Prepared by: Nir Yehuda

With contributions by Stephen H. Penman Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia University of Navarra, IESE Business School

What you will learn from this Chapter

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

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Cash Flows for a Going Concern

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)

C1

C2

C3

C4

C5

I1 C1-I1

I2 C2-I2

I3 C3-I3

I4 C4-I4

I5 C5-I5

Free cash flow

Time, t

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The Discounted Cash Flow Model (DCFM)

Cash flow from operations (inflows) Cash investment (outflows) Free cash flow

C1 I1 C1 I1

C2 I2 C2 I2

C3 I3 C3 I3

C4 I4 C4 I4

C5 ---> I5 --->

C5 I5 ---> --->

________________________________________________ Time, t 1 2 3 4 5

E F D V0 V0 V0

V0E

C1 I1 C 2 I 2 C 3 I 3 C I CV T T T T T V0D 2 3 F F F F F

F VO

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The Continuing Value for the DCFM

A. Capitalize terminal free cash flow

C T 1 I T 1 CVT F 1

B. Capitalize terminal free cash flow with growth

C T 1 I T 1 CVT F g

Will it work?

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______________________________________________________________________________ New York State Electric and Gas Corp. (Amounts in millions of dollars except per share data) 1987
Cash from operations Cash investments Free cash flow Discount factor (1.09)t PV of cash flows Total PV of cash flows Continuing value1 PV of CV Value 1,795 the firm 3,150 1,355 3,578

DCF Valuation: New York State Electric and Gas

1988
602 207 395 1.090 362

1989
460 191 269 1.188 226

1990
381 211 170 1.295 131

1991
403 301 102 1.412 72

1992
379 243 136 1.539 88

1993
499 302 197 1.677 117

1994
533 216 317 1.828 173

1995
531 160 371 1.993 186

1996
534 212 322

V
F 1987

of

Book value of debt and preferred stock Value of equity

2,290

V
E 1987

860 15.43

Value per share (55.733 shares) Dividends per share Price per share

2.00
3 22 4

2.02
7 28 8

2.06 26

2.10 29

2.14
32 1 2

2.18
3 30 4

2.00 19

1.40
7 25 8

1.40
5 21 8

$322 Continuing value = .09 = $3,578 million

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Simple Valuations
Simple valuations make valuations solely from information in the financial statements. They avoid analysis and avoid forecasting. They can work, but beware ! A simple DCF valuation for NY State Electric and Gas, 1996
F V1996

C1996 I1996 F 1

322 .09

3,578 million 1,875 million 1,703 million 24.44 21 5 8

Book Value of debt

E V1996

$ $

Value per share on 69.67 million shares Price per share, 1996

$ $

Another simple valuation

F V1996
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322 1.09 g

where g is a growth rate

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The DCFM: 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

Cash investments Free cash flow Dividends per share

536
627 (91) 0.03

828
541 287 0.04

968
894 74 0.06

1,422
1,526 (104) 0.07

1,553
2,150 (597) 0.09

1,540
3,506 (1,966) 0.11

2,573
4,486 (1,913) 0.13

3,410
3,792 (382) 0.17

2,993
3,332 (339) 0.20

Price per share

10

16

27

32

26

25

24

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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 - except for long forecast horizons

Note: 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

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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.
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Statement of Cash Flows: Dell Computer

Fiscal Year Ended ------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------$ 2,177 $ 1,666

Cash flows from operating activities: Net income $ 1,246 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 239 Tax benefits of employee 487 stock plans Special charges 742 (Gains)/losses on investments 17 Other 178 Changes in operating working capital: Accounts receivable, net 222 Inventories 111 Accounts payable 826 Accrued and other liabilities (210) Other, net (123) Non-current assets and 62 liabilities -----Net cash provided by 3,797 operating activities -----Cash flows from investing activities: Investments: Purchases (5,382) Maturities and sales 3,425 Capital expenditures (303) -----Net cash used in investing (2,260) activities -----Supplemental Statement Of Cash Flows Information: Interest paid Investment income, primarily interest 31 314

240 929 105 (307) 135 (531) (11) 780 404 274 -----4,195 ------

156 1,040 194 (80) 56 (394) (123) 988 416 (75) 82 -----3,926 ------

(2,606) 2,331 (482) -----(757) ------

(3,101) 2,319 (401) -----(1,183) ------

49 305

34 158

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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

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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

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Calculating Free Cash Flow: Dell Computer, 2002

Reported cash flow from operations Interest payments Interest income* Net interest payments 3,797 31 (314) (283)

Taxes (35%) Net interest payments after tax (65%) Cash flow from operations
Reported cash used in investing activities Purchases of interesting-bearing securities Sales of interest-bearing securities Cash investment in operations Free cash flow

99
(184) 3,613 2,260

5,382 (3,425)

1,957 303 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. Dells statutory tax rate (for federal and state taxes) is 35 percent, as indicated in the financial Statement footnotes.

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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))
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Forecasting Free Cash Flow: Dell Computer

Forecast Earnings Accrual adjustment Levered cash flows from operations Interest payments Interest receipts Net interest payments Tax at 35% Cash flow from operations Cash investment in operations Free cash flow 2000 1,666 2,260 2001 2,177 2,018 2002 1,246 2,551

3,926
34 (158) (124) 43

4,195
31 (314) (283) 99

3,797

49 (305) (256) (81) 90 (166) 3,845 4,029 (401) (482) 3,444 3,547

(184) 3,613 (303) 3,310

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Features of the Income Statement

1. Dividends dont affect income 2. Investment doesnt affect income 3. 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

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The Income Statement: Dell Computer

Net revenue Cost of revenue Gross margin Operating expenses: Selling, general and administrative Research, development and engineering Special charges Total operating expenses Operating income Investment and other income (loss), net Income before income taxes and cumulative effect of change in accounting principle Provision for income taxes Income before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle, net Net income

Fiscal Year Ended

------------------------------------------February 1, February 2, January 28, 2002 2001 2000 ----------------------------------$ 31,168 $ 31,888 $ 25,265 25,661 25,445 20,047 ---------------5,507 6,443 5,218 ---------------2,784 452 482 -----3,718 -----1,789 (58) -----1,731 485 -----1,246 $ -----1,246 -----$ 3,193 482 105 -----3,780 -----2,663 531 -----3,194 958 -----2,236 59 -----2,177 -----$ 2,387 374 194 -----2,955 -----2,263 188 -----2,451 785 -----1,666 -----1,666 ------

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The Revenue Calculation

Revenue =

Cash receipts from sales + New sales on credit Cash received for previous periods' sales Estimates of credit sales not collectible Estimated sales returns and rebates Deferred revenue for cash received in advance of sale + Revenue previously deferred

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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

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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.

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Earnings and Cash Flows: Wal-Mart Stores

____________________________________________________________________________ Wal-Mart Stores, Inc. 1988 1989 1990 1991 1992 1993 1994 1995 1996 Cash from operations Cash investments Free cash flow Net income Eps 536 627 ( 91) 628 .28 828 541 287 968 1,422 1,553 1,540 2,573 3,410 2,993 894 1,526 2,150 3,506 4,486 3,792 3,332 74 (104) (597) (1,966) (1,913) (382) (339)

837 1,076 1,291 1,608 1,995 2,333 2,681 2,740 .37 .48 .57 .70 .87 1.02 1.17 1.19

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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
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The Balance Sheet: Dell Computer

Current assets: Cash and cash equivalents Short-term investments Accounts receivable, net Inventories Other Total current assets Property, plant and equipment, net Investments Other non-current assets

Fiscal Year Ended

_______________________
February 1, 2002 ------------ASSETS $ 3,641 273 2,269 278 1,416 -----7,877 826 $ 4,910 525 2,424 400 1,467 -----9,726 996 February 2, 2001 -------------

4,373 459 -----Total assets $ 13,535 -----LIABILITIES AND STOCKHOLDERS EQUITY

2,418 530 -----$ 13,670 ------

Current liabilities: Accounts payable Accrued and other Total current liabilities Long-term debt Other Commitments and contingent liabilities (Note 7) Total liabilities Stockholders equity: Preferred stock and capital in excess of $.01 par value; shares issued and outstanding: none Common stock and capital in excess of $.01 par value;

5,075 2,444 -----7,519 520 802 -----8,841 ------

4,286 2,492 -----6,778 509 761 -----8,048 ------

5,605

4,795

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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
Beginning stocks Flows Cash Flow Statement year 1 Ending Balance Sheet year 0
Cash0 + Other Assets0 Total Assets0 - Liabilities0 Owners equity0 Cash from operations Cash from investing Debt financing Equity financing Net change in cash

Ending stocks

Ending Balance Sheet year 1

Cash1 + Other Assets1 Total Assets1 - Liabilities1 Owners equity1

Statement of Shareholders Equity year 1

Investment and disinvestment by owners Earnings Net change in owners equity

Income Statement year 1

Cash from operations + Accruals Net income

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