BUS331 Company Valuation
(Lectures 4 and 5. Estimating Cash Flows)
Weeks 4 (14th Feb 2023) and 5 (21st Feb 2023)
Module Leader: Dr Zhe Li
Assistant Professor in Accounting
School of Business & Management
Key Reading
• Damodaran, A. 2006, Damodaran on Valuation, 2nd Edition, Wiley, NY.
• Damodaran, A, 2002, Investment Valuation, 2nd Edition, Wiley, NY.
Week/Date
Session Topic
Investment
Valuation
Damodaran on
Valuation
Week 1 (24th Jan.
2023)
Introduction
Chapters 1 & 2
Chapter 1
Week 2 (31st Jan.
2023)
DCF, Estimating Discount
Rates, Cost of Equity
Chapter 7
Chapter 2
Week 3 (7th Feb.
2023)
DCF, Estimating Discount
Rates, Cost of Debt
Chapter 8
Chapter 2
Week 4 (14th Feb.
2023)
DCF, Estimating Cash
Flows, Cash Flows to Firm
Chapter 9
Chapter 3
Week 5 (21st Feb.
2023)
DCF, Cash Flows to
Equity Holders
Chapter 10
Chapter 3
Steps in Cash Flow Estimation
•
Estimate the current earnings of the firm
- If looking at cash flows to equity, look at earnings after
interest expenses - i.e., net income
- If looking at cash flows to the firm, look at operating earnings
after taxes
•
Consider how much the firm invested to create future growth
- If the investment is not expensed, it will be categorized as
capital expenditures. To the extent that depreciation provides
a cash flow, it will cover some of these expenditures.
- Increasing working capital needs are also investments for
future growth
•
If looking at cash flows to equity, consider the cash flows from net
debt issues (debt issued - debt repaid)
3
Measuring Cash Flows
Lays out the three definitions of cashflows. The strictest measure is the dividend measure. (In fact, there
are some who do not count stock buybacks.) The more expansive equity measure is the free cashflow to
equity, which you can think off as potential dividends.
The free cashflow to the firm is the cash available for all claimholders in the firm - it is before cashflows to
any of the claimholders in the firm - debt or equity.
4
Measuring Cash Flow to the Firm
EBIT * ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm
•
Where are the tax savings from interest payments in this cash
flow?
•
The tax savings from interest payments do not show up in the
cashflows because they have already been counted in the cost of
capital (in the use of the after-tax cost of debt). If you add the
interest tax benefits to the cashflows, you will double count the
benefit.
5
From Reported to Actual Earnings
6
From Reported to Actual Earnings
• Very seldom can you use the reported earnings in the annual report in valuation. This (the
chart in the previous page) lays out the three adjustments that you usually have to make
before you start doing valuation:
 You might need to update the accounting information for most recent reports that have
come from the firm or other sources.
 If you have a cyclical or commodity firm, you have to adjust the earnings for where in the
cycle (of the economy, for a cyclical firm, or for the commodity price, for a commodity
firm) you are currently.
 You may have to clean up for obvious shortcomings in accounting rules.
7
I. Update Earnings
•
When valuing companies, we often depend upon financial statements for inputs on
earnings and assets. Annual reports are often outdated and can be updated by using- Trailing 12-month data, constructed from quarterly earnings reports.
- Informal and unofficial news reports, if quarterly reports are unavailable.
•
Updating makes the most difference for smaller and more volatile firms, as well as for
firms that have undergone significant restructuring.
Trailing 12-month Revenue = Annual Revenues
- Revenues from first 3 quarters of last year
+ Revenues from first 3 quarters of this year.
PS. For larger and more mature firms, you can get away with using the most recent annual report. The
younger the firm and the more tumultuous the times (the economy entering a recession, for instance),
the more you have to worry about using dated information. Your objective in valuation is simple. You
want to use the most recent information you can get for every input, even if it means that your inputs are
observed at different points in time - the market values may be from today and the accounting
information from the most recent quarterly report.
8
II. Correcting Accounting Earnings
•
Make sure that there are no financial expenses mixed in with operating expenses
- Financial expense: Any commitment that is tax deductible that you have to meet no
matter what your operating results: Failure to meet it leads to loss of control of the
business.
- Example: Operating Leases: While accounting convention treats operating leases as
operating expenses, they are really financial expenses and need to be reclassified as
such. This has no effect on equity earnings but does change the operating earnings
•
Make sure that there are no capital expenses mixed in with the operating expenses
- Capital expense: Any expense that is expected to generate benefits over multiple
periods.
- R & D Adjustment: Since R&D is a capital expenditure (rather than an operating
expense), the operating income has to be adjusted to reflect its treatment.
9
The Magnitude of Operating Leases
The firms where
operating leases
matter the most
are retail firms…
10
Dealing with Operating Lease Expenses
•
Operating Lease Expenses are treated as operating expenses in computing operating
income. In reality, operating lease expenses should be treated as financing expenses,
with the following adjustments to earnings and capital:
•
Debt Value of Operating Leases = Present value of Operating Lease Commitments at the
pre-tax cost of debt
•
When you convert operating leases into debt, you also create an asset to counter it of
exactly the same value.
•
Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses Depreciation on Leased Asset
- As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of
Operating Leases.
11
Operating Leases at The Gap in 2xx3 (real-world example)
The Gap has conventional debt of about $ 1.97 billion on its balance sheet and its pre-tax cost of debt is about 6%. Its operating
lease payments in the 2xx3 were $978 million and its commitments for the future are below:
Year
Commitment (millions)
Present Value (at 6%)
1
$899.00
$848.11
2
$846.00
$752.94
3
$738.00
$619.64
4
$598.00
$473.67
5
$477.00
$356.44
6&7
$982.50 each year
$1,346.04
Debt Value of leases =
$4,396.85 (Also value of leased asset)
•
Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m
•
Adjusted Operating Income = Stated Operating Income (OI) + Operating Lease (OL) exp. this year - Deprec’n
= $1,012 m + 978 m - 4397 m /7 = $1,362 million (7-year life for assets)
•
Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m
12
The Collateral Effects of Treating Operating Leases as Debt
Traces the
effect of
converting
operating
leases to debt.
Both
operating
income and
capital
invested
increase. The
net effect on
return on
capital will
depend upon
which
increases
more.
13
The Magnitude of R&D Expenses
Again, the effects of
R&D expensing are
uneven. They matter
more for technology
firms and
pharmaceutical
firms than for the
rest of the market.
However, you could
argue that training
expenses are the
equivalent of R&D
for a financial
services or
consulting firm.
14
R&D Expenses: Operating or Capital Expenses
•
Accounting standards require us to consider R&D as an operating expense even though it is designed to
generate future growth. It is more logical to treat it as capital expenditures.
•
To capitalize R&D,
- Specify an amortizable life for R&D (2 - 10 years)
- Collect past R&D expenses for as long as the amortizable life
- Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the
research asset can be obtained by adding up 1/5th of the R&D expense from five years ago, 2/5th
of the R&D expense from four years ago...:
•
PS. Generally speaking, the argument used by accountants - that R&D yields uncertain benefits - is specious. You could make the
same argument about other investments - investing in a factory in an emerging market, deciding to build a concept car - and you
are forced to treat these as capital expenditures.
•
To capitalize R&D, you need to specify
•
On average, how long it takes between the time you do research and a commercial product emerges from the research. (This
is the amortizable life)
•
R&D expenses from the past (for a period equivalent to the amortizable life). If your firm has not been in existence for that
long, you would go back for as many years as you can.
•
Depreciation schedules - stick with the simplest which is straight line depreciation.
15
III. One-Time and Non-recurring Charges
•
Assume that you are valuing a firm that is reporting a loss of $ 500 million, due to a onetime charge of $ 1 billion. What is the earnings you would use in your valuation?
 A loss of $ 500 million
 A profit of $ 500 million
Would your answer be any different if the firm had reported one-time losses like these once
every five years?
 Yes
 No
•
PS. If it is truly a one-time change, you should use a profit of $ 500 million. If the firm is
playing games (consolidating expenses and reporting them as one-time charges every five
years), you should take the average annual expense of $ 200 million (1/5 of $ 1 billion)
and estimate a profit of $ 300 million. Don’t take company characterizations of nonrecurring charges at face value. Look at the firm’s history.
16
IV. Accounting Malfeasance….
•
Though all firms may be governed by the same accounting standards, the fidelity that they
show to these standards can vary. More aggressive firms will show higher earnings than
more conservative firms.
•
While you will not be able to catch outright fraud, you should look for warning signals in
financial statements and correct for them:
- Income from unspecified sources - holdings in other businesses that are not revealed
or from special purpose entities.
- Income from asset sales or financial transactions (for a non-financial firm)
- Sudden changes in standard expense items - a big drop in S,G &A or R&D expenses
as a percent of revenues, for instance.
- Frequent accounting restatements
PS. This is a challenge. There are clues, though none of them are fool proof and it
makes sense to be skeptical about accounting numbers post-Enron. Check the
footnotes. Bear in mind that this what forensic accounting tries to do and there are
relatively few good forensic accountants around.
17
V. Dealing with Negative or Abnormally Low Earnings
18
V. Dealing with Negative or Abnormally Low Earnings
•
To decide what to do when your firm is losing money, you first have to diagnose the
problem. If the problem is transitory (a short recession, a loss caused by a strike), you can
normalize earnings instantaneously and use the normalized earnings in valuation.
•
If it is long term, you have to first figure out what the long-term problem is. If it is
financial - the firm has too much debt - you have to consider whether the firm can pay
down its debt and survive. If you believe it can, lower the debt ratio each year and
compute a cost of capital. If it is operating or strategic - you have to work out what it will
cost the firm to fix these problems- and build the expected improvement in margins over
time.
•
If it is life cycle related - the firm is in early stage of its life cycle and it is normal to lose
money at that stage - you have to build in the expectations of the improvements that will
occur as the firm moves up the life cycle (with a healthy dose of skepticism about whether
the firm will make it).
19
What tax rate?
•
The tax rate that you should use in computing the after-tax operating income should be
 The effective tax rate in the financial statements (taxes paid/Taxable income)
 The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
 The marginal tax rate for the country in which the company operates
 The weighted average marginal tax rate across the countries in which the company
operates
 None of the above
 Any of the above, as long as you compute your after-tax cost of debt using the same tax
rate
20
The Right Tax Rate to Use
•
The choice really is between the effective and the marginal tax rate. In doing projections,
it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of
the difference between the accounting and the tax books.
•
By using the marginal tax rate, we tend to understate the after-tax operating income in
the earlier years, but the after-tax operating income is more accurate in later years
•
If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate
over time.
- While an argument can be made for using a weighted average marginal tax rate, it is
safest to use the marginal tax rate of the country
PS. Marginal tax rate refers to the rate that is applied to the last dollar of a company's taxable
income, based on the statutory tax rate of the relevant jurisdiction, which is partly based on
which tax bracket the company occupies (for US corporations, the federal corporate tax rate
would be 35%)
21
The Right Tax Rate to Use
•
If you have a choice, you would prefer to do valuation with the tax books in front of you,
but since you do not have that choice as an outsider you have to choose between the
effective tax rate and the marginal tax rate.
•
If you use the effective tax rate all the way through, you are assuming that taxes can be
deferred forever. This is unrealistic - tax deferrals catch up with you as your growth flags and will result in an overvaluation of your firm.
•
If you use a marginal tax rate, you are assuming that you cannot defer taxes from this
point on. This is far too conservative and will yield too low a value for your firm.
•
Suggestion: Start with the effective tax rate in the early years and move towards the
marginal tax rate in the terminal year.
22
A Tax Rate for a Money Losing Firm
• Assume that you are trying to estimate the after-tax operating income for a firm with $ 1
billion in net operating losses carried forward. This firm is expected to have operating
income of $ 500 million each year for the next 3 years, and the marginal tax rate on income
for all firms that make money is 40%. Estimate the after-tax operating income each year for
the next 3 years.
EBIT
Year 1
Year 2
Year 3
500
500
500
Taxes
EBIT (1-t)
Tax rate
• Emphasizes the importance of NOLs. The tax rate will be zero in the first two years and will be
40% in the third year. (Suggestion: Change the first year to a loss of $ 500 million, the third year to a
profit of $ 1 billion and work out the solution. The NOL will increase to $1.5 billion after year 1 and cover
income in years 2 and 3.)
23
Net Capital Expenditures
• Net capital expenditures represent the difference between capital expenditures and
depreciation. Depreciation is a cash inflow that pays for some or a lot (or sometimes all of)
the capital expenditures.
• In general, the net capital expenditures will be a function of how fast a firm is growing or
expecting to grow. High growth firms will have much higher net capital expenditures than
low growth firms.
• Assumptions about net capital expenditures can therefore never be made independently of
assumptions about growth in the future.
PS. It is dangerous to have three separate (and unconnected) line items for capital
expenditures, depreciation and growth in a valuation. Analysts very quickly discover the
secret of value creation (at least on paper) - decrease cap ex, increase depreciation and
increase growth.
24
Capital expenditures should include
• Research and development expenses, once they have been re-categorized as capital
expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D
expenses - Amortization of Research Asset
• Acquisitions of other firms, since these are like capital expenditures. The adjusted net cap
ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other
firms - Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of
acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually categorized
under other investment activities
25
Capital expenditures should include
• In addition to those stated in the last page, you should know the following:
• The accounting definition of cap ex is too narrow. It excludes external cap ex (which is what
acquisitions are) and intangible cap ex (which is what R&D is).
• We would include all acquisitions, including stock swaps acquisitions. To those who would
argue that there is no cashflow associated with stock swaps, we would suggest that all that
has occurred is that the firm has just skipped a step - the firm could have issued the stock to
the market and used the cash on the acquisitions.
• It is true that incorporating acquisitions into valuation can be messy for firms that do
relatively few and very diverse acquisitions over time. You have the option of ignoring these
acquisitions when you do valuation but make sure that the expected growth rate in earnings
does not then include the expected growth from acquisitions. You are implicitly assuming
that acquisitions in the future will be done at fair value and hence have no value impact.
26
Cisco’s Acquisitions: 2xx9
• Cisco’s 10K yielded this. To estimate the price paid for the pooling acquisitions - which were
funded with stock - we multiplied the shares offered in the acquisition by the share price at
the time of the acquisition.
27
Cisco’s Acquisitions: 2xx9
Cap Expenditures (from statement of CF)
- Depreciation (from statement of CF)
= $ 584 mil
= $ 486 mil
Net Cap Ex (from statement of CF)
= $ 98 mil
+ R & D expense
= $ 1,594 mil
(capitalized)
- Amortization of R&D
= $ 485 mil
+ Acquisitions
= $ 2,516 mil
Adjusted Net Capital Expenditures
= $3,723 mil
(Amortization was included in the depreciation number)
28
Working Capital Investments
• In accounting terms, the working capital is the difference between current assets
(inventory, cash and accounts receivable) and current liabilities (accounts payables,
short term debt and debt due within the next year)
• A cleaner definition of working capital from a cash flow perspective is the difference
between non-cash current assets (inventory and accounts receivable) and non-debt current
liabilities (accounts payable)
• Any investment in this measure of working capital ties up cash. Therefore, any increases
(decreases) in working capital will reduce (increase) cash flows in that period.
• When forecasting future growth, it is important to forecast the effects of such growth on
working capital needs, and building these effects into the cash flows.
PS. We remove cash from current assets because cash is not a wasting asset for most firms with substantial cash balances.
Cash today tends to be invested in treasuries or commercial paper which yields a fair return for the risk taken (which is little or
none). There are some analysts who still use operating cash (which they estimate as a percent of revenues) as part of working
capital, but we believe that this is no longer appropriate for firms in markets with well developed banking systems and
investment alternatives. The debt in current liabilities is included in the debt used for cost of capital.
29
Working Capital: General Propositions
• Changes in non-cash working capital from year to year tend to be volatile. A far better
estimate of non-cash working capital needs, looking forward, can be estimated by looking at
non-cash working capital as a proportion of revenues
• Some firms have negative non-cash working capital. Assuming that this will continue into
the future will generate positive cash flows for the firm. While this is indeed feasible for a
period of time, it is not forever. Thus, it is better that non-cash working capital needs be set
to zero, when it is negative.
• Firms like Walmart have been able to generate cashflows by keeping non-cash working
capital low or negative - in a sense, supplier credit is being used a source of capital. The
possible downside is that you can increase credit risk if it gets out of control. That is why
you should not assume negative non-cash working capital in perpetuity.
30
Dividends and Cash Flows to Equity
• In the strictest sense, the only cash flow that an investor will receive from an equity
investment in a publicly traded firm is the dividend that will be paid on the stock.
• Actual dividends, however, are set by the managers of the firm and may be much lower than
the potential dividends (that could have been paid out)
• managers are conservative and try to smooth out dividends
• managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities
• When actual dividends are less than potential dividends, using a model that focuses only on
dividends will under state the true value of the equity in a firm.
31
Dividends and Cash Flows to Equity
• In the strictest sense, the only cash flow that an investor will receive from an equity
investment in a publicly traded firm is the dividend that will be paid on the stock.
• Actual dividends, however, are set by the managers of the firm and may be much lower than
the potential dividends (that could have been paid out)
• managers are conservative and try to smooth out dividends
• managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities
• When actual dividends are less than potential dividends, using a model that focuses only on
dividends will under state the true value of the equity in a firm.
• PS. In the strict view of the world, even stock buybacks are not cashflows to equity investors because they
go to someone else - a person cannot sell their stock back to the company and hold it for dividends at the
same time. In 2000, US companies paid out about 60% of what was available to be paid out (after
reinvestment and debt payments) in dividends. Historically, the unwillingness of managers to cut
dividends has also made them more reluctant to increase dividends as earnings increase.
32
Measuring Potential Dividends
• Some analysts assume that the earnings of a firm represent its potential dividends. This
cannot be true for several reasons:
• Earnings are not cash flows, since there are both non-cash revenues and expenses in
the earnings calculation
• Even if earnings were cash flows, a firm that paid its earnings out as dividends would
not be investing in new assets and thus could not grow
• Valuation models, where earnings are discounted back to the present, will over
estimate the value of the equity in the firm
• The potential dividends of a firm are the cash flows left over after the firm has made any
“investments” it needs to make to create future growth and net debt repayments (debt
repayments - new debt issues)
• The common categorization of capital expenditures into discretionary and nondiscretionary loses its basis when there is future growth built into the valuation.
33
Estimating Cash Flows: FCFE
• Cash flows to Equity for a Levered Firm
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
• I have ignored preferred dividends. If preferred stock exist, preferred dividends will
also need to be netted out
• Note the differences between this and Free cashflow to firm:
• Start with net income (equity earnings) rather than operating earnings. Interest
expenses are subtracted out from earnings and the tax benefits are reflected.
• Net out net debt payments. If a firm raises more new debt than it pays off, this can be a
positive number which, if large enough can make the free cashflow to equity higher
than the free cashflow to the firm.
34
Estimating FCFE when Leverage is Stable
Net Income
- (1- ) (Capital Expenditures - Depreciation)
- (1- ) Working Capital Needs
= Free Cash flow to Equity
where  = Debt/Capital Ratio
For this firm,
• Proceeds from new debt issues = Principal Repayments +  (Capital Expenditures - Depreciation +
Working Capital Needs)
• In computing FCFE, the book value debt to capital ratio should be used when looking back in time but
can be replaced with the market value debt to capital ratio, looking forward.
• This is a steady state equation and works if the firm is at a debt ratio that it feels that it can maintain for
the foreseeable future. When this equation is used to estimate free cashflows to equity in the
past, the average book debt to capital ratio could be used. The free cashflows to equity each year will be
different from the actual numbers, but the averages will converge.
35
Estimating FCFE: Disney
Net Income
- (1- ) (Capital Expenditures - Depreciation)
- (1- ) Working Capital Needs
= Free Cash flow to Equity
where  = Debt/Capital Ratio
For this firm,
• Proceeds from new debt issues = Principal Repayments +  (Capital Expenditures - Depreciation +
Working Capital Needs)
• In computing FCFE, the book value debt to capital ratio should be used when looking back in time but
can be replaced with the market value debt to capital ratio, looking forward.
• This is a steady state equation and works if the firm is at a debt ratio that it feels that it can maintain for
the foreseeable future. When this equation is used to estimate free cashflows to equity in the
past, the average book debt to capital ratio could be used. The free cashflows to equity each year will be
different from the actual numbers, but the averages will converge.
36
Estimating FCFE: Disney
37
Revision of Steps in Cash Flow Estimation
• Cash flows to Equity and Cash Flows to the Firm
• Estimate the current earnings of the firm
• If looking at cash flows to equity, look at earnings after interest expenses - i.e. net
income
• If looking at cash flows to the firm, look at operating earnings after taxes
• Consider how much the firm invested to create future growth
• If the investment is not expensed, it will be categorized as capital expenditures. To the
extent that depreciation provides a cash flow, it will cover some of these expenditures.
• Increasing working capital needs are also investments for future growth
• If looking at cash flows to equity
• consider the cash flows from net debt issues (debt issued - debt repaid)
38
Teaching Assistants (who will cover academic questions in seminars)
Dr Xianmin Liu (xianmin.liu@qmul.ac.uk)
Supriya Shinde (supriya.shinde@qmul.ac.uk)
39
Thank you