1、McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies,Inc.All rights reserved.Cash Accounting,Accrual Accounting,and Discounted Cash Flow ValuationHow the dividend discount model works(or does not work)What is meant by cash flow from operationsWhat is meant by cash used in investing activiti
2、esWhat is meant by free cash flowHow discounted cash flow valuation worksProblems that arise in applying cash flow valuationWhy free cash flow may not measure value added in operationsWhy free cash flow is a liquidation conceptHow discounted cash flow valuation involves cash accounting for operating
3、 activitiesWhy“cash flow from operations”reported in U.S.financial statements does not measure operating cash flows correctlyWhy“cash flows in investing activities”reported in U.S.financial statements does not measure cash investment in operations correctlyHow accrual accounting for operations diffe
4、rs from cash accounting for operationsThe difference between earnings and cash flow from operationsThe difference between earnings and free cash flowHow accruals and the accounting for investment affect the balance sheet as well as the income statementWhy analysts forecast earnings rather than cash
5、flowsHow a valuation model is a model of accounting for the futureHow reverse engineering works as an analysis toolWhat a“simple valuation”is4-3CF1CF2CF3CF4CF5A Firm123450d1d2d3d4d5Dividend Flow123450TVTTd TEquity The terminal value,TVT is the price payoff,PT when the share is sold Valuation issues:
6、The forecast target:dividends,cash flow,earnings?The time horizon:T=5,10,?The terminal valueThe discount rate4-4 DDM:Problems:How far does one project?Doesprovide 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 do
7、es 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
8、 distribution of wealth.312023EEEEdddV312023ETTEEEEddddV4-5A.Capitalize expected terminal dividendsB.Capitalize expected terminal dividends with growthWill it work?T 1TTEdTVP1T 1TTEdTVPg4-6The Value of a PerpetuityA perpetuity is a constant stream that continues without end.The periodic payoff in th
9、e 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 s
10、tream=The Value of a Perpetuity with GrowthIf 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=110EEdVgdVEE104-7 Easy concept:dividends are what
11、 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)Relevance:dividends payout is not related to value,at least in the short run;dividend forecasts ignore the capital gain component of payoffs.Forec
12、ast horizons:typically requires forecasts for long periods;terminal values for shorter 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).4-8Cash flow from operati
13、ons(inflows)Cash investment(outflows)Free cash flowTime,tC1C2C3C4I1I2I3I4C1-I1C2-I2C3-I3C4-I4C5I5C5-I512435Free cash flow is cash flow from operations that results from investments minus cash used to make investments.4-9Cash flow from operations(inflows)C1 C2 C3 C4 C5 -Cash investment I1 I2 I3 I4 I5
14、 -(outflows)Free cash flow C1 I1 C2 I2 C3 I3 C4 I4 C5 I5-_ -Time,t 1 2 3 4 5 D0TFTTFTT3F332F22F11E0VVCICICICICV FOVD0F0E0VVV4-10A.Capitalize terminal free cash flowB.Capitalize terminal free cash flow with growthWill it work?1ICCVF1T1TTgICCVF1T1TT4-11In millions of dollars except share and per-share
15、 numbers.Required return for the firm is 9%199920002001200220032004Cash from operations3,6574,0974,7365,4575,929Cash investments 9471,1871,167 906 618Free cash flow2,7102,9103,5694,5515,311Discount rate(1.09)t 1.09 1.1881 1.2950 1.4116 1.5386Present value of free cash flows2,4862,4492,7563,2243,452T
16、otal present value to 2004 14,367Continuing value(CV)*139,414Present value of CV 90,611Enterprise value 104,978Book value of net debt 4,435Value of equity 100,543Shares outstanding 2,472 Value per share$40.67*CV=5,311 x 1.05 =139,414 1.09-1.05Present value of CV =139,414 =90,611 1.53864-12Here are t
17、he steps to follow for a DCF valuation:1.Forecast free cash flow to a horizon2.Discount the free cash flow to present value3.Calculate a continuing value at the horizon with an estimated growth rate4.Discount the continuing value to the present5.Add 2 and 46.Subtract net debt4-13A Firm with Negative
18、 Free Cash Flows:General Electric CompanyIn millions of dollars,except per-share amounts.20002001200220032004Cash from operations30,00939,39834,84836,10236,484Cash investments37,69940,30861,22721,84338,414Free cash flow(7,690)(910)(26,379)14,259(1,930)Earnings12,73513,68414,11815,00216,593Earnings p
19、er share(eps)1.29 1.38 1.42 1.50 1.60Dividends per share(dps)0.57 0.66 0.73 0.77 0.824-14 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
20、 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.4-15million$140,904 sharesmillion 2,472 x 57 P Coke,For$o$4,435-1.5386g -1.09g x 311,55386.1311,54116.1551,42950.1569
21、,31881.1910,21.092,710million 140,904$Reverse engineer as follows:Can Coke maintain this growth rate?rate)growth%6.2 a (062.1g4-16Simple 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.
22、A simple DCF for Coca-Cola,2000Debt NetgICVEEO11315,63$05.109.1710,2$4,435 4-17435,4$0g-1.092,710 140,904PApplying the simple model to reverse engineer Cokes stock price,%)7.13 is rate(growth g0713.14-18 Wal-Mart Stores,Inc.(Fiscal years ending January 31.Amounts in millions of dollars.)198819891990
23、199119921993199419951996Cash from operations5368289681,4221,5531,5402,5733,4102,993Cash investments6275418941,5262,1503,5064,4863,7923,332Free cash flow(91)28774(104)(597)(1,966)(1,913)(382)(339)Dividends per share0.030.040.060.070.090.110.130.170.20Price per share6810162732262524 4-19 Cash flow fro
24、m 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
25、 partially a liquidation conceptNote:analysts forecast earnings,not cash flows4-20 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 Suspect concept:free cash flow does not
26、 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 ba
27、ck on investments.Forecast horizons:typically requires forecasts for long periods;terminal values for shorter periods are hard to calculate with any reliability Validation:it is hard to validate free cash flow forecasts Not aligned with what people forecast:analysts forecast earnings,not free cash f
28、low;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.4-214-22Reported cash flows from operations in U.S.cash flow statements is after int
29、erest:Cash Flow from Operations=Reported Cash Flow from Operations+After-tax Net Interest PaymentsAfter-tax Net Interest =Net Interest x(1-tax rate)Net interest=Interest payments Interest receiptsReported cash flow from operations is sometimes referred to as levered cash flow from operations4-23Repo
30、rted 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 securities4-24Reported cash flow from operations3,949 Interest payments 54 Interest income*(387)Net inte
31、rest payments (333)Taxes(35%)117 Net interest payments after tax(65%)(216)Cash flow from operations3,733Reported cash used in investing activities1,763 Purchases of interesting-bearing securities2,394 Sales of interest-bearing securities (3,679)1,285Cash investment in operations 3,048Free cash flow
32、685*Interest payments are given as supplemental data to the statement of cash flows,but interest receipts usually are not.Interest income(from the income statement)is used instead;this includes accruals but is usually close to the cash interest received.Dells statutory tax rate(for federal and state
33、 taxes)is 35 percent,as indicated in the financial statement footnotes.4-25It 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 availa
34、ble to commonii.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 byadding after-tax net interestv.Forecast cash investments in op
35、erationsvi.Calculate forecasted free cash flow,C-I(Step(iv)-Step(v)4-264-274-281.Dividends dont affect income2.Investment doesnt affect income3.There is a matching ofValue added(revenues)Value lost(expenses)Net value added(net income)4.Accruals adjust cash flowsAccrualsValue added that is not cash f
36、lowAdjustments to cash inflows that are not value added4-294-30Revenue=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 deferred4-31Expense=Cash paid for
37、 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 period4-32Earnings=C-I-i+I+accruals =C-i+accruals The earnings calculation adds back investments and puts them back in
38、 the balance sheet.It also adds accruals.4-33_ W al-M art 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)(38
39、2)(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 4-34Accruals and investments are put in the balance sheetShareholders equity=Cash+Other Assets-LiabilitiesEarningsCash from OperationsAccrualsFree cash flowCash from OperationsInvestments4-
40、354-36 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 equityAccruals increase net income,shareholders equity,assets and liabilities4-37
