Lecture 6 Forecasting Cash Flow Statement

Lecture 6

Forecasting Cash Flow Statement

Michael Ungeheuer / Aalto BIZ Finance 2

Takeaways from income statement and balance sheet forecasting


Note on our discussion today

Discussion today:

• Rather high-level• Focuses on indirect method in cash-flow analysis

• Skips some accounting subtleties

• Focus on future prediction rather than historical reporting

• To get the details of cash flow analysis absolutely right and understand how it should be done according to IAS, consider taking the following courses:

Cash-flow analysis (22C00900) Financial Statement Analysis

(22E00100)


Structure of discussion today

• Three cardinal rules of cash-flow analysis

• How to prepare cash-flow statement

• Some tricks of the trade in actual valuation


Three cardinal rules of cash-flow analysis

Be specific which cash-flow: FCFF or FCFE1

Make your cash-flow analysis as simple as possible, but not simpler3

Use either direct or indirect method to do cash-flow statement2


Free Cash Flow to the Firm (FCFF)

= Cash flow available to

Common stockholders

Debtholders

Preferred stockholders

Free Cash Flow to Equity (FCFE)

= Cash flow available to

Common stockholders

Be specific which cash flow

Use WACC in discounting

Use return on equity in discounting

1


There are two ways to do a cash-flow statement

• Typically more detailed approach

• Uses actual cash flows

• Breaks cash-flows into operating (OCF), investing, and financing cash flows

• In practice very rare

Direct method

• Coarse, high-level approach

• Uses net income as a starting point

• May be regarded as an approximation of true cash flow

• Often only method available for an external analyst without access to detailed financial data, especially with the case non private companies or with quarterly data

Indirect method

Focus of this lecture

2


Make your cash-flow analysis as simple as possible, but not simpler• Your FCF(E) forecast and analysis should be as simple as possible:

– The big things that will drive the value are revenue, margin, terminal value, and discount rate assumptions

– Modeling a minuscule minority interest or accrual items in quarterly data is more likely to confuse you than add insight

– When adding additional level of detail ask yourself: is this big and do I have an insight on the item

• But not simpler:– Remember that insight can often be developed so lack of insight is not an

excuse to skip a large item– One-off items such as restructuring charges, cross-holdings, large tax assets

or liabilities must be understood and modeled. Otherwise your baseline may be off for forecasting

3


Direct method – OCF illustration

Source: E&Y ”Statement of cash flows”, 2012

FASB and IAS both allow for interest paid and income taxes to be listed either under operating activities or financing activities:

• Most companies put them under operating activities• From valuation and finance theory perspective makes sense to put

these cash flows later in the cash flow statement: you want to know first how much the company makes money and later who gets the money (government, debtholders, equityholders)


Direct method – illustration continued


Indirect method – Finnair forecasted FCFE

• Forecasted net interest paid using average interest rate on short- and long-term borrowings• For after-tax interest expense, multiply by (1-Tax rate). Alternatively, we could leave out the tax-adjustment in

WACC and use pretax interest rates. Be consistent: either do tax-shield adjustment for FCFF or WACC, not both• Depreciation is added back to ”investment in fixed capital”. Investment is depreciation plus change in non-current

assets (tangible + intangible)• Investment in working capital: change in receivables + change in inventory – change in payables• Add back interest expense• Net borrowing: increase in short- and long-term borrowing from forecasted balance sheet• FCFE should equal dividend

• Start with forecasted net income

• Depreciation added to net income, along with all other noncash expenses. Other non-cash items ignored for simplicity

1

2

33

4

5678

12345

67

8


• Added backAmortization

• Added backRestructuring Expense

• Subtracted outRestructuring Income

• Subtracted outCapital Gains

• Added back Capital Losses

• Added backEmployee Option Exercise

• Added back?Deferred Taxes

• Subtracted out?Tax Asset

In a more detailed cash-flow analysis, consider also the following items for your baseline year


Finally, there is your baby – DCF estimate for the stock value


Excess cash

Operating leases

R&D and other noncapitalized expenses with future value

Nonrecurring charges

Tax rate

Abnormally low profit

Dividend and FCFE

Further issues in FCFF and FCFE analysis


Excess cash is not king and should be thrown out from the court • Simplest way: verify that there is no

excess cash. Some cash is required as part of NWC

• Simple way: in case of excess cash, keep cash and associated interest income out from valuation and add back book value of cash after you are done

• Complex way: include interest income from cash. Adjust discount rate to incorporate the low-risk of cash: cash is a zero-beta asset


• Operating lease expenses should be treated as financing expenses, with the following adjustments:• Debt value of operating Leases = PV of operating lease commitments at

the pre-tax cost of debt• Add operating lease asset with exactly the same value to “assets”

• Adjust operating profit (net income does not change in this simplified case)• Adjusted operating profit = Operating profit + Operating lease expenses –

depreciation of operating lease asset• Introducing taxes and detailed depreciation schedule into the equation may

change net income as well• Shorthand:

• Adjusted operating profit = Operating profit + pre-tax cost of debt * PV of operating leases

• Adjusted interest expenses = interest expenses + pre-tax cost of debt * PV of operating leases

Operating leases – once spotted, what then?


R&D expenses and other uncapitalizedexpenses with future value

• Usually companies err on the side of capitalizing expenses too aggressively

• However, sometimes research and development that are likely to generate future cash flows that are not capitalized should be moved from operating expenses into capital expenses

• How to do this: • Specify an amortizable life for R&D (2 - 10 years)• Collect past R&D expenses for as long as the amortizable life• Sum up the unamortized R&D over the period (i.e., if your

amortization life is 5 years, take 1/5 of unamortized R&D 5 years ago, 2/5 unamortized R&D 4 years ago…)

• Put summed amortized R&D in balance sheet and add corresponding annual values to operating profit


• You are valuing a firm that is reporting a operating loss of €200 million, due to a one-time charge of €400 million. Which operating profit to use? a. An operating loss of € 200 millionb. An operating profit of € 200 million

• Would your answer be any different if the firm had reported one-time losses like these once every five years?a. Yesb. No

Extraordinary items – part of business or not?


• Effective (=total income taxes paid / net income before taxes) or marginal tax rate (=corporate tax rate)? • More conservative to use the marginal tax rate • Effective tax rate is driven by tax accountants and

taxman• Using marginal tax rate understates the after-tax operating

income in the earlier years (capital is typically depreciated faster early, possible to do more tax-decreasing choices in growing phase of business)

• If you use effective tax rate, adjust the tax rate towards the marginal tax rate over time

Which tax rate should in put in my projections?


What to do when the company has negative net income?

Source: Aswath Damodaran

When facing a loss-making company:

• Remember that eternal loser is worth nothing and if the cash flows are too far away, nobody will finance the losses meanwhile

• Use this framework to see where is the problem:

• If you believe the problem can be solved, adjust forecasts

• If not, put big fat zero on your valuation model


• Dividend is money paid into bank account, not bizarre “FCFE” made up by valuation gurus

• Actual dividends are set by the managers of the firm and may be much lower than the potential dividends (=FCFE) • Dividend smoothing• Managers like to hold on to cash to meet unforeseen future

contingencies and investment opportunities• Excess cash built up from potential dividends that were never

paid does build up in the balance sheet• Using DDM will understate firm value, if excess cash is piling up

• FCFE often more accurate• DDM works when “bird in the hand” is only thing that matters

(e.g., managers with agency problems, restructuring with fights over the cash flow)

Is FCFE same as dividend?


Closing thought

Source: Green, Jeremiah, John RM Hand, and Frank Zhang. "A New Perspective on Analyst Sophistication: Errors and Dubious Judgments in Analysts’ DCF Valuation Models."

Lecture 6 Forecasting Cash Flow Statement

Documents

Transcript of Lecture 6 Forecasting Cash Flow Statement