investing
Debt financing
Equity financing
Net change in cash
Cash0
+ Other Assets0
Total Assets0
Statement of Shareholders’ Equity –
year 1
Ending Balance Sheet –
year 1
Cash1
+ Other Assets1
Total Assets1
Investment and disinvestment by owners
- Liabilities0
Owners’ equity0
- Liabilities1
Earnings
Net change in owners’ equity
Owners’ equity1
Income Statement – year 1
Cash from operations
+ Accruals
Net income
McGraw-Hill/Irwin
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