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13/03/2016

BUSINESS ANALYSIS AND


VALUATION: FINA2207

Lecture 3
Stephen H. Penman: Chapter 4
Prepared and delivered by Dr. Mahmoud Agha, CFA

Chapter 4
Cash Accounting, Accrual Accounting, and Discounted
Cash Flow Valuation

The Big Picture in This Chapter


A valuation model is a method of accounting for value

Discounted cash flow (DCF) valuation employs cash accounting for


valuation such as dividends and cash flows

However, DCF Valuation and cash accounting for value does not work
because they do not capture value added in a business.

Move to accrual accounting for value in Chapters 5 and 6

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A Reminder :Valuation Models for Going Concerns


A Firm
1

CF1

CF 2

CF 3

CF4

d1

d2

d3

d4

d5

dT
TVT

5
CF5

Equity
0
Dividend
Flow

The terminal value, TVT is the price payoff PT , when the share is sold
Valuation issues :

The forecast target: dividends, cash flow, earnings?

The time horizon: T = 5, 10,


?

The terminal value, PT, How to calculate it?

The discount rate: assumed to be the same for all periods?

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The Dividend Discount Model: Forecasting Dividends

V0E

d1

d2

2
E

d3

3
E

d4

E4

...

Clearly, forecasting dividends for many infinite periods in the future is a


problem.
Hence, we need to define an investment horizon T, but still we face the
problem of finding the terminal stock price at time T. Circularity problem!

V0E

d1

d2

2
E

d3

3
E

...

dT

T
E

PT

ET

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The Dividend Discount Model: Forecasting


Dividends
Terminal Values for the DDM
To find the TV at the end of our forecasting horizon (T) we have two methods:
A. Capitalize expected terminal dividends if you believe that dividends at the
forecast horizon will be the same forever afterward. (Perpetuity)

TVT PT

d T 1

E 1

B. Capitalize expected terminal dividends with growth if you believe that


dividend at forecast horizon will grow at a constant growth rate afterward.
(Growing perpetuity)

TVT PT

d T 1

E g

Where g = (1+ forecasted growth rate)

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Dividend Discount Analysis: Advantages


and Disadvantages
Advantages

Easy concept: dividends are


what shareholders get, so
forecast them

Predictability: dividends are


usually fairly stable in the short
run, so dividends are easy to
forecast (in the short run)

Disadvantages

Relevance: dividends payout is not


related to value, at least in the short
run; dividend forecasts ignore the
capital gain component of payoffs.

Forecast horizons: typically requires


forecasts for long periods; terminal
values for longer periods are hard to
calculate with any reliability

When It Works Best


When payout is permanently tied to the value generation in the firm.
For example, when a firm has a fixed payout ratio (dividends/earnings).
Dividends are cash flows paid out of the firm (to shareholders)
Can we focus on cash flows within a firm instead?
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Cash Flows Within a Firm: Free


Cash Flow
Free cash flow is cash flow from operations that results from investments
minus cash used to make investments.
Cash flow from operations
(inflows)

C1

C2

C3

C4

C5

Cash investment (outflows)

I1

I2

I3

I4

I5

C1-I1

C2-I2

C3-I3

C4-I4

C5-I5

Free cash flow


Time, t

The value of the firm = value of its investing and operating activities =
value of the operations = the enterprise value.

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The Discounted Cash Flow (DCF)


Model
One can value firm equity by forecasting free cash flow to
equityholders, then discount these cash flows to the present as
we did with DDM.
Alternatively, we can forecast the free cash flow to the whole
firm, find the present value of these cash flow, then subtract the
value of debt and preferred equity claims on these cash flows.
The discount rate here is the cost of capital. We can use book
value of debt.
We shall use the second method due to the simplicity of
calculating the free cash flow to the firm.
See the next slide for more details.

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The Discounted Cash Flow (DCF) Model


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

V0F

C1 I1 C 2 I 2 C3 I 3
C I
CV

T T T TT
2
3
F
F
F
F
F

V0E

C1 I1 C 2 I 2 C3 I 3
C I
CV

T T T TT V0ND
2
3
F
F
F
F
F

--->

--->

VND = debt obligations-debt assets + preferred equity


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The Continuing Value (CV) for the


DCF Model
Similar to the DDM, we can calculate the continuing value of the firm by
the end of our investment horizon using one of two methods:
A. Capitalize terminal free cash flow if you believe the free cash flow at
the forecast horizon will be the same forever afterward (Perpetuity).
CVT

C T 1 I T 1
F 1

B. Capitalize expected terminal free cash flow with growth if you


believe that the free cash flow at forecast horizon will grow at a
constant growth rate afterward (Growing perpetuity).
CVT

C T 1 I T 1
F g

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DCF Valuation: The Coca-Cola Company


Assume we are standing by end of 1999 and the figures up to 2004 are
forecasted (figures are in millions of dollars except share and per-share
numbers). Required return for the firm is 9%. Assume that the
estimated growth rate in free cash flow after 2004 is 5%p.a. What was
the stock value of Coca-Cola at that time?

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DCF Valuation: The Coca-Cola Company


1999

2000

2001

2002

2003

2004

Cash from operations


Cash investments
Free cash flow

3,657
947
2,710

4,097
1,187
2,910

4,736
1,167
3,569

5,457
906
4,551

5,929
618
5,311

Discount rate (1.09)t

1.09

1.1881

1.2950

1.4116

1.5386

Present value of free cash flows


Total present value to 2004
Continuing value (CV)*
139,414
Present value of CV
Enterprise value
Book value of net debt
Value of equity

2,486

2,449

2,756

3,224

3,452

14,367
90,611
104,978
4,435
100,543

Shares outstanding

2,472

Value per share

$40.67

*CV = 5,311 x 1.05 = 139,414


1.09 - 1.05
Present value of CV = 139,414 = 90,611
1.5386

The actual stock price by end of 1999 was $57, Was it overpriced?
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Steps for a DCF Valuation


Here are the steps to follow for a DCF valuation:
1.
2.
3.
4.
5.
6.

Forecast free cash flow to a horizon


Discount the free cash flow to present value
Calculate a continuing value at the horizon with an estimated growth rate
Discount the continuing value to the present
Add 2 and 4
Subtract net debt

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Free cash flow and value added: Will DCF


Valuation Always Work?
A Firm with Negative Free Cash Flows: General Electric Company

In millions of dollars, except per-share amounts.


2000

2001

Cash from operations


Cash investments
Free cash flow

30,009
37,699
(7,690)

39,398
40,308
(910)

Earnings
Earnings per share (eps)
Dividends per share (dps)

12,735
1.29
0.57

13,684
1.38
0.66

2002

2003

2004

34,848
61,227
(26,379)

36,102
21,843
14,259

36,484
38,414
(1,930)

14,118
1.42
0.73

15,002
1.50
0.77

16,593
1.60
0.82

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Will DCF Valuation Work for these firms?


The answer is no because the free cash flow does not measure value
added from operations.
As we can see from the previous examples, the two firms were really
profitable, but their FCFFs were negative because they invest more
than they receive from operations.
Cash flow from operations (value added) is reduced by investments
(which also add value in the future): investments are treated as value
losses. So, value received is not matched against value surrendered
to generate value.
So, we need to forecast earnings, not cash flows

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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 longer periods are
hard to calculate with any reliability

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.

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The statement of cash flow (SCF)

Let use have a look at the SCF in the next slide.


The reported statement of cash flows usually contains some items in accurate
reporting. The next slide show the SCF for Nike, INC.

The reported free cash flows = $1896.7

However, the statement as prepared under IAS is not what we want


because some items are not properly classified.

So, we cannot use the financial statements reported by firms as given; we


need to make necessary adjustments to reflect the true value.

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Corrections to the Reported Cash Flow


from Operations

Reported cash flows from operations in U.S. and most countries include interest,
which is a financing rather than an operating cash flow:

Unlevered Cash Flow from Operations =


Reported Cash Flow from Operations (levered) + 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

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Corrections to the Reported Cash Flow


from investment

Reported cash investments also include net investments in interest


bearing financial assets (excess cash), which is a financing flow rather
than investment in operations):
Cash investment in operations =
Reported cash flow from investing - Net investment in interest-bearing securities
Net investment in interest-bearing securities =
Purchase of interest-bearing securities sale of interest-bearing securities.

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Calculating Free Cash Flow from the Cash Flow Statement


after making the necessary adjustments: Nike, Inc., 2010

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Converting Earnings to Free Cash Flow


after adjustments : Nike, Inc., 2010

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Tips to the analyst:

Under the IFRS, firms can classify dividends paid and received as either
operating or financing activities. As an analyst, you should make adjustment
such that dividends paid are transferred to the financing section and
dividends received to the operating section.
Interest paid and received should be adjusted as we have done in the
former example.
Taxes are in cash flow from operations
Purchases and sales of interest-bearing securities are to be excluded from
cash investment in operations
These amendments need to be made before forecasting future free cash
flows. Forecasting future FCFs will be discussed in Chapter 11.
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Cash flow, Earnings and Accrual Accounting

Forecasting FCFF requires forecasting the firms sales and earnings.

Analysts usually forecast earnings rather than cash flows. The stock price is
very sensitive to earnings announcements. Earnings drive stock prices.

The difference between earnings and cash flow from operations is the
accruals.

These accruals capture value added in operations that cash flows do not.

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The Income Statement: Nike, Inc.

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Earnings and Cash Flows

Earnings = Free cash flow Net cash interest + investments + accruals


= [C - I] Net cash interest + I + accruals
= C Net cash interest (after tax)+ accruals

The earnings calculation adds back investments and puts them back in the
balance sheet. It also adds accruals.

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Earnings and Cash Flows: Nike, Inc.,


2010

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Features of the income statement:


1.

Dividends do not appear in the statement because it is a distribution


of value, not a part of value generation.

2.

Investment also is not subtracted in the income statement (exception


R&D)
There is a matching of value inflows (revenues) and outflows
(expenses) as the result of the matching principles.

3.

4.

Accruals are recognized in the statement. So sales made during the


period are recognized even if the value of these sales has not yet
been collected. Similarly, expenses incurred are recognized even if
payment is made later.

Earnings look like a better basis for valuing a firm than cash flows.
Nevertheless, still accrual accounting and earning calculations are
subject to manipulation.

Next week we will discuss how earnings are used in valuation.


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Workshop Questions
Penman, Financial Statement Analysis and Security Valuation, 5th Edition
Chapter 4: E4.1, E4.4, E4.5, E4.10, E4.11

3/13/2
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