Discounted free cash flow valuation model

Transcription

1 SESSION 4 Topics: Analysis of statement of cash flows Case analysis Mechanical preparation of SCF: Costco Discounted free cash flow valuation model Free cash flow vs EDITDA REVIEW OF SESSION 3 About A/R, inventory, and fixed asset turnover ratios: What do they intend to measure? Which step of FSA do they relate to? What are the main factors influencing these ratios? What are the possible reasons for an increase in A/R turnover? In fixed asset turnover ratio? What did we learn from Electrona? 1

2 ANALYZE SCF What information does SCF provide? Accrual vs. cash aspect of operations CFO vs. Net income Cash inflows/outflows related to operating, investing, or financing activities Disaggregated information in each of the activities ANALYZE SCF Typical questions to ask in analyzing SCF: How much cash is generated or used from operation? What expenditures are made with CFO? Investing or financing? What s the source of cash for debt payment? dividend payment? 2

3 ANALYZE SCF Complementary relation between NI and CFO: NI: profitability of operation; revenue and expenses are accrual concepts CFO: liquidity aspect of operation; not a measure of profitability (e.g., it excludes depreciation expense) NI: affected by accounting policy choice; reflects mgmt s expectation/discretion; may or may not convey useful information CFO: free of these choices, thus can serve as a check for quality of earnings. CASE DISCUSSION Three examples of SCF 3

4 ANALYZE SCF Relation between SCF and firms life cycle ANALYZE SCF Things to consider when analyzing SCF: Ambiguous definitions of activities: Example 1: Interest and dividend received: classified as operating; do they measure operating from firm s core business? Example 2: Interest paid: interest payment is classified as operating by SFAS 95 but it s an outcome of firms financing choices. Analysts often exclude the above finance related numbers from CFO to arrive at their assessment of the firm s cash from operations. Effect of extraordinary events on cash is often difficult to assess. 4

5 ANALYZE SCF Things to consider when analyzing SCF: Distortions by noncash transactions: Capex includes only cash investment (need balance sheet for a complete picture) SCF can be manipulated! Mostly by misclassification: put good things into CFO, take bad things out of CFO. More about this later Pay attention to the persistence of CFO. MECHANICAL PREPARATION OF SCF Costco example 5

6 SESSION 4 Topics: Analysis of statement of cash flows Case discussion Mechanical Preparation of SCF Costco Discounted free cash flow valuation model Free cash flow vs EDITDA FREE CASH FLOW VALUATION What is free cash flow? Idea: cash available to the firm for discretionary uses after making all required cash outlays. Conceptually: Total after tax cash flow generated by the company that is available to all capital providers after paying for all investments necessary for growth. Calculation: varies across analysts and firms. 6

7 FREE CASH FLOW VALUATION Our calculation: CFO + after tax int. exp capex This calculation assumes interest expense equals to cash paid for interest. When this assumption is not valid, use CFO + cash paid for interest expense total int. exp *tax rate capital expenditures Unaffected by company s financial structure. Why? Thus, this measure is referred to as FCFU, where U stands for Unlevered. Which items are capital expenditures? Use your own discretion/judgment on which items in the investment section are investments necessary for growth. FREE CASH FLOW VALUATION A firm s intrinsic value can be expressed as the discounted sum of all future free cash flow generated by the firm: FCFU1 FCFU 2 FCFUt V0 = = 1 2 t 1+ r 1+ r t= 1 1+ r ( ) ( ) ( ) This is the firm s enterprise value, which is the sum of the firm s equity value and debt value. 7

8 FREE CASH FLOW VALUATION In reality, we often assume a constant growth rate of FCF after period T.Then: Then: V ( ) ( ) ( + g ) FCFT ( ) FCF 1 1 FCFT o = T T 1+ r 1 + r ( r g) 1+ r Here, r is the discount rate (WACC), g is the assumed growth rate, and the above expression is based on the assumption that r > g. SESSION 4 Topics: Analysis of statement of cash flows Case discussion Mechanical Preparation of SCF Costco Discounted free cash flow valuation model Free cash flow vs EDITDA 8

9 THE THING ABOUT EBITDA EBITDA: earnings before interest, taxes, depreciation and amortization expenses Why was EBITDA a darling of Wall Street? EBITDA originated as a response to leverage buyout (LBO) in the 80 s and M&A in the 90 s. LBO usually involves large interest expense, and capital expenditure is often halted immediately after LBO M&A: large amortization expense EBITDA is meant to provide a metric free of those effects, as well as free of the influence of management s depreciation policy choice. THE THING ABOUT EBITDA EBITDA is not a perfect proxy for cash from operations because it does not capture cash provided from changes in working capital accounts. EBITDA can be abused WorldCom: capitalize operating expenses Then encourage investors to focus on the EBITDA 9

10 THE THING ABOUT EBITDA Is EBITDA the same as free cash flow? SESSION 4 REVIEW QUESTIONS How does a firm s life cycle relate to its SCF? To its free cash flow measure? What discount rate should be used in FCFU? Why? True or false: a firm s discounted FCFU value is usually higher than its equity value. 10

11 IN PREPARATION FOR SESSION 5 Read class note and/or SBW Chapter 10 on pro forma preparation p Movie Night s pro forma case discussion. We will go through it step by step in class The main focus of this case is on the mechanics of pro forma. However, it is very important to think about the rationale (or the lack thereof) for the underlying assumptions. You can, though you don thaveto to, bringyourlaptop to the next class. If you do, make sure you have Movie Night s spreadsheet on your computer. 11

12 1991 Alpha Beta Gamma Part I: a) Major sources b) Major uses c) CFO>0? CFO>, =, <NI? Main reasons NI $amount d) CFO>Capex? e) CFO>Capex+Div? f) Source of cash for dividends+capex Part II Part III Other major items affecting cash flows Trends NI CFO Capex Dividends Net borrowing (debt) Working capital (A/R, Inventory, A/P) Part IV Overall assessment

13 COSTCO Consolidated Balance Sheets (in $1000s) ASSETS Current Assets Cash and cash equivalents $2,062,585 $2,823,135 Short-term investments 1,397, ,747 Receivables, net 399, ,175 Merchandise inventories 4,014,699 3,643,585 Other current assets 211, ,457 Total current assets 8,086,438 7,269,099 Net property and equipment 7,790,192 7,219,829 Other assets 637, ,620 TOTAL ASSETS $16,513,642 $15,092,548 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Short-term borrowings $54,356 $21,595 Accounts payable 4,213,724 3,600,200 Accrued salaries and benefits 1,025, ,209 Accrued sales and other taxes 263, ,009 Deferred membership income 500, ,881 Current portion long-term debt 3, ,594 Other current liabilities 548, ,062 Total current liabilities 6,608,974 6,170,550 Long term debt, excl. current portion 710, ,746 Deferred taxes and other liab. 254, ,176 Total liabilities 7,573,919 7,408,472 MINORITY INTEREST 58,614 59,266 STOCKHOLDERS' EQUITY Common stock at par 2,362 2,313 Additional paid-in-capital 2,096,554 1,466,366 Other accumulated comprehensive inco 158,039 16,144 Retained earnings 6,624,154 6,139,987 Total stockholders' equity 8,881,109 7,624,810 $16,513,642 $15,092,548 COSTCO Mechanical SCF Predicted Aug Aug-04 Operating Investing Financing Additional information: Begin Cash $2,823,135 Net income for year 2005 is 1,063,092 Total changes in cash Depreciation expense for year 2005 is 477,868 Ending cash