CHAPTER FOUR

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Cash Accounting, Accrual Accounting,

and Discounted Cash Flow Valuation

What 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

4-3

Valuation Models: Going 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

4-4

The Dividend Discount Model: Targeting 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.

31 20 2 3E

E E E

dd dV

31 20 2 3E T

TE E E E

dd d dV

4-5

Terminal Values for the DDM

A. Capitalize expected terminal dividends

B. Capitalize expected terminal dividends with growth

Will it work?

T 1T T

E

dTV P

1

T 1T T

E

dTV P

g

4-6

Some 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 =

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

4-7

Dividend Discount Analysis: Advantages and Disadvantages

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).

4-8

Cash Flows for a Going Concern

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.

4-9

The Discounted Cash Flow (DCF) 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

4-10

The Continuing Value for the DCF Model

A. Capitalize terminal free cash flow

B. Capitalize terminal free cash flow with growth

Will it work?

1ρ

ICCV

F

1T1TT

gρ

ICCV

F

1T1TT

4-11

DCF Valuation: The Coca-Cola CompanyIn 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 5,929Cash investments 947 1,187 1,167 906 618Free 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 flows 2,486 2,449 2,756 3,224 3,452Total 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 100,543

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

4-12

Steps for a DCF Valuation

Here are the 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 debt

4-13

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

4-14

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.

4-15

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

million $140,904

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

$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

4-16

Simple 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

EO

11

315,63$

05.109.1

710,2

$4,435

4-17

Reverse Engineering a Simple Valuation: Coca-Cola

435,4$$0 g-1.09

2,710 140,904P

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

%) 7.13 is rate (growth g 0713.1

4-18

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

Wal-Mart Stores, Inc.

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

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

4-19

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

4-20

Discounted Cash Flow Analysis: Advantages and Disadvantages

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: 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 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.

4-21

Partial Statementof Cash Flows: Dell Inc., 2008

4-22

Reported 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

4-23

Reported Cash Flow in Investing Activities

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

4-24

Calculating Free Cash Flow from the Cash Flow Statement: Dell Inc., 2008

Reported cash flow from operations

3,949 Interest payments

54 Interest income*

(387)

Net interest payments

(333)

Taxes (35%) †

117 Net interest payments after tax (65%)

(216)Cash flow from operations

3,733

Reported cash used in investing activities

1,763 Purchases of interesting-bearing securities 2,394

Sales of interest-bearing securities (3,679) 1,285

Cash investment in operations

3,048Free cash flow

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.

†Dell’s statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial statement footnotes.

4-25

From Earnings to 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))

4-26

Converting Earnings to Free Cash Flow:Dell Inc., 2008

4-27

A Common Approximation

4-28

Features of the Income Statement

1. Dividends don’t affect income2. Investment doesn’t affect income3. There is a matching of

Value added (revenues)Value lost (expenses)Net value added (net income)

4. Accruals adjust cash flows

Accruals

Value added that is not cash flow

Adjustments to cash inflows that are not value added

4-29

The Income Statement: Dell Inc.

4-30

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

4-31

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

4-32

Earnings 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.

4-33

Earnings and Cash Flows: Wal-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

4-34

Accruals, Investments and the Balance Sheet

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

4-35

The Balance Sheet: Dell Inc.

4-36

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

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

4-37