estimating cash flows

ESTIMATINGCASHFLOWS

Cashisking…

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StepsinCashFlowEstimation

¨ Estimatethecurrentearningsofthefirm¤ Iflookingatcashflowstoequity,lookatearningsafterinterest

expenses- i.e.netincome¤ Iflookingatcashflowstothefirm,lookatoperatingearningsafter

taxes

¨ Considerhowmuchthefirminvestedtocreatefuturegrowth¤ Iftheinvestmentisnotexpensed,itwillbecategorizedascapital

expenditures.Totheextentthatdepreciationprovidesacashflow,itwillcoversomeoftheseexpenditures.

¤ Increasingworkingcapitalneedsarealsoinvestmentsforfuturegrowth

¨ Iflookingatcashflowstoequity,considerthecashflowsfromnetdebtissues(debtissued- debtrepaid)

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MeasuringCashFlows

Cash flows can be measured to

All claimholders in the firm

EBIT (1- tax rate) - ( Capital Expenditures - Depreciation)- Change in non-cash working capital= Free Cash Flow to Firm (FCFF)

Just Equity Investors

Net Income- (Capital Expenditures - Depreciation)- Change in non-cash Working Capital- (Principal Repaid - New Debt Issues)- Preferred Dividend

Dividends+ Stock Buybacks

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MeasuringCashFlowtotheFirm:Threepathwaystothesameendgame

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Where are the tax savings from interest expenses?

AccountingEarnings,FlawedbutImportant

CashFlowsI117

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FromReportedtoActualEarnings

Update- Trailing Earnings- Unofficial numbers

Normalize Earnings

Cleanse operating items of- Financial Expenses- Capital Expenses- Non-recurring expenses

Operating leases- Convert into debt- Adjust operating income

R&D Expenses- Convert into asset- Adjust operating income

Measuring Earnings

Firmʼs history

Comparable Firms

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I.UpdateEarnings

¨ Whenvaluingcompanies,weoftendependuponfinancialstatementsforinputsonearningsandassets.Annualreportsareoftenoutdatedandcanbeupdatedbyusing-¤ Trailing12-monthdata,constructedfromquarterlyearningsreports.¤ Informalandunofficialnewsreports,ifquarterlyreportsareunavailable.

¨ Updatingmakesthemostdifferenceforsmallerandmorevolatilefirms,aswellasforfirmsthathaveundergonesignificantrestructuring.

¨ Timesaver:Togetatrailing12-monthnumber,allyouneedisone10Kandone10Q(examplethirdquarter).UsetheYeartodatenumbersfromthe10Q.Forexample,togettrailingrevenuesfromathirdquarter10Q:¤ Trailing12-monthRevenue=Revenues(inlast10K)- Revenuesfromfirst3

quartersoflastyear+Revenuesfromfirst3quartersofthisyear.

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II.CorrectingAccountingEarnings

¨ Makesurethattherearenofinancialexpensesmixedinwithoperatingexpenses¤ Financialexpense:Anycommitmentthatistaxdeductiblethatyouhaveto

meetnomatterwhatyouroperatingresults:Failuretomeetitleadstolossofcontrolofthebusiness.

¤ Example:OperatingLeases:Whileaccountingconventiontreatsoperatingleasesasoperatingexpenses,theyarereallyfinancialexpensesandneedtobereclassifiedassuch.Thishasnoeffectonequityearningsbutdoeschangetheoperatingearnings

¨ Makesurethattherearenocapitalexpensesmixedinwiththeoperatingexpenses¤ Capitalexpense:Anyexpensethatisexpectedtogeneratebenefitsover

multipleperiods.¤ R&DAdjustment:SinceR&Disacapitalexpenditure(ratherthanan

operatingexpense),theoperatingincomehastobeadjustedtoreflectitstreatment.

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TheMagnitudeofOperatingLeases

Operating Lease expenses as % of Operating Income

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Market Apparel Stores Furniture Stores Restaurants

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DealingwithOperatingLeaseExpenses

¨ OperatingLeaseExpensesaretreatedasoperatingexpensesincomputingoperatingincome.Inreality,operatingleaseexpensesshouldbetreatedasfinancingexpenses,withthefollowingadjustmentstoearningsandcapital:

¨ DebtValueofOperatingLeases=PresentvalueofOperatingLeaseCommitmentsatthepre-taxcostofdebt

¨ Whenyouconvertoperatingleasesintodebt,youalsocreateanassettocounteritofexactlythesamevalue.

¨ AdjustedOperatingEarnings¤ AdjustedOperatingEarnings=OperatingEarnings+OperatingLease

Expenses- DepreciationonLeasedAssetAsanapproximation,thisworks:¤ AdjustedOperatingEarnings=OperatingEarnings+Pre-taxcostof

Debt*PVofOperatingLeases.

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OperatingLeasesatTheGapin2003

¨ TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetanditspre-taxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003were$978millionanditscommitmentsforthefuturearebelow:

Year Commitment(millions) PresentValue(at6%)1 $899.00 $848.112 $846.00 $752.943 $738.00 $619.644 $598.00 $473.675 $477.00 $356.446&7 $982.50eachyear $1,346.04¨ DebtValueofleases= $4,396.85(Alsovalueofleasedasset)¨ DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m¨ AdjustedOperatingIncome=StatedOI+OLexp thisyear- Deprec’n

=$1,012m+978m- 4397m/7=$1,362million(7yearlifeforassets)¨ ApproximateOI=$1,012m+$4397m(.06)=$1,276m

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TheCollateralEffectsofTreatingOperatingLeasesasDebt

! Conventional!Accounting! Operating!Leases!Treated!as!Debt!Income!Statement!

EBIT&&Leases&=&1,990&0&Op&Leases&&&&&&=&&&&978&EBIT&&&&&&&&&&&&&&&&=&&1,012&

!Income!Statement!EBIT&&Leases&=&1,990&0&Deprecn:&OL=&&&&&&628&EBIT&&&&&&&&&&&&&&&&=&&1,362&

Interest&expense&will&rise&to&reflect&the&conversion&of&operating&leases&as&debt.&Net&income&should&not&change.&

Balance!Sheet!Off&balance&sheet&(Not&shown&as&debt&or&as&an&asset).&Only&the&conventional&debt&of&$1,970&million&shows&up&on&balance&sheet&&

Balance!Sheet!Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&OL&Asset&&&&&&&4397&&&&&&&&&&&OL&Debt&&&&&4397&

Total&debt&=&4397&+&1970&=&$6,367&million&

Cost&of&capital&=&8.20%(7350/9320)&+&4%&(1970/9320)&=&7.31%&

Cost&of&equity&for&The&Gap&=&8.20%&After0tax&cost&of&debt&=&4%&Market&value&of&equity&=&7350&

Cost&of&capital&=&8.20%(7350/13717)&+&4%&(6367/13717)&=&6.25%&&

Return&on&capital&=&1012&(10.35)/(3130+1970)&&&&&&&&&&=&12.90%&

Return&on&capital&=&1362&(10.35)/(3130+6367)&&&&&&&&&&=&9.30%&

&

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TheMagnitudeofR&DExpenses

R&D as % of Operating Income

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Market Petroleum Computers

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R&DExpenses:OperatingorCapitalExpenses

¨ AccountingstandardsrequireustoconsiderR&Dasanoperatingexpenseeventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreatitascapitalexpenditures.

¨ TocapitalizeR&D,¤ SpecifyanamortizablelifeforR&D(2- 10years)¤ CollectpastR&Dexpensesforaslongastheamortizablelife¤ SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpensefromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:

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CapitalizingR&DExpenses:SAP

¨ R&Dwasassumedtohavea5-yearlife.Year R&DExpense Unamortized AmortizationthisyearCurrent 1020.02 1.00 1020.02-1 993.99 0.80 795.19 €198.80-2 909.39 0.60 545.63 €181.88-3 898.25 0.40 359.30 €179.65-4 969.38 0.20 193.88 €193.88-5 744.67 0.00 0.00 €148.93Valueofresearchasset= €2,914millionAmortizationofresearchassetin2004 = €903millionIncreaseinOperatingIncome=1020- 903= €117million

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TheEffectofCapitalizingR&DatSAP

! Conventional!Accounting! R&D!treated!as!capital!expenditure!Income!Statement!

EBIT&&R&D&&&=&&3045&.&R&D&&&&&&&&&&&&&&=&&1020&EBIT&&&&&&&&&&&&&&&&=&&2025&EBIT&(1.t)&&&&&&&&=&&1285&m&

!Income!Statement!EBIT&&R&D&=&&&3045&.&Amort:&R&D&=&&&903&EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&EBIT&(1.t)&&&&&&&&=&1359&m&

Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&(Increase&of&117&million)&Net&Income&will&also&increase&by&117&million&&

Balance!Sheet!Off&balance&sheet&asset.&Book&value&of&equity&at&3,768&million&Euros&is&understated&because&biggest&asset&is&off&the&books.&

Balance!Sheet!Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&

Total&Book&Equity&=&3768+2914=&6782&mil&&Capital!Expenditures!

Conventional&net&cap&ex&of&2&million&Euros&

Capital!Expenditures!Net&Cap&ex&=&2+&1020&–&903&=&119&mil&

Cash!Flows!EBIT&(1.t)&&&&&&&&&&=&&1285&&.&Net&Cap&Ex&&&&&&=&&&&&&&&2&FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&&

Cash!Flows!EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&.&Net&Cap&Ex&&&&&&=&&&&&&&119&FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&

Return&on&capital&=&1285/(3768+530)& Return&on&capital&=&1402/(6782+530)&

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III.One-TimeandNon-recurringCharges

¨ Assumethatyouarevaluingafirmthatisreportingalossof$500million,duetoaone-timechargeof$1billion.Whatistheearningsyouwoulduseinyourvaluation?a. Alossof$500millionb. Aprofitof$500million

¨ Wouldyouranswerbeanydifferentifthefirmhadreportedone-timelossesliketheseonceeveryfiveyears?a. Yesb. No

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IV.AccountingMalfeasance….

¨ Thoughallfirmsmaybegovernedbythesameaccountingstandards,thefidelitythattheyshowtothesestandardscanvary.Moreaggressivefirmswillshowhigherearningsthanmoreconservativefirms.

¨ Whileyouwillnotbeabletocatchoutrightfraud,youshouldlookforwarningsignalsinfinancialstatementsandcorrectforthem:¤ Incomefromunspecifiedsources- holdingsinotherbusinessesthatare

notrevealedorfromspecialpurposeentities.¤ Incomefromassetsalesorfinancialtransactions(foranon-financialfirm)¤ Suddenchangesinstandardexpenseitems- abigdropinS,G&AorR&D

expensesasapercentofrevenues,forinstance.¤ Frequentaccountingrestatements¤ Accrualearningsthatrunaheadofcashearningsconsistently¤ Bigdifferencesbetweentaxincomeandreportedincome

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V.DealingwithNegativeorAbnormallyLowEarnings

A Framework for Analyzing Companies with Negative or Abnormally Low Earnings

Why are the earnings negative or abnormally low?

TemporaryProblems

Cyclicality:Eg. Auto firmin recession

Life Cycle related reasons: Young firms and firms with infrastructure problems

LeverageProblems: Eg. An otherwise healthy firm with too much debt.

Long-termOperatingProblems: Eg. A firm with significant production or cost problems.

Normalize Earnings

Value the firm by doing detailed cash flow forecasts starting with revenues and reduce or eliminate the problem over time.:(a) If problem is structural: Target for operating margins of stable firms in the sector.(b) If problem is leverage: Target for a debt ratio that the firm will be comfortable with by end of period, which could be its own optimal or the industry average.(c) If problem is operating: Target for an industry-average operating margin.

If firmʼs size has notchanged significantlyover time

Average DollarEarnings (Net Income if Equity and EBIT if Firm made bythe firm over time

If firmʼs size has changedover time

Use firmʼs average ROE (if valuing equity) or average ROC (if valuing firm) on current BV of equity (if ROE) or current BV of capital (if ROC)

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TaxesandReinvestment

CashFlowsII132

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Whattaxrate?

¨ Thetaxratethatyoushoulduseincomputingtheafter-taxoperatingincomeshouldbea. Theeffectivetaxrateinthefinancialstatements(taxes

paid/Taxableincome)b. ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)c. Themarginaltaxrateforthecountryinwhichthecompany

operatesd. Theweightedaveragemarginaltaxrateacrossthecountriesin

whichthecompanyoperatese. Noneoftheabovef. Anyoftheabove,aslongasyoucomputeyourafter-taxcostof

debtusingthesametaxrate

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TheRightTaxRatetoUse

¨ Thechoicereallyisbetweentheeffectiveandthemarginaltaxrate.Indoingprojections,itisfarsafertousethemarginaltaxratesincetheeffectivetaxrateisreallyareflectionofthedifferencebetweentheaccountingandthetaxbooks.

¨ Byusingthemarginaltaxrate,wetendtounderstatetheafter-taxoperatingincomeintheearlieryears,buttheafter-taxtaxoperatingincomeismoreaccurateinlateryears

¨ Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowardsthemarginaltaxrateovertime.¤ Whileanargumentcanbemadeforusingaweightedaverage

marginaltaxrate,itissafesttousethemarginaltaxrateofthecountry

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ATaxRateforaMoneyLosingFirm

¨ Assumethatyouaretryingtoestimatetheafter-taxoperatingincomeforafirmwith$1billioninnetoperatinglossescarriedforward.Thisfirmisexpectedtohaveoperatingincomeof$500millioneachyearforthenext3years,andthemarginaltaxrateonincomeforallfirmsthatmakemoneyis40%.Estimatetheafter-taxoperatingincomeeachyearforthenext3years.

Year1 Year2 Year3EBIT 500 500 500TaxesEBIT(1-t)Taxrate

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NetCapitalExpenditures

¨ Netcapitalexpendituresrepresentthedifferencebetweencapitalexpendituresanddepreciation.Depreciationisacashinflowthatpaysforsomeoralot(orsometimesallof)thecapitalexpenditures.

¨ Ingeneral,thenetcapitalexpenditureswillbeafunctionofhowfastafirmisgrowingorexpectingtogrow.Highgrowthfirmswillhavemuchhighernetcapitalexpendituresthanlowgrowthfirms.

¨ Assumptionsaboutnetcapitalexpenditurescanthereforeneverbemadeindependentlyofassumptionsaboutgrowthinthefuture.

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Capitalexpendituresshouldinclude

¨ Researchanddevelopmentexpenses,oncetheyhavebeenre-categorizedascapitalexpenses.Theadjustednetcapexwillbe¤ AdjustedNetCapitalExpenditures=NetCapitalExpenditures+

Currentyear’sR&Dexpenses- AmortizationofResearchAsset¨ Acquisitionsofotherfirms,sincethesearelikecapital

expenditures.Theadjustednetcapexwillbe¤ AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofother

firms- Amortizationofsuchacquisitions¨ Twocaveats:

1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureofacquisitions(lookingatanaverageovertime)shouldbeused

2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usuallycategorizedunderotherinvestmentactivities

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Cisco’sAcquisitions:1999

Acquired MethodofAcquisition PricePaidGeoTel Pooling $1,344Fibex Pooling $318Sentient Pooling $103AmericanInternet Purchase $58SummaFour Purchase $129ClarityWireless Purchase $153Selsius Systems Purchase $134PipeLinks Purchase $118Amteva Tech Purchase $159

$2,516

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Cisco’sNetCapitalExpendituresin1999

CapExpenditures(fromstatementofCF)=$584mil- Depreciation(fromstatementofCF) =$486milNetCapEx(fromstatementofCF)=$98mil+R&Dexpense =$1,594mil- AmortizationofR&D =$485mil+Acquisitions =$2,516milAdjustedNetCapitalExpenditures =$3,723mil

¨ (Amortizationwasincludedinthedepreciationnumber)

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WorkingCapitalInvestments

¨ Inaccountingterms,theworkingcapitalisthedifferencebetweencurrentassets(inventory,cashandaccountsreceivable)andcurrentliabilities(accountspayables,shorttermdebtanddebtduewithinthenextyear)

¨ Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthedifferencebetweennon-cashcurrentassets(inventoryandaccountsreceivable)andnon-debtcurrentliabilities(accountspayable)

¨ Forfirmsinsomesectors,itistheinvestmentinworkingcapitalthatisthebiggerpartofreinvestment.

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WorkingCapital:GeneralPropositions

1. Working Capital Detail: While some analysts break downworking capital into detail (inventory, deferred taxes,payables etc.), it is a pointless exercise unless you feel thatyou can bring some specific information that lets youforecast the details.

2. Working Capital Volatility: Changes in non-cash workingcapital from year to year tend to be volatile. So, building ofthe change in the most recent year is dangerous. It is betterto either estimate the change based on working capital as apercent of sales, while keeping an eye on industry averages.

3. Negative Working Capital: Some firms have negative non-cash working capital. Assuming that this will continue intothe future will generate positive cash flows for the firm andwill get more positive as growth increases.

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VolatileWorkingCapital?

Amazon Cisco MotorolaRevenues $1,640 $12,154 $30,931Non-cashWC -$419 -$404 $2547%ofRevenues -25.53% -3.32% 8.23%Changefromlastyear $(309) ($700) ($829)Average:last3years -15.16% -3.16% 8.91%Average:industry 8.71% -2.71% 7.04%

MyPredictionWCas%ofRevenue 3.00% 0.00% 8.23%

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Fromthefirmtoequity

CashFlowsIII143

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DividendsandCashFlowstoEquity

¨ Inthestrictestsense,theonlycashflowthataninvestorwillreceivefromanequityinvestmentinapubliclytradedfirmisthedividendthatwillbepaidonthestock.

¨ Actualdividends,however,aresetbythemanagersofthefirmandmaybemuchlowerthanthepotentialdividends(thatcouldhavebeenpaidout)¤ managersareconservativeandtrytosmoothoutdividends¤ managersliketoholdontocashtomeetunforeseenfuturecontingenciesandinvestmentopportunities

¨ Whenactualdividendsarelessthanpotentialdividends,usingamodelthatfocusesonlyondividendswillunderstatethetruevalueoftheequityinafirm.

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MeasuringPotentialDividends

¨ Someanalystsassumethattheearningsofafirmrepresentitspotentialdividends.Thiscannotbetrueforseveralreasons:¤ Earningsarenotcashflows,sincetherearebothnon-cashrevenuesand

expensesintheearningscalculation¤ Evenifearningswerecashflows,afirmthatpaiditsearningsoutas

dividendswouldnotbeinvestinginnewassetsandthuscouldnotgrow¤ Valuationmodels,whereearningsarediscountedbacktothepresent,will

overestimatethevalueoftheequityinthefirm¨ Thepotentialdividendsofafirmarethecashflowsleftoverafter

thefirmhasmadeany“investments” itneedstomaketocreatefuturegrowthandnetdebtrepayments(debtrepayments- newdebtissues)¤ Thecommoncategorizationofcapitalexpendituresintodiscretionaryand

non-discretionarylosesitsbasiswhenthereisfuturegrowthbuiltintothevaluation.

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EstimatingCashFlows:FCFE

¨ CashflowstoEquityforaLeveredFirmNetIncome- (CapitalExpenditures- Depreciation)- Changesinnon-cashWorkingCapital- (PrincipalRepayments- NewDebtIssues)=FreeCashflowtoEquity

¨ Ihaveignoredpreferreddividends.Ifpreferredstockexist,preferreddividendswillalsoneedtobenettedout

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EstimatingFCFEwhenLeverageisStable

NetIncome- (1- DR)(CapitalExpenditures- Depreciation)- (1- DR)WorkingCapitalNeeds=FreeCashflowtoEquity

DR=Debt/CapitalRatioForthisfirm,

¤ Proceedsfromnewdebtissues=PrincipalRepayments+d(CapitalExpenditures- Depreciation+WorkingCapitalNeeds)

¨IncomputingFCFE,thebookvaluedebttocapitalratioshouldbeusedwhenlookingbackintimebutcanbereplacedwiththemarketvaluedebttocapitalratio,lookingforward.

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EstimatingFCFE:Disney

¨ NetIncome=$1533Million¨ Capitalspending=$1,746Million¨ DepreciationperShare=$1,134Million¨ Increaseinnon-cashworkingcapital=$477Million¨ DebttoCapitalRatio(DR)=23.83%¨ EstimatingFCFE(1997):

NetIncome $1,533Mil- (Cap.Exp - Depr)*(1-DR) $465.90[(1746-1134)(1-.2383)]Chg.WorkingCapital*(1-DR) $363.33 [477(1-.2383)]=FreeCFtoEquity $704Million

DividendsPaid $345Million

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FCFEandLeverage:Isthisafreelunch?

Debt Ratio and FCFE: Disney

0

200

400

600

800

1000

1200

1400

1600

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Debt Ratio

FCFE

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FCFEandLeverage:TheOtherShoeDrops

Debt Ratio and Beta

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%Debt Ratio

Beta

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Leverage,FCFEandValue

¨ Inadiscountedcashflowmodel,increasingthedebt/equityratiowillgenerallyincreasetheexpectedfreecashflowstoequityinvestorsoverfuturetimeperiodsandalsothecostofequityappliedindiscountingthesecashflows.Whichofthefollowingstatementsrelatingleveragetovaluewouldyousubscribeto?a. Increasingleveragewillincreasevaluebecausethecashfloweffects

willdominatethediscountrateeffectsb. Increasingleveragewilldecreasevaluebecausetheriskeffectwillbe

greaterthanthecashfloweffectsc. Increasingleveragewillnotaffectvaluebecausetheriskeffectwill

exactlyoffsetthecashfloweffectd. Anyoftheabove,dependinguponwhatcompanyyouarelookingat

andwhereitisintermsofcurrentleverage

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