Cash Accounting, Accrual Cash Accounting, Accrual Accounting, and Discounted Accounting, and Discounted

Cash Flow AnalysisCash Flow Analysis

Chapter 4Chapter 4

Cashing Accounting, Accrual Accounting, Cashing Accounting, Accrual Accounting, and Discounted Cash Flow Analysisand Discounted Cash Flow Analysis

Chapter 3 outlined the process of fundamental analysis and depicted

valuation as a matter of forecasting future

financial statements

This web page provides further explanation and additional examples of discounted cash flow

analysis, cash accounting, and accrual

accounting.

Chapter 5 and 6 together lay out valuation

methods that forecast accrual accounting

income statements and balance sheets.

This chapter introduces discounted cash flow

valuation, a method that involves forecasting

future cash flow statements. The chapter

also shows how cash flows differ from accrual earnings in the income

statement, and how ignoring accruals in

discounted cash flow valuation can cause

problems.

What form of accounting

best captures value added

in operations: cash

accounting or accrual

accounting?

What is the difference

between cash accounting and accrual accounting?

What is the discounted cash flow model?

Does it work?

What is the dividend discount model?

Does it work?

Link to next chapter

This Chapter

Link to web page

Link to pervious chapter

What you will learn from this ChapterWhat you will learn from this Chapter

• How the dividend discount model works (or does not work)• 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• How reverse engineering works as an analysis tool • What a “simple valuation” is

A Reminder: Valuation Models for A Reminder: Valuation Models for Going ConcernsGoing Concerns

CF1 CF2 CF3 CF4 CF5

A Firm1 2 3 4 50

d1 d2 d3 d4 d5Dividend Flow

1 2 3 4 50

TVT

T

d T

Equity

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: The Dividend Discount Model: Targeting DividendsTargeting Dividends

• DDM:

Problems: How far does one project?

• Does

provide a good estimate of VE0?

(i) Dividend policy can be arbitrary and not linked to value added.

(ii) The firm can borrow to pay dividends; this does not create value

(iii) Think of a firm that “pays no dividends”

• The dividend irrelevancy concept

• The dividend conundrum:

– Equity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value

• Conclusion: Focus on creation of wealth rather than distribution of wealth.

Vd d dE

E E E0

1 22

33

Vd d d dE

E E E

T

ET0

1 22

33

Terminal Values for the DDMTerminal Values for the DDM

A. Capitalize expected terminal dividends

B. Capitalize expected terminal dividends with growth

Will it work?

1

dT

E

1TT

TPV

gPV

E

1T

T

dT

T

Some Math: The Value of a Perpetuity Some Math: The Value of a Perpetuity and a Perpetuity with Growthand a Perpetuity with Growth

The Value of a Perpetuity

A perpetuity is a constant stream that continues without end. A constant 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 =

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:

Value of a dividend growing at a constant rate =

11

0

E

E dV

g

dV

E

E

1

0

Dividend Discount Analysis: Dividend Discount Analysis: Advantages and DisadvantagesAdvantages and Disadvantages

Dividend Discount Analysis

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 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).

Cash Flows for a FirmCash Flows for a Firm

Cash flow from

operations (inflows)

Cash investment(outflows)

Free cash flow

Time, t

C1 C2 C3 C4

I1 I2 I3 I4

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

C5

I5

C5-I5

1 2 43 5

Free cash flow is cash flow from operations that results from investments minus cash used to make investments.

The Discounted Cash Flow (DCF) The Discounted Cash Flow (DCF) Model Model

C a s h f l o w f r o m o p e r a t i o n s ( i n f l o w s ) C 1 C 2 C 3 C 4 C 5 - - - > C a s h i n v e s t m e n t I 1 I 2 I 3 I 4 I 5 - - - > ( o u t f l o w s )

F r e e c a s h f l o w C 1 I 1 C 2 I 2 C 3 I 3 C 4 I 4 C 5 I 5 - - - >

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ - - - >

T i m e , t 1 2 3 4 5

D0T

F

TTF

TT3F

332F

22

F

11E0 V

VCICICICICV

FOV

D0

F0

E0 VVV

The Continuing Value for the The Continuing Value for the DCF ModelDCF Model

• A. Capitalize terminal free cash flow

• B. Capitalize terminal free cash flow with growth

1ρ

ICCV

F

1T1TT

gρ

ICCV

F

1T1TT

DCF Valuation: The Coca-Cola DCF Valuation: The Coca-Cola CompanyCompany

In millions of dollars except 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 1,167 906 618

Free cash flow 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 flow 2,486 2,449 2,756 3,224 3,452

Total present value to 2004 14,367

Continuing Value (CV) * 139,414

Present value of CV 90,611

Enterprise value 104,978

Book value of net debt 4,435

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

)( 1999EV

Will DCF Valuation Always Work?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 36,484Cash investments 37,699 40,308 61,227 21,843 38,414Free cash flow (7,690) (910) (26,379) 14,259 (1,930)

Earnings 12,735 13,684 14,118 15,002 16,593Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

Reverse Engineering: What Forecasts Reverse Engineering: What Forecasts are Implied by the Current Market are Implied by the Current Market Price?Price?

million $140,904

sharesmillion 2,472 x 57 P Coke, For $0

$4,435-1.5386g - 1.09

g x 311,5

5386.1

311,5

4116.1

551,4

2950.1

569,3

1881.1

910,2

1.09

2,710million 140,904$

Reverse engineer as follows:

Can Coke maintain this growth rate?

rate)growth % 6.2 a ( 062.1 g

Simple ValuationsSimple Valuations

Simple valuations use very short forecasts horizons, and isolate more speculative, long-term forecasts. Accordingly, they anchor on “what we know” or are relatively sure about.

A simple DCF for Coca-Cola, 2000

Debt Netg

ICV

E

E

110

$4,435 09.1

710,2

g

Reverse Engineering a Simple Reverse Engineering a Simple Valuation: Coca-ColaValuation: Coca-Cola

435,4$g-1.09

2,710 140,904$0 P

Applying the simple model to reverse engineer Coke’s stock price,

%) 7.13 is rate(growth 0713.1 g

The DCF Model: The DCF Model: Will it work for Wal-Mart Stores?Will it work for Wal-Mart Stores?

Walt-Mart Stores, Inc.

(Fiscal years ending January 31. Amounts in millions of dollars, except per-share data)

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

Why Free Cash Flow is not a Value-Why Free Cash Flow is not a Value-Added ConceptAdded 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: Discounted Cash Flow Analysis: Advantages and DisadvantagesAdvantages and Disadvantages

Discounted Cash Flow (DCF) Analysis

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: can require long forecast horizons to recognize cash inflows from investments, particularly when investments are growing. 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.

Partial Statement of Cash Flows: Partial Statement of Cash Flows: Dell ComputerDell Computer

Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Cash flows from operating activities: Net income $ 1,246 $ 2,177 $ 1,666 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 239 240 156 Tax benefits of employee 487 929 1,040 stock plans Special charges 742 105 194 (Gains)/losses on investments 17 (307) (80) Other 178 135 56 Changes in operating working capital: Accounts receivable, net 222 (531) (394) Inventories 111 (11) (123) Accounts payable 826 780 988 Accrued and other liabilities (210) 404 416 Other, net (123) - (75) Non-current assets and 62 274 82 liabilities ------ ------ ------ Net cash provided by 3,797 4,195 3,926 operating activities ------ ------ ------ Cash flows from investing activities: Investments: Purchases (5,382) (2,606) (3,101) Maturities and sales 3,425 2,331 2,319 Capital expenditures (303) (482) (401) ------ ------ ------ Net cash used in investing (2,260) (757) (1,183) activities ------ ------ ------ Supplemental Statement Of Cash Flows Information: Interest paid 31 49 34 Investment income, primarily 314 305 158 interest

Reported Cash Flow from OperationsReported 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

Reported Cash Flow in Investing Reported Cash Flow in Investing ActivitiesActivities

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

Calculating Free Cash Flow: Calculating Free Cash Flow: Dell Computer, 2002Dell Computer, 2002

Reported cash flow from operations 3,797 Interest payments 31 Interest income* (314)Net interest payments (283)

Taxes (35%) † 99 Net interest payments after tax (65%) (184)Cash flow from operations 3,613

Reported cash used in investing activities 2,260 Purchases of interesting-bearing securities 5,382 Sales of interest-bearing securities (3,425) 1,957Cash investment in operations 303Free cash flow 3,310

*Interest payments are given as supplemental data to the statement of cash flows, but interestreceipts 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 financialstatement footnotes.

Forecasting Free Cash FlowsForecasting 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 available to common

(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))

Forecasting Free Cash Flow: Forecasting Free Cash Flow: Dell ComputerDell Computer

Forecast 2000 2001 2002 Earnings 1,666 2,177 1,246 Accrual adjustment 2,260 2,018 2,551

Levered cash flows from operations

3,926 4,195 3,797

Interest payments 34 49 31 Interest receipts (158) (305) (314) Net interest payments (124) (256) (283) Tax at 35% 43 (81) 90 (166) 99 (184) Cash flow from operations 3,845 4,029 3,613 Cash investment in operations (401) (482) (303) Free cash flow 3,444 3,547 3,310

Features of the Income StatementFeatures of the Income Statement1. 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

Revenue Accruals

Expense Accruals

Value added that is not cash flow

Adjustments to cash flows that are not value added

Value decreases that are not cash flows

Adjustments to cash outflows that are not value decreases

The Income Statement: Dell ComputerThe Income Statement: Dell Computer

Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Net revenue $ 31,168 $ 31,888 $ 25,265 Cost of revenue 25,661 25,445 20,047 ------ ------ ------ Gross margin 5,507 6,443 5,218 ------ ------ ------ Operating expenses: Selling, general and 2,784 3,193 2,387 administrative Research, development and 452 482 374 engineering Special charges 482 105 194 ------ ------ ------ Total operating expenses 3,718 3,780 2,955 ------ ------ ------ Operating income 1,789 2,663 2,263 Investment and other income (58) 531 188 (loss), net ------ ------ ------ Income before income taxes and 1,731 3,194 2,451 cumulative effect of change in accounting principle Provision for income taxes 485 958 785 ------ ------ ------ Income before cumulative 1,246 2,236 1,666 effect of change in accounting principle Cumulative effect of change in - 59 - accounting principle, net ------ ------ ------ Net income $ 1,246 $ 2,177 $ 1,666 ------ ------ ------

The Revenue CalculationThe 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 CalculationThe 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 FlowsEarnings 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.

Earnings and Cash Flows: Earnings and Cash Flows: Wal-Mart StoresWal-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 .48 .57 .70 .87 1.02 1.17 1.19

Accruals, Investments and the Balance Accruals, Investments and the Balance SheetSheet

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

The Balance Sheet: Dell ComputerThe Balance Sheet: Dell Computer

Fiscal Year Ended _______________________ February 1, February 2, 2002 2001 ------------- ------------- ASSETS Current assets: Cash and cash equivalents $ 3,641 $ 4,910 Short-term investments 273 525 Accounts receivable, net 2,269 2,424 Inventories 278 400 Other 1,416 1,467 ------ ------ Total current assets 7,877 9,726 Property, plant and equipment, 826 996 net Investments 4,373 2,418 Other non-current assets 459 530 ------ ------ Total assets $ 13,535 $ 13,670 ------ ------ LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 5,075 $ 4,286 Accrued and other 2,444 2,492 ------ ------ Total current liabilities 7,519 6,778 Long-term debt 520 509 Other 802 761 Commitments and contingent - - liabilities (Note 7) ------ ------ Total liabilities 8,841 8,048 ------ ------ Stockholders equity: Preferred stock and capital in - - excess of $.01 par value; shares issued and outstanding: none Common stock and capital in 5,605 4,795 excess of $.01 par value;

The articulation of the financial statements The articulation of the financial statements through the recording of cash flows and through the recording of cash flows and accrualsaccruals

Investment and disinvestment by owners

Earnings

Net change in owners’ equity

SSttaatteemmeenntt ooff SShhaarreehhoollddeerrss’’ EEqquuiittyy –– yyeeaarr 11

Cash from operations

+ Accruals

Net income

IInnccoommee SSttaatteemmeenntt –– yyeeaarr 11

Cash from operations Cash from investing Debt financing

Net change in cash

CCaasshh FFllooww SSttaatteemmeenntt –– yyeeaarr 11

Cash0

+ Other Assets0

Total Assets0

- Liabilities0

Owners’ equity0

Cash1

+ Other Assets1

Total Assets1

- Liabilities1

Owners’ equity1

EEnnddiinngg BBaallaannccee SShheeeett –– yyeeaarr 11

Beginning stocks Flows Ending stocks

EEnnddiinngg BBaallaannccee SShheeeett –– yyeeaarr 00

Equity financing

Net cash flows from all activities increases cash in the balance sheetCash from operations increases net income and shareholders’ equityCash investments increase other assetsCash from debt financing increases liabilitiesCash from equity financing increases shareholders’ equity

Accruals increase net income, shareholders’ equity, assets and liabilities