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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

A valuation model is a method of accounting for value

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.

4-2

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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 :

?

4-3

V0E

d1

d2

2

E

d3

3

E

d4

E4

...

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

4-4

13/03/2016

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

dividend at forecast horizon will grow at a constant growth rate afterward.

(Growing perpetuity)

TVT PT

d T 1

E g

4-5

and Disadvantages

Advantages

what shareholders get, so

forecast them

usually fairly stable in the short

run, so dividends are easy to

forecast (in the short run)

Disadvantages

related to value, at least in the short

run; dividend forecasts ignore the

capital gain component of payoffs.

forecasts for long periods; terminal

values for longer periods are hard to

calculate with any reliability

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?

4-6

13/03/2016

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

I1

I2

I3

I4

I5

C1-I1

C2-I2

C3-I3

C4-I4

C5-I5

Time, t

The value of the firm = value of its investing and operating activities =

value of the operations = the enterprise value.

4-7

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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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

--->

--->

4-9

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

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

4-10

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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?

4-11

1999

2000

2001

2002

2003

2004

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

1.09

1.1881

1.2950

1.4116

1.5386

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

$40.67

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?

4-12

13/03/2016

Here are the steps to follow for a DCF valuation:

1.

2.

3.

4.

5.

6.

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

4-13

Valuation Always Work?

A Firm with Negative Free Cash Flows: General Electric Company

2000

2001

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

4-14

13/03/2016

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

4-15

and Disadvantages

Advantages

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.

long periods; terminal values for longer periods are

hard to calculate with any reliability

forecast earnings, not free cash flow; adjusting

earnings forecasts to free cash forecasts requires

further forecasting of accruals

When the investment pattern is such as to produce constant free cash flow

or free cash flow growing at a constant rate.

4-16

13/03/2016

The reported statement of cash flows usually contains some items in accurate

reporting. The next slide show the SCF for Nike, INC.

because some items are not properly classified.

need to make necessary adjustments to reflect the true value.

4-18

13/03/2016

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:

Reported Cash Flow from Operations (levered) + After-tax Net Interest Payments

flow from operations

4-19

from investment

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.

4-20

10

13/03/2016

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

4-21

after adjustments : Nike, Inc., 2010

4-22

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13/03/2016

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.

4-23

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.

12

13/03/2016

4-25

= [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.

4-26

13

13/03/2016

2010

4-27

1.

of value, not a part of value generation.

2.

R&D)

There is a matching of value inflows (revenues) and outflows

(expenses) as the result of the matching principles.

3.

4.

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.

4-28

14

13/03/2016

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

016

29

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