Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis Chapter 4 Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis

Link to pervious chapter Cashing Accounting, Accrual Accounting, and Discounted Cash Flow Analysis Link to pervious chapter Chapter 3 outlined the process of fundamental analysis and depicted valuation as a matter of forecasting future financial statements 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. This Chapter What is the dividend discount model? Does it work? What is the discounted cash flow model? Does it work? What is the difference between cash accounting and accrual accounting? What form of accounting best captures value added in operations: cash accounting or accrual accounting? Chapter 5 and 6 together lay out valuation methods that forecast accrual accounting income statements and balance sheets. Link to next chapter This web page provides further explanation and additional examples of discounted cash flow analysis, cash accounting, and accrual accounting. Link to web page

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

A Reminder: Valuation Models for Going Concerns CF 1 2 3 4 5 A Firm d 1 2 3 4 5 Dividend Flow 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: 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.

Terminal Values for the DDM A. Capitalize expected terminal dividends B. Capitalize expected terminal dividends with growth Will it work?

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

Dividend Discount Analysis: Advantages and Disadvantages

Cash Flows for a Firm C1 C2 C3 C4 I1 I2 I3 I4 C1-I1 C2-I2 C3-I3 C4-I4 Free cash flow is cash flow from operations that results from investments minus cash used to make investments. 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 4 3 5

The Discounted Cash Flow (DCF) Model

The Continuing Value for the DCF Model A. Capitalize terminal free cash flow B. Capitalize terminal free cash flow with growth

DCF Valuation: The Coca-Cola Company 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

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 36,484 Cash investments 37,699 40,308 61,227 21,843 38,414 Free cash flow (7,690) (910) (26,379) 14,259 (1,930) Earnings 12,735 13,684 14,118 15,002 16,593 Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60 Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

Reverse Engineering: What Forecasts are Implied by the Current Market Price? Reverse engineer as follows: Can Coke maintain this growth rate?

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

Reverse Engineering a Simple Valuation: Coca-Cola Applying the simple model to reverse engineer Coke’s stock price,

The DCF Model: 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 3,5 06 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-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

Discounted Cash Flow Analysis: Advantages and Disadvantages

Partial Statement of Cash Flows: Dell Computer

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

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

Calculating Free Cash Flow: Dell 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) 1,957 Cash investment in operations 303 Free cash flow 3,310 *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.

Forecasting 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: Dell Computer 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) 9 (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 Statement 1. 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 Value added that is not cash flow Adjustments to cash flows that are not value added Expense Accruals Value decreases that are not cash flows Adjustments to cash outflows that are not value decreases

The Income Statement: Dell Computer

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

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

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.

Earnings and Cash Flows: Wal-Mart Stores

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

The Balance Sheet: Dell Computer

The articulation of the financial statements through the recording of cash flows and accruals Net cash flows from all activities increases cash in the balance sheet Cash from operations increases net income and shareholders’ equity Cash investments increase other assets Cash from debt financing increases liabilities Cash from equity financing increases shareholders’ equity Accruals increase net income, shareholders’ equity, assets and liabilities