1. Estimating Cash Flows Cash is king…
Now to the numerator, where all the action is… or should be..
Cash is king…

2. Steps in Cash Flow Estimation
Estimate the current earnings of the firm
If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income
If looking at cash flows to the firm, look at operating earnings after taxes
Consider how much the firm invested to create future growth
If the investment is not expensed, it will be categorized as capital expenditures. To the extent that depreciation provides a cash flow, it will cover some of these expenditures.
Increasing working capital needs are also investments for future growth
If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid)
Sets up the process. Much as we do not trust accounting statements, that is where we go for the information. Accounting earnings are not cash flows.
We do not draw a distinction between discretionary and required capital expenditures. Once you introduce growth in earnings, the distinction becomes largely symbolic.
Draws a distinction between cashflows to equity and the firm again.

3. Measuring Cash Flows
Lays out the three definitions of cashflows. The strictest measure is the dividend measure. (In fact, there are some who do not count stock buybacks.) The more expansive equity measure is the free cashflow to equity, which you can think off as potential dividends. The free cashflow to the firm is the cash available for all claimholders in the firm - it is before cashflows to any of the claimholders in the firm - debt or equity.

4. Measuring Cash Flow to the Firm: Three pathways to the same end game
The tax savings from interest payments do not show up in the cashflows because they have already been counted in the cost of capital (in the use of the after-tax cost of debt). If you add the interest tax benefits to the cashflows, you will double count the benefit.
Where are the tax savings from interest expenses?

5. Cash Flows I
Accounting Earnings, Flawed but Important

6. From Reported to Actual Earnings
Very seldom can you use the reported earnings in the annual report in valuation. This lays out the three adjustments that you usually have to make before you start doing valuation:
You might need to update the accounting information for most recent reports that have come from the firm or other sources.
If you have a cyclical or commodity firm, you have to adjust the earnings for where in the cycle (of the economy, for a cyclical firm, or for the commodity price, for a commodity firm) you are currently.
You have to clean up for obvious shortcomings in accounting rules.

7. I. Update Earnings
When valuing companies, we often depend upon financial statements for inputs on earnings and assets. Annual reports are often outdated and can be updated by using-
Trailing 12-month data, constructed from quarterly earnings reports.
Informal and unofficial news reports, if quarterly reports are unavailable.
Updating makes the most difference for smaller and more volatile firms, as well as for firms that have undergone significant restructuring.
Time saver: To get a trailing 12-month number, all you need is an annual report and one quarterly report (example third quarter). Use the Year to date numbers from the quarterly report. For example, to get trailing revenues from a third quarter quarterly report:
Trailing 12-month Revenue = Revenues (in last annual report) - Revenues from first 3 quarters of last year + Revenues from first 3 quarters of this year.
For larger and more mature firms, you can get away with using the most recent annual report. The younger the firm and the more tumultuous the times (the economy entering a recession, for instance), the more you have to worry about using dated information.
Your objective in valuation is simple. You want to use the most recent information you can get for every input, even if it means that your inputs are observed at different points in time - the market values may be from today and the accounting information from the most recent quarterly report.

8. II. Correcting Accounting Earnings
Make sure that there are no financial expenses mixed in with operating expenses
Financial expense: Any commitment that is tax deductible that you have to meet no matter what your operating results: Failure to meet it leads to loss of control of the business.
Example: Operating Leases: While accounting convention treats operating leases as operating expenses, they are really financial expenses and need to be reclassified as such. This has no effect on equity earnings but does change the operating earnings
Make sure that there are no capital expenses mixed in with the operating expenses
Capital expense: Any expense that is expected to generate benefits over multiple periods.
R & D Adjustment: Since R&D is a capital expenditure (rather than an operating expense), the operating income has to be adjusted to reflect its treatment.
Financial expense: Any commitment that is tax deductible that you have to meet no matter what your operating results: Failure to meet it leads to loss of control of the business.
Capital expense: Any expense that is expected to generate benefits over multiple periods.
These are two fairly standard adjustments you have to make to almost every firm that you encounter though the consequences are going to be larger for some firms than others.

9. The Magnitude of Operating Leases
The firms where operating leases matter the most are retail firms…

10. Dealing with Operating Lease Expenses
Operating Lease Expenses are treated as operating expenses in computing operating income. In reality, operating lease expenses should be treated as financing expenses, with the following adjustments to earnings and capital:
Debt Value of Operating Leases = Present value of Operating Lease Commitments at the pre-tax cost of debt
When you convert operating leases into debt, you also create an asset to counter it of exactly the same value.
Adjusted Operating Earnings
Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses - Depreciation on Leased Asset
As an approximation, this works:
Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases.
Computational note: You use the pre-tax cost of debt as your discount rate because you are discounting pre-tax operating lease expenses.
From an intuitive standpoint, there is little difference between a term loan (where you pay off a loan in equal annual installments) and an operating lease. It may be more like unsecured debt than secured debt but it is debt.
It is not just debt that is affected when you convert operating leases to debt. The operating income also will change.

11. Operating Leases at The Gap in 2003
The Gap has conventional debt of about $ 1.97 billion on its balance sheet and its pre-tax cost of debt is about 6%. Its operating lease payments in the 2003 were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $ $848.11
2 $ $752.94
3 $ $619.64
4 $ $473.67
5 $ $356.44
6&7 $ each year $1,346.04
Debt Value of leases = $4, (Also value of leased asset)
Debt outstanding at The Gap = $1,970 m + $4,397 m = $6,367 m
Adjusted Operating Income = Stated OI + OL exp this year - Deprec’n
= $1,012 m m m /7 = $1,362 million (7 year life for assets)
Approximate OI = $1,012 m + $ 4397 m (.06) = $1,276 m
The Gap reports its lease commitments in its financial statements. The present value of operating lease expenses is computed using the pre-tax cost of debt. (An argument can be made that the unsecured cost of debt should be used.)

12. The Collateral Effects of Treating Operating Leases as Debt
Traces the effect of converting operating leases to debt. Both operating income and capital invested increase. The net effect on return on capital will depend upon which increases more.
In general, treating leases as debt will affect the return spread you earn (by changing both the cost of capital and return on capital). If the spread decreases (as it does for the Gap), your values will decrease when you capitalize leases. If the spread increases, your value will increase. In either case, the values that you get with the capitalized leases is the more realistic estimate of value.

13. The Magnitude of R&D Expenses
Again, the effects of R& D expensing are uneven. They matter more for technology firms and pharmaceutical firms than for the rest of the market. However, you could argue that training expenses are the equivalent of R&D for a financial services or consulting firm.

14. R&D Expenses: Operating or Capital Expenses
Accounting standards require us to consider R&D as an operating expense even though it is designed to generate future growth. It is more logical to treat it as capital expenditures.
To capitalize R&D,
Specify an amortizable life for R&D ( years)
Collect past R&D expenses for as long as the amortizable life
Sum up the unamortized R&D over the period. (Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5th of the R&D expense from five years ago, 2/5th of the R&D expense from four years ago...:
The argument used by accountants - that R&D yields uncertain benefits - is specious. You could make the same argument about other investments - investing in a factory in an emerging market, deciding to build a concept car - and you are forced to treat these as capital expenditures.
To capitalize R&D, you need to specify
On average, how long it takes between the time you do research and a commercial product emerges from the research. (This is the amortizable life)
R&D expenses from the past (for a period equivalent to the amortizable life). If your firm has not been in existence for that long, you would go back for as many years as you can.
Depreciation schedules - stick with the simplest which is straight line depreciation.

15. Capitalizing R&D Expenses: SAP
R & D was assumed to have a 5-year life.
Year R&D Expense Unamortized Amortization this year
Current € € € € €
Value of research asset = € 2,914 million
Amortization of research asset in = € 903 million
Increase in Operating Income = = € 117 million
The amortizable life is an assumption based upon SAP’s business. It would be shorter in other businesses (such as computer chips) and longer in businesses that need regulatory approval (such as pharmaceuticals).
Note that the amortization is 1/5 of the R&D expense each year.
We are also assuming that R&D expenses are spent at the end of each year - not realistic, but simplifies analysis - that is why there is no amortization of the current year’s expense.
The effect of capitalizing R&D will be greatest at firms where R&D is growing over time and be non-existent at firms with flat R&D.

16. The Effect of Capitalizing R&D at SAP
Traces out the effects of capitalizing R&D. The key aspect is that operating income will be increased by exactly the same amount that net capital expenditures will be increased, with the increase being:
Change in operating income and net cap ex = Current year’s R&D expense - R&D amortization
In other words, the free cashflow to the firm will not change as a result of this capitalization. So why do it? It allows us to
Get a better sense of the profitability of the firm (operating income and return on capital)
Better estimate how much the firm is reinvesting for future growth.
Get a measure of whether R&D is value creating or value destroying.
Aswath Damodaran

17. III. One-Time and Non-recurring Charges
Assume that you are valuing a firm that is reporting a loss of $ 500 million, due to a one-time charge of $ 1 billion. What is the earnings you would use in your valuation?
A loss of $ 500 million
A profit of $ 500 million
Would your answer be any different if the firm had reported one-time losses like these once every five years?
Yes No
If it is truly a one-time change, you should use a profit of $ 500 million.
If the firm is playing games (consolidating expenses and reporting them as one-time charges every five years), you should take the average annual expense of $ 200 million (1/5 of $ 1 billion) and estimate a profit of $ 300 million.
Don’t take company characterizations of non-recurring charges at face value. Look at the firm’s history.

18. IV. Accounting Malfeasance….
Though all firms may be governed by the same accounting standards, the fidelity that they show to these standards can vary. More aggressive firms will show higher earnings than more conservative firms.
While you will not be able to catch outright fraud, you should look for warning signals in financial statements and correct for them:
Income from unspecified sources - holdings in other businesses that are not revealed or from special purpose entities.
Income from asset sales or financial transactions (for a non-financial firm)
Sudden changes in standard expense items - a big drop in S,G &A or R&D expenses as a percent of revenues, for instance.
Frequent accounting restatements
Accrual earnings that run ahead of cash earnings consistently
Big differences between tax income and reported income
This is a challenge. There are clues, though none of them are fool proof and it makes sense to be skeptical about accounting numbers post-Enron.
Check the footnotes. Bear in mind that this what forensic accounting tries to do and there are relatively few good forensic accountants around.

19. V. Dealing with Negative or Abnormally Low Earnings
To decide what to do when your firm is losing money, you first have to diagnose the problem. If the problem is transitory (a recession, a loss caused by a strike), you can normalize earnings instantaneously and use the normalized earnings in valuation.
If it is long term, you have to first figure out what the long term problem is. If it is financial - the firm has too much debt - you have to consider whether the firm can pay down its debt and survive. If you believe it can, lower the debt ratio each year and compute a cost of capital. If it is operating or strategic - you have to work out what it will cost the firm to fix these problems- and build the expected improvement in margins over time. If it is life cycle related - the firm is in early stage of its life cycle and it is normal to lose money at that stage - you have to build in the expectations of the improvements that will occur as the firm moves up the life cycle (with a healthy dose of skepticism about whether the firm will make it).

20. Cash Flows II
Taxes and Reinvestment

21. What tax rate?
The tax rate that you should use in computing the after- tax operating income should be
The effective tax rate in the financial statements (taxes paid/Taxable income)
The tax rate based upon taxes paid and EBIT (taxes paid/EBIT)
The marginal tax rate for the country in which the company operates
The weighted average marginal tax rate across the countries in which the company operates
None of the above
Any of the above, as long as you compute your after-tax cost of debt using the same tax rate
The effective tax rate is defined as taxes paid/ taxable income, as defined in the reporting books. The marginal tax rate is the tax rate on the last dollar of income. The effective tax rate is lower than the marginal tax rate for most firms. Why?
Bracket creep: Can be a reason for small private businesses but not for large publicly traded firms where most of the income is at the highest marginal tax rate anyway.
Cosmetic factors: Two sets of books with different accounting standards for tax and reporting books.
Real factors: Capacity to defer taxes to the future.

22. The Right Tax Rate to Use
The choice really is between the effective and the marginal tax rate. In doing projections, it is far safer to use the marginal tax rate since the effective tax rate is really a reflection of the difference between the accounting and the tax books.
By using the marginal tax rate, we tend to understate the after-tax operating income in the earlier years, but the after- tax tax operating income is more accurate in later years
If you choose to use the effective tax rate, adjust the tax rate towards the marginal tax rate over time.
While an argument can be made for using a weighted average marginal tax rate, it is safest to use the marginal tax rate of the country
If you have a choice, you would prefer to do valuation with the tax books in front of you, but since you do not have that choice as an outsider you have to choose between the effective tax rate and the marginal tax rate.
If you use the effective tax rate all the way through, you are assuming that taxes can be deferred forever. This is unrealistic - tax deferrals catch up with you as your growth flags - and will result in an overvaluation of your firm.
If you use a marginal tax rate, you are assuming that you cannot defer taxes from this point on. This is far too conservative and will yield too low a value for your firm.
Suggestion: Start with the effective tax rate in the early years and move towards the marginal tax rate in the terminal year.

23. Net Capital Expenditures
Net capital expenditures represent the difference between capital expenditures and depreciation. Depreciation is a cash inflow that pays for some or a lot (or sometimes all of) the capital expenditures.
In general, the net capital expenditures will be a function of how fast a firm is growing or expecting to grow. High growth firms will have much higher net capital expenditures than low growth firms.
Assumptions about net capital expenditures can therefore never be made independently of assumptions about growth in the future.
It is dangerous to have three separate (and unconnected) line items for capital expenditures, depreciation and growth in a valuation. Analysts very quickly discover the secret of value creation (at least on paper) - decrease cap ex, increase depreciation and increase growth.

24. Capital expenditures should include
Research and development expenses, once they have been re-categorized as capital expenses. The adjusted net cap ex will be
Adjusted Net Capital Expenditures = Net Capital Expenditures + Current year’s R&D expenses - Amortization of Research Asset
Acquisitions of other firms, since these are like capital expenditures. The adjusted net cap ex will be
Adjusted Net Cap Ex = Net Capital Expenditures + Acquisitions of other firms - Amortization of such acquisitions
Two caveats:
1. Most firms do not do acquisitions every year. Hence, a normalized measure of acquisitions (looking at an average over time) should be used
2. The best place to find acquisitions is in the statement of cash flows, usually categorized under other investment activities
The accounting definition of cap ex is too narrow. It excludes external cap ex (which is what acquisitions are) and intangible cap ex (which is what R&D is).
We would include all acquisitions, including stock swaps acquisitions. To those who would argue that there is no cashflow associated with stock swaps, we would suggest that all that has occurred is that the firm has just skipped a step - the firm could have issued the stock to the market and used the cash on the acquisitions.
It is true that incorporating acquisitions into valuation can be messy for firms that do relatively few and very diverse acquisitions over time. You have the option of ignoring these acquisitions when you do valuation but make sure that the expected growth rate in earnings does not then include the expected growth from acquisitions. You are implicitly assuming that acquisitions in the future will be done at fair value and hence have no value impact.

25. Cisco’s Acquisitions: 1999
Acquired Method of Acquisition Price Paid
GeoTel Pooling $1,344
Fibex Pooling $318
Sentient Pooling $103
American Internet Purchase $58
Summa Four Purchase $129
Clarity Wireless Purchase $153
Selsius Systems Purchase $134
PipeLinks Purchase $118
Amteva Tech Purchase $159
$2,516
You have to dig to find this. Cisco’s 10K yielded this. To estimate the price paid for the pooling acquisitions - which were funded with stock - we multiplied the shares offered in the acquisition by the share price at the time of the acquisition.

26. Cisco’s Net Capital Expenditures in 1999
Cap Expenditures (from statement of CF) = $ 584 mil
- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil
(Amortization was included in the depreciation number)
The true net cap ex of $ 3.7 billion is well in excess of the net cap ex from the accounting statement ($98 million).

27. Working Capital Investments
In accounting terms, the working capital is the difference between current assets (inventory, cash and accounts receivable) and current liabilities (accounts payables, short term debt and debt due within the next year)
A cleaner definition of working capital from a cash flow perspective is the difference between non-cash current assets (inventory and accounts receivable) and non-debt current liabilities (accounts payable)
For firms in some sectors, it is the investment in working capital that is the bigger part of reinvestment.
We remove cash from current assets because cash is not a wasting asset for most firms with substantial cash balances. Cash today tends to be invested in treasuries or commercial paper which yields a fair return for the risk taken (which is little or none). There are some analysts who still use operating cash (which they estimate as a percent of revenues) as part of working capital, but we believe that this is no longer appropriate for firms in markets with well developed banking systems and investment alternatives.
The debt in current liabilities is included in the debt used for cost of capital.

28. Working Capital: General Propositions
Working Capital Detail: While some analysts break down working capital into detail (inventory, deferred taxes, payables etc.), it is a pointless exercise unless you feel that you can bring some specific information that lets you forecast the details.
Working Capital Volatility: Changes in non-cash working capital from year to year tend to be volatile. So, building of the change in the most recent year is dangerous. It is better to either estimate the change based on working capital as a percent of sales, while keeping an eye on industry averages.
Negative Working Capital: Some firms have negative non- cash working capital. Assuming that this will continue into the future will generate positive cash flows for the firm and will get more positive as growth increases.
Firms like Walmart have been able to generate cashflows by keeping non-cash working capital low or negative - in a sense, supplier credit is being used a source of capital. The possible downside is that you can increase credit risk if it gets out of control. That is why you should not assume negative non-cash working capital in perpetuity.

29. Volatile Working Capital?
Amazon Cisco Motorola Revenues $ 1,640 $12,154 $30,931 Non-cash WC -$419 -$404 $2547 % of Revenues % -3.32% 8.23% Change from last year $ (309) ($700) ($829) Average: last 3 years % -3.16% 8.91% Average: industry 8.71% -2.71% 7.04% My Prediction WC as % of Revenue 3.00% 0.00% 8.23%
In each case, we have used both the company’s history and the industry averages as the basis for our forecasts for the future. The advantage of linking working capital to revenues is that eliminates the need to estimate working capital as a separate line item.
There are some analysts who prefer to estimate each item in working capital separately - inventory, accounts receivable and accounts payable. We would do this only
If we had a strong basis for separating the items and a way of forecasting each individually.
For the short term. As you push out into future years, you are better off estimating aggregate rather than individual numbers.

30. Cash Flows III
From the firm to equity

31. Dividends and Cash Flows to Equity
In the strictest sense, the only cash flow that an investor will receive from an equity investment in a publicly traded firm is the dividend that will be paid on the stock.
Actual dividends, however, are set by the managers of the firm and may be much lower than the potential dividends (that could have been paid out)
managers are conservative and try to smooth out dividends
managers like to hold on to cash to meet unforeseen future contingencies and investment opportunities
When actual dividends are less than potential dividends, using a model that focuses only on dividends will under state the true value of the equity in a firm.
In the strict view of the world, even stock buybacks are not cashflows to equity investors because they go to someone else - a person cannot sell their stock back to the company and hold it for dividends at the same time.
In 2012, US companies paid out about 40% of what was available to be paid out (after reinvestment and debt payments) in dividends. Historically, the unwillingness of managers to cut dividends has also made them more reluctant to increase dividends as earnings increase.

32. Measuring Potential Dividends
Some analysts assume that the earnings of a firm represent its potential dividends. This cannot be true for several reasons:
Earnings are not cash flows, since there are both non-cash revenues and expenses in the earnings calculation
Even if earnings were cash flows, a firm that paid its earnings out as dividends would not be investing in new assets and thus could not grow
Valuation models, where earnings are discounted back to the present, will over estimate the value of the equity in the firm
The potential dividends of a firm are the cash flows left over after the firm has made any “investments” it needs to make to create future growth and net debt repayments (debt repayments - new debt issues)
The common categorization of capital expenditures into discretionary and non-discretionary loses its basis when there is future growth built into the valuation.
Models that discount earnings and assume a growth rate in earnings at the same time will systematically overvalue companies because they assume that firms can grow earnings without any reinvestment. (Glassman and Hassett made this mistake in their book Dow 36000, where the discounted earnings at close to the riskfree rate and assumed real growth in perpetuity.)

33. Estimating Cash Flows: FCFE
Cash flows to Equity for a Levered Firm
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
I have ignored preferred dividends. If preferred stock exist, preferred dividends will also need to be netted out
Note the differences between this and Free cashflow to firm:
Start with net income (equity earnings) rather than operating earnings. Interest expenses are subtracted out from earnings and the tax benefits are reflected.
Net out net debt payments. If a firm raises more new debt than it pays off, this can be a positive number which, if large enough can make the free cashflow to equity higher than the free cashflow to the firm.

34. Estimating FCFE when Leverage is Stable
Net Income
- (1- DR) (Capital Expenditures - Depreciation)
- (1- DR) Working Capital Needs
= Free Cash flow to Equity
DR = Debt/Capital Ratio
For this firm,
Proceeds from new debt issues = Principal Repayments + DR* (Capital Expenditures - Depreciation + Working Capital Needs)
In computing FCFE, the book value debt to capital ratio should be used when looking back in time but can be replaced with the market value debt to capital ratio, looking forward.
This is a steady state equation and works if the firm is at a debt ratio that it feels that it can maintain for the foreseeable future.
When this equation is used to estimate free cashflows to equity in the past, the average book debt to capital ratio has to be used. The free cashflows to equity each year will be different from the actual numbers, but the averages will converge.

35. Estimating FCFE: Zain Net Income= KWD 159 Million
Capital spending = KWD 167 Million
Depreciation = KWD 222 Million
Increase in non-cash working capital = KWD 158 Million
Debt to Capital Ratio (DR) = 42%
Estimating FCFE (1997):
Net Income KWD 159 Mil
- (Cap. Exp - Depr)*(1-DR) KWD [( )(1-.42)]
- Chg. Working Capital*(1-DR) KWD [158(1-.42)]
= Free CF to Equity KWD Million
Dividends Paid KWD Million
Estimates Disney’s free cashflow to equity, using a book debt to capital ratio, for 1996.
Disney actually paid out $345 million.

36. FCFE and Leverage: Is this a free lunch?
As the debt ratio increases, equity investors are putting in less of the required reinvestment each year, which will push up the free cashflow to equity. This is based upon changing the debt ratio only on new investment. If you change the total debt ratio for the firm on existing assets, there will be higher interest expense and lower net income (but also fewer shares outstanding).

37. FCFE and Leverage: The Other Shoe Drops
But the higher leverage increases the beta for the firm as well. The levered beta equation developed earlier is used. The unlevered beta is 1.09 and the tax rate is 36%:
Levered Beta = 1.09 ( 1 + (1-.36) (Debt/Equity))

38. Leverage, FCFE and Value
In a discounted cash flow model, increasing the debt/equity ratio will generally increase the expected free cash flows to equity investors over future time periods and also the cost of equity applied in discounting these cash flows. Which of the following statements relating leverage to value would you subscribe to?
Increasing leverage will increase value because the cash flow effects will dominate the discount rate effects
Increasing leverage will decrease value because the risk effect will be greater than the cash flow effects
Increasing leverage will not affect value because the risk effect will exactly offset the cash flow effect
Any of the above, depending upon what company you are looking at and where it is in terms of current leverage
Any of the above, if you believe that value can be affected by leverage and that there is an optimal debt ratio.
The third choice if you are a true believer in Miller-Modigliani I (that leverage does not affect value)