Chapter 12 Valuation: Cash –Flow- Based Approaches

Valuing the Firm Economic theory teaches us that the value of an investment is: Chapter: 122 Expected future payoffs can be measured in terms of: Dividends Cash Flows Earnings

Approaches to firm valuation Chapter: 123

Focus is on the cash that flows into the firm. Measures the cash flows that are “free” to be distributed to shareholders. Cash flows generated by the firm create dividend-paying capacity. Chapter: 124 Cash-Flow-Based Valuation

Amount of cash flowing into firm differs from dividends paid in a particular period. But over the lifetime of the firm, cash flows into and cash flows out of the firm will be equivalent. Chapter: 125 Cash-Flow-Based Valuation (Contd.)

Cash is the ultimate source of value. The free cash flows approach measures value based on the cash flows that the firm generates that can be distributed to investors. It is a measurable common denominator for comparing the future benefits of alternative investment instruments. Chapter: 126 Rationale for Using Free-Cash-Flows

Cost of Common Equity Capital CAPM Model: Chapter: 127

Weighted Average Cost of Capital Chapter: 128

Measuring Free Cash Flows Under U.S. GAAP and IFRS, Cash flow statement categorize the activities as operating, investing and financing. Some rearrangements are necessary to compute free cash flows. Chapter: 129

Measuring Free Cash Flows (Contd.) Cash flow from operations from the projected statement of cash flows is the most direct starting point because it requires the fewest adjustments. However, some analysts compute free cash flows using alternative starting points. Chapter: 1210

Measuring Free Cash Flows Free Cash Flows for All Debt and Equity Stakeholders: Operating Activities: Cash Flow from Operations +/- Net Interest after Tax +/- Changes in Cash Requirements for Liquidity = Free Cash Flows from Operations for All Debt and Equity Investing Activities: +/- Net Capital Expenditures = Free Cash Flows for All Debt and Equity Stakeholders Chapter: 1211

Measuring Free Cash Flows Free Cash Flows for Common Equity Shareholders: Operating Activities: Cash Flow from Operations +/- Changes in Cash Requirements for Liquidity = Free Cash Flows from Operations for Equity Investing Activities: +/- Net Capital Expenditures Financing Activities: +/- Debt Cash Flows +/- Financial Asset Cash Flows +/- Preferred Stock Cash Flows = Free Cash Flows for Common Equity Stakeholders Chapter: 1212

Cash-Flows-Based Valuation Models To value common equity measure: Discount rate – R E. Expected future free cash flows – FCF Eq for periods 1 through T over forecast horizon. Continuing free cash flows, FCF Eq(T+1), and long- run growth rate, g. Chapter: 1213

Free-Cash-Flows-Based Valuation Models For common equity shareholders: Chapter: 1214

Free-Cash-Flows-Based Valuation Models For all debt and equity capital stakeholders: Chapter: 1215

Continuing Value Represented by last term of equation: Use expected long-term growth rate, g, to project all items on Year T+1 income statement and balance sheet. R A must be greater than g for this formula to work. Chapter: 1216

What now? Once valuation model is applied, then Conduct sensitivity analysis: Vary cost of equity capital rate (R E ) Vary long-run growth rate (g) Discount rate assumptions Vary these parameters and assumptions individually and jointly. Chapter: 1217

Evaluation of the Free-Cash-Flows-Valuation method Advantages: Focuses on free cash flows, believed to have more economic meaning than earnings. Results from projections of future operating, investing, and financing decisions of a firm made by the analyst. Chapter: 1218

Evaluation of the Free-Cash-Flows-Valuation method Advantages: (Contd.) Focuses directly on net cash inflows available to be distributed to capital providers. This perspective is especially pertinent to acquisition decisions. Widely used in practice. Chapter: 1219

Evaluation of the Free-Cash-Flows-Valuation method Disadvantages: Can be time-consuming making it costly. Continuing value tends to dominate the total value but is sensitive to assumptions growth rates and discount rates. Free cash flow computations must be internally consistent with long-run assumptions regarding growth and payout. And is affected by estimation errors. Chapter: 1220