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 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 4-8 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 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 © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 4-36