FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 3 – Financial Statements and Valuation (2)
What You Will Learn From This Lecture
• How the dividend discount model works (or does not work)
• How a constant growth model works
• 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. and IFRS financial statements does not measure operating cash flows correctly
• Why “cash flows in investing activities” reported in U.S. and IFRS 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
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

• DCF Valuation – and cash accounting for value – does not work

• Move to accrual accounting for value in Chapters 5 and 6

A Reminder :Valuation Models for Going Concerns
A Firm
0 1 2 3 4 5

CF 1 CF2 CF3 CF4 CF5

Equity

0 1 2 3 4 5 T

Dividend
d1 d2 d3 d4 d5
Flow dT
TVT

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?
The discount rate?
The Dividend Discount Model: Forecasting
Dividends
Terminal Values for the DDM
A. Capitalize expected terminal dividends
d
T+1
TV T = P T= pE −1

B. Capitalize expected terminal dividends with growth

T+1
d
TV T = P T =
pE − g

Will it work?
Some Financial Math:
The Value of a Perpetuity and a Perpetuity with Growth
• The Value of a Perpetuity

A perpetuity is a constant stream that continues without end. The periodic payoff in the stream is sometimes referred to as an
annuity, so a perpetuity is an annuity that continues forever. To value that stream, one capitalizes the constant amount expected. If
the dividend expected next year is expected to be a perpetuity, the value of the dividend stream is

Value of a perpetual dividend stream = V0 E d

• The Value of a Perpetuity with Growth

If an amount is forecasted to grow at a constant rate, its value can be calculated by capitalizing the amount at the required return
adjusted for the growth rate:

E
Value of a dividend growing at a constant rate = V0 =
DCF: Advantages and Disadvantages
Advantages Disadvantages
• Easy concept: dividends are • Relevance: dividends payout is not
what shareholders get, so related to value, at least in the short
forecast them run; dividend forecasts ignore the
capital gain component of payoffs.
• Predictability: dividends are
usually fairly stable in the short • Forecast horizons: typically requires
run so dividends are easy to forecasts for long periods; terminal
forecast ( in the short run) values for shorter 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 wefocus on cashflows within afirm?
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

Free cash flow

C1-I1 C2-I2 C3-I3 C4-I4 C5-I5

Time, t

1 2 3 4 5
The Discounted Cash Flow (DCF)
Model
Cash flow from
operations ( inflows) C1 C2 C3 C4 C5 --->

Cash investment I I I I I5 --->

1 2 3 4
( outflows)

Free cash flow C1 − I1 C2 − I2 C3 − I3 C 4 − I4 C5 − I5 ---

>
________________________________________________ ---
>
1 2 3 4 5
Time, t

E F ND
V0 = V0 − V0

E ND
V0 = + + +−−− + − V0

VOF
The Continuing Value for the DCF Model
A. Capitalize terminal free cash flow

CT+1 − IT+1
CVT =
ρ F −1

B. Capitalize terminal free cash flow with growth

CT+1 − IT+1
CVT =
ρF− g
Will it work?
DCF Valuation: The Coca-Cola Company
In millions of dollars except share and per-share numbers. Required return for the firm is 9%

1999 2000 2001 2002 2003 2004

Cash from operations 3,657 4,097 4,736 5,457 5,929

Cash investments 947 1,187 1,167
Free cash flow 906 618
2,710 2,910 3,569 4,551 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 2,486 2,449 2,756 3,224 3,452
Continuing value (CV)* 14,367
Present value of CV 139,414
Enterprise value 90,611
Book value of net debt 4,435 104,978
Value of equity
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
Steps for a DCF Valuation
Here are the steps to follow for a DCF valuation:

1. Forecast free cash flow to a horizon

2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with an estimated growth rate
4. Discount the continuing value to the present
5. Add 2 and 4
6. Subtract net debt
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 2002 2003 2004

Cash from operations 30,009 39,398 34,848 36,102 36,484

Cash investments 37,699 21,843 38,414
40,308 61,227
(7,690) (1,930)
Free cash flow

12,735 16,593
Earnings 1.60
Earnings per share (eps) 1.29
0.57 0.82
Dividends per share (dps)
(910) (26,379) 14,259

13,684 14,118
1.38 1.42 15,00
0.66 0.73 2
1.50
0.77
Will DCF Valuation Work for Starbucks?
Will DCF Valuation Work for Wal-Mart Stores?
Wal-Mart Stores, Inc.

(Fiscal years ending January 31. Amounts in millions of dollars.)

1990 1992 1993 1994 1995 1996

1988 1989 1991

Cash from operations 536 828 1,422 1,553 1,540 2,573 3,410 2,993
968

Cash investments 627 541 1,526 2,150 3,506 4,486 3,792 3,332
894
Free cash flow (91) 287 (104) (597) (1,966) (1,913) (382) (339)
74
Dividends per share 0.03 0.04 0.07 0.09 0.11 0.13 0.17 0.20
0.06
Price per share 6⅞ 8½ 16½ 27 32½ 26½ 25⅞ 24⅜
10⅝
DCF Valuation and Speculation
• Formal valuation aims to reduce our uncertainty about value and to discipline
speculation

• The most uncertain (speculative) part of a valuation is the continuing value. So

valuation techniques are preferred if they result in a smaller amount of the
value attributable to the continuing value

• DCF techniques can result in more than 100% of the valuation in the
continuing value: See General Electric and Starbucks
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

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

Discounted Cash Flow
Analysis:
Advantages
Advantages and Disadvantages
Disadvantages
• Easy concept: cash • Suspect concept:
flows are “real” and • free cash flow does not measure value added in the short
easy to think about; run; value gained is not matched with value given up.
they are not affected • free cash flow fails to recognize value generated that does
by accounting rules not involve cash flows
• investment is treated as a loss of value
• free cash flow is partly a liquidation concept; firms increase
• Familiarity: is a straight free cash flow by cutting back on investments.
application of familiar • Forecast horizons: typically requires forecasts for
net present value long periods; terminal values for shorter periods
techniques 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.
Nike, Inc.:
Operating and
Investing
Cash Flows,
2010
Reported Cash Flow from Operations is
Incorrect
Reported cash flows from operations in U.S. cash flow statements includes
interest (a financing cash flow):

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
Reported Cash Flow in Investing Activities is Incorrect
Reported cash investments include net investments in interest bearing
financial assets (excess cash) (which is a financing flow):

Cash investment in operations =

Reported cash flow from investing
- Net investment in interest-bearing securities
Calculating Free Cash Flow from the Cash
Flow
Statement: Nike, Inc., 2010
Converting Earnings to Free Cash
Flow:
Nike, Inc., 2010
A Common Approximation
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)
RevenueAccruals
4 . Accruals adjust cash flows

Value added that Adjustments to cash inflows

is not cash flow that are not value added

ExpenseAccruals

Value decreases that Adjustments to cash outflows

are not cash flow that are not value added
The Income Statement: Nike,
Inc.
The Revenue Calculation
Revenue = Cash receipts from sales

+ New sales on credit

− Cash received for previous periods' sales

− Estimated sales returns and rebates

− Deferred revenue for cash received in advance of sale

+ Revenue previously deferred

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
Earnings and Cash Flows
Earnings from the business ( operating earnings)
= Earnings + Net interest (after tax)
= Free cash flow + investment + accruals
= [C - I]+ I + accruals
= C + accruals

• The earnings calculation adds back investments and puts them

back in the balance sheet. It also adds accruals.
Earnings and Cash Flows: Nike, Inc.,
2010
Homework
• Read Chapter 4 – Cash Accounting, Accrual Accounting, and Discounted
Cash Flow Valuation
• Attempt E4.1 to E4.12 (excluding E4.5 and E4.6)
QUESTIONS?
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