cash accounting, accrual accounting, and discounted cash flow analysis chapter 4
TRANSCRIPT
Cash Accounting, Accrual Cash Accounting, Accrual Accounting, and Discounted Accounting, and Discounted
Cash Flow AnalysisCash Flow Analysis
Chapter 4Chapter 4
Cashing Accounting, Accrual Accounting, Cashing Accounting, Accrual Accounting, and Discounted Cash Flow Analysisand Discounted Cash Flow Analysis
Chapter 3 outlined the process of fundamental analysis and depicted
valuation as a matter of forecasting future
financial statements
This web page provides further explanation and additional examples of discounted cash flow
analysis, cash accounting, and accrual
accounting.
Chapter 5 and 6 together lay out valuation
methods that forecast accrual accounting
income statements and balance sheets.
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.
What form of accounting
best captures value added
in operations: cash
accounting or accrual
accounting?
What is the difference
between cash accounting and accrual accounting?
What is the discounted cash flow model?
Does it work?
What is the dividend discount model?
Does it work?
Link to next chapter
This Chapter
Link to web page
Link to pervious chapter
What you will learn from this ChapterWhat 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 A Reminder: Valuation Models for Going ConcernsGoing Concerns
CF1 CF2 CF3 CF4 CF5
A Firm1 2 3 4 50
d1 d2 d3 d4 d5Dividend Flow
1 2 3 4 50
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: The Dividend Discount Model: Targeting DividendsTargeting 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.
Vd d dE
E E E0
1 22
33
Vd d d dE
E E E
T
ET0
1 22
33
Terminal Values for the DDMTerminal Values for the DDM
A. Capitalize expected terminal dividends
B. Capitalize expected terminal dividends with growth
Will it work?
1
dT
E
1TT
TPV
gPV
E
1T
T
dT
T
Some Math: The Value of a Perpetuity Some Math: The Value of a Perpetuity and a Perpetuity with Growthand a Perpetuity with Growth
The Value of a Perpetuity
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 =
11
0
E
E dV
g
dV
E
E
1
0
Dividend Discount Analysis: Dividend Discount Analysis: Advantages and DisadvantagesAdvantages and Disadvantages
Dividend Discount Analysis
Advantages Easy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs. Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).
Cash Flows for a FirmCash Flows for a Firm
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 43 5
Free cash flow is cash flow from operations that results from investments minus cash used to make investments.
The Discounted Cash Flow (DCF) The Discounted Cash Flow (DCF) Model Model
C a s h f l o w f r o m o p e r a t i o n s ( i n f l o w s ) C 1 C 2 C 3 C 4 C 5 - - - > C a s h i n v e s t m e n t I 1 I 2 I 3 I 4 I 5 - - - > ( o u t f l o w s )
F r e e c a s h f l o w C 1 I 1 C 2 I 2 C 3 I 3 C 4 I 4 C 5 I 5 - - - >
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ - - - >
T i m e , t 1 2 3 4 5
D0T
F
TTF
TT3F
332F
22
F
11E0 V
VCICICICICV
FOV
D0
F0
E0 VVV
The Continuing Value for the The Continuing Value for the DCF ModelDCF Model
• A. Capitalize terminal free cash flow
• B. Capitalize terminal free cash flow with growth
1ρ
ICCV
F
1T1TT
gρ
ICCV
F
1T1TT
DCF Valuation: The Coca-Cola DCF Valuation: The Coca-Cola CompanyCompany
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
)( 1999EV
Will DCF Valuation Always Work?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 36,484Cash investments 37,699 40,308 61,227 21,843 38,414Free cash flow (7,690) (910) (26,379) 14,259 (1,930)
Earnings 12,735 13,684 14,118 15,002 16,593Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82
Reverse Engineering: What Forecasts Reverse Engineering: What Forecasts are Implied by the Current Market are Implied by the Current Market Price?Price?
million $140,904
sharesmillion 2,472 x 57 P Coke, For $0
$4,435-1.5386g - 1.09
g x 311,5
5386.1
311,5
4116.1
551,4
2950.1
569,3
1881.1
910,2
1.09
2,710million 140,904$
Reverse engineer as follows:
Can Coke maintain this growth rate?
rate)growth % 6.2 a ( 062.1 g
Simple ValuationsSimple 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
Debt Netg
ICV
E
E
110
$4,435 09.1
710,2
g
Reverse Engineering a Simple Reverse Engineering a Simple Valuation: Coca-ColaValuation: Coca-Cola
435,4$g-1.09
2,710 140,904$0 P
Applying the simple model to reverse engineer Coke’s stock price,
%) 7.13 is rate(growth 0713.1 g
The DCF Model: The DCF Model: Will it work for Wal-Mart Stores?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 3,506 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-Why Free Cash Flow is not a Value-Added ConceptAdded 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: Discounted Cash Flow Analysis: Advantages and DisadvantagesAdvantages and Disadvantages
Discounted Cash Flow (DCF) Analysis
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: can require long forecast horizons to recognize cash inflows from investments, particularly when investments are growing. 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.
Partial Statement of Cash Flows: Partial Statement of Cash Flows: Dell ComputerDell Computer
Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Cash flows from operating activities: Net income $ 1,246 $ 2,177 $ 1,666 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 239 240 156 Tax benefits of employee 487 929 1,040 stock plans Special charges 742 105 194 (Gains)/losses on investments 17 (307) (80) Other 178 135 56 Changes in operating working capital: Accounts receivable, net 222 (531) (394) Inventories 111 (11) (123) Accounts payable 826 780 988 Accrued and other liabilities (210) 404 416 Other, net (123) - (75) Non-current assets and 62 274 82 liabilities ------ ------ ------ Net cash provided by 3,797 4,195 3,926 operating activities ------ ------ ------ Cash flows from investing activities: Investments: Purchases (5,382) (2,606) (3,101) Maturities and sales 3,425 2,331 2,319 Capital expenditures (303) (482) (401) ------ ------ ------ Net cash used in investing (2,260) (757) (1,183) activities ------ ------ ------ Supplemental Statement Of Cash Flows Information: Interest paid 31 49 34 Investment income, primarily 314 305 158 interest
Reported Cash Flow from OperationsReported 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 Reported Cash Flow in Investing ActivitiesActivities
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: Calculating Free Cash Flow: Dell Computer, 2002Dell 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) 1,957Cash investment in operations 303Free cash flow 3,310
*Interest payments are given as supplemental data to the statement of cash flows, but interestreceipts 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 financialstatement footnotes.
Forecasting Free Cash FlowsForecasting 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: Forecasting Free Cash Flow: Dell ComputerDell Computer
Forecast 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) 90 (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 StatementFeatures of the Income Statement1. 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
Expense Accruals
Value added that is not cash flow
Adjustments to cash flows that are not value added
Value decreases that are not cash flows
Adjustments to cash outflows that are not value decreases
The Income Statement: Dell ComputerThe Income Statement: Dell Computer
Fiscal Year Ended ------------------------------------------- February 1, February 2, January 28, 2002 2001 2000 ------------ ------------ ------------- Net revenue $ 31,168 $ 31,888 $ 25,265 Cost of revenue 25,661 25,445 20,047 ------ ------ ------ Gross margin 5,507 6,443 5,218 ------ ------ ------ Operating expenses: Selling, general and 2,784 3,193 2,387 administrative Research, development and 452 482 374 engineering Special charges 482 105 194 ------ ------ ------ Total operating expenses 3,718 3,780 2,955 ------ ------ ------ Operating income 1,789 2,663 2,263 Investment and other income (58) 531 188 (loss), net ------ ------ ------ Income before income taxes and 1,731 3,194 2,451 cumulative effect of change in accounting principle Provision for income taxes 485 958 785 ------ ------ ------ Income before cumulative 1,246 2,236 1,666 effect of change in accounting principle Cumulative effect of change in - 59 - accounting principle, net ------ ------ ------ Net income $ 1,246 $ 2,177 $ 1,666 ------ ------ ------
The Revenue CalculationThe 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 CalculationThe 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 FlowsEarnings 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: Earnings and Cash Flows: Wal-Mart StoresWal-Mart Stores
____________________________________________________________________________ Wal-Mart Stores, Inc.
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 3,506 4,486 3,792 3,332
Free cash flow ( 91) 287 74 (104) (597) (1,966) (1,913) (382) (339)
Net income 628 837 1,076 1,291 1,608 1,995 2,333 2,681 2,740
Eps .28 .37 .48 .57 .70 .87 1.02 1.17 1.19
Accruals, Investments and the Balance Accruals, Investments and the Balance SheetSheet
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 ComputerThe Balance Sheet: Dell Computer
Fiscal Year Ended _______________________ February 1, February 2, 2002 2001 ------------- ------------- ASSETS Current assets: Cash and cash equivalents $ 3,641 $ 4,910 Short-term investments 273 525 Accounts receivable, net 2,269 2,424 Inventories 278 400 Other 1,416 1,467 ------ ------ Total current assets 7,877 9,726 Property, plant and equipment, 826 996 net Investments 4,373 2,418 Other non-current assets 459 530 ------ ------ Total assets $ 13,535 $ 13,670 ------ ------ LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 5,075 $ 4,286 Accrued and other 2,444 2,492 ------ ------ Total current liabilities 7,519 6,778 Long-term debt 520 509 Other 802 761 Commitments and contingent - - liabilities (Note 7) ------ ------ Total liabilities 8,841 8,048 ------ ------ Stockholders equity: Preferred stock and capital in - - excess of $.01 par value; shares issued and outstanding: none Common stock and capital in 5,605 4,795 excess of $.01 par value;
The articulation of the financial statements The articulation of the financial statements through the recording of cash flows and through the recording of cash flows and accrualsaccruals
Investment and disinvestment by owners
Earnings
Net change in owners’ equity
SSttaatteemmeenntt ooff SShhaarreehhoollddeerrss’’ EEqquuiittyy –– yyeeaarr 11
Cash from operations
+ Accruals
Net income
IInnccoommee SSttaatteemmeenntt –– yyeeaarr 11
Cash from operations Cash from investing Debt financing
Net change in cash
CCaasshh FFllooww SSttaatteemmeenntt –– yyeeaarr 11
Cash0
+ Other Assets0
Total Assets0
- Liabilities0
Owners’ equity0
Cash1
+ Other Assets1
Total Assets1
- Liabilities1
Owners’ equity1
EEnnddiinngg BBaallaannccee SShheeeett –– yyeeaarr 11
Beginning stocks Flows Ending stocks
EEnnddiinngg BBaallaannccee SShheeeett –– yyeeaarr 00
Equity financing
Net cash flows from all activities increases cash in the balance sheetCash from operations increases net income and shareholders’ equityCash investments increase other assetsCash from debt financing increases liabilitiesCash from equity financing increases shareholders’ equity
Accruals increase net income, shareholders’ equity, assets and liabilities