How Do You Calculate Cash Flow in Real Life for a Real Company?

Transcription

1 How Do You Calculate Cash Flow in Real Life for a Real Company? Hello and welcome to our second lesson in our free tutorial series on how to calculate free cash flow and create a DCF analysis for Jazz Pharmaceuticals and then ultimately use it in real life. Now, last time around, I told you that there were three steps to learning and mastering financial modeling. Step 1 is understanding the concept. Step 2 is practicing with a real company. Step 3 is learning how to apply it in real life and then applying it yourself. Last time around we took a look at the concept of free cash flow and a DCF analysis and the near-term period and the far-in-the-future period. Now we re going to apply all those concepts to our real company here, Jazz Pharmaceuticals, as we fill out portions of a discounted cash flow analysis for them. Last time around if you remember, we were a little bit imprecise with cash flow and what those terms actually meant. We called it free cash flow. In other places we just said cash flow. [01:01] We weren t very precise about what exactly this includes and what it doesn t include and how you calculate it in the first place. When you re creating a discounted cash flow analysis though, there are certain items you always want to include and certain items you want to exclude. Now at a basic level, yes, this metric is measuring a company s profitability after you ve taken into account other possible ways that it can get cash and use cash, but, as always, that s a very high-level summary. There s more to it than that. For an item to be included in this metric, it has to be related to the company s core business; if the core business here is developing and selling pharmaceuticals and then they also have a business where they rent out apartments or do something else unrelated, then you would not include anything related to that in this metric because it s not related to the core business. [02:00] Similarly, if something is more related to the way that a company is financing its business such as the amount of debt it has raised or the amount of equity it has raised, those are also not core businessrelated. So you re not going to include them in this unlevered free cash flow metric. An item should be mandatory if it is in here. If it is not mandatory, then it should not be in here. So, for example, if a company such as a retailer needs to spend money on inventory so that they can order products and sell them to customers, yes, that is mandatory for their business. So you need to include that spending on inventory. On the other hand if a company chooses to issue dividends or chooses to

2 issue shares or chooses to raise debt, none of those are truly required. There are always other ways to raise funding and to get funds to run and expand a business. We leave those types of items out because they are not mandatory. [03:00] Then, finally, for an item to be included here, it has to be recur from year to year. Even if you see a large use of cash or a source of cash on the company s financial statements, you re only going to count it here if it s something that actually recurs from year to year. Now these three guidelines are very helpful. The problem is that once you delve into real companies and you use some examples of real financial statements, these don t always hold up. You will see some cases where it is not immediately obvious all the time exactly what you do. One of the reasons why this concept gets very confusing is that a lot of sources and textbooks and other training materials present you with a lot of formulas for memorizing free cash flow or memorizing unlevered free cash flow. In our opinion, the easiest way to do it and the easiest way to think about it is to not memorize formulas but instead just take a company s cash flow statement, remove anything that is nonrecurring and then remove anything that is related to its financing. [04:06] Its cash, debt, items like that and then interest paid on those and interest earned on those. If you think about it, that really lines up with the previous definition because those items are not core businessrelated. They are not mandatory. Interest may recur from year to year, but actually raising debt or buying investments or selling investments, those are not generally going to be recurring items. So we think that s the easiest way to think about this concept. In this lesson, we re going to go through the financial statements of Jazz Pharmaceuticals and start with their cash flow statement right here. We re going to pick apart each of these different line items and learn what should go into this calculation and then what should not go into this calculation. Should we leave out anything that s included here? Should we add anything that s not already here? Should we leave out entire sections or keep in entire sections? We re going to cover that in this lesson. [05:04] The basic point is that you don t want to get into this business of memorizing exact formulas because it s a very easy way to get tripped up. You can have a general sense of how to do this in an interview but even there, you open yourself up to a lot of danger if you just give them a simple formula whereas

3 if you describe the process and how you think about it and what you do, it s a lot lower risk for you. You have a lower chance of getting very difficult questions from the interviewer. So let s get started with the first part of Jazz Pharmaceuticals financial statements. Once we complete this exercise, we re going to go into Excel and then fill out their actual unlevered free cash flow based on all these items. Starting with the cash flow from operations section, you always want to include net income or some type of after-tax profitability metric. [06:00] As I say over here in this analysis and in most analyses, we re not quite going to use net income. We will often modify it a little bit. I will get to that in the upcoming slides but you always want to have a starting point of the company s after-tax profitability. Then after that, you re always going to add back these two items and include them in a section, amortization and depreciation, no matter what type of company, no matter what industry it is. The reason is that the company has spent cash on these items a long time ago. It recognizes these as noncash expenses over time. They reduce their taxes. Then they get added back here because they re not actually paid out in cash. They were paid out in cash a long time ago. Then moving down, items like the loss on disposal of property and equipment, these are usually nonrecurring. They re very tough to predict. You leave them out for those reasons. [06:58] Share-based compensation, or stock-based compensation as it s often called. I ve circled it here but I will make this one note and say that this is a very controversial item. We think it s better to actually exclude it from this analysis and leave it off of the cash flow statement entirely and not it include it in your analysis for free cash flow. We ll get into some of the reasons for that later on, but I will say here that a lot of people will disagree with that. I know I'll see plenty of people who add this back and keep it within their free cash flow calculation anyway. Then the rest of this section we would cross out most of these items. Anything that doesn t appear in all the years we can almost certainly cross off. So a lot of these are going to be non-recurring. We may leave in some of these items in our own projections but we re typically going to set anything that doesn t appear to recur with a certain pattern, we ll typical set anything like that to zero. [07:57]

4 The one item here that I will include is the non-cash transactions all the way at the bottom because this does seem to be recurring, somewhat. In general, most companies do have a certain amount of non-cash items that need to be factored in even though they tend to be very small. One other note here as I mentioned before is that with a lot of these items, we will include ones like deferred income taxes, for example, but we re typically going to set them to zero or at least very small numbers because we don t want them to really impact a company s value going forward. Now, two quick notes on this about what you do in a few cases: first off, for net income the issue here is that, remember, we want to remove the impact of financing items. In other words, the company s debt, their equity, their cash and then also the interest paid on debt or the interest earned on cash. The problem is that net income includes both of those because you start with the company s operating income. You factor in other charges. You include the interests on debt or cash whether it s interest expense or interest income. [09:01] Then you multiply by one minus the tax rate to get to that net income. You have a problem here because you need to remove this from the net income metric. So typically what you do is look at something called net operating profit after taxes instead. This lets you exclude interest when you re calculating net income. So you modify this a little bit when you use it in the analysis. In our own Excel file over here you can see how it works. Instead of starting with pre-tax income as you usually do, which includes interest expense and interest income, we instead start with operating income. Then we tax-effect that to get to NOPAT rather than net income. That is the starting point of our analysis. Then the second note I ll make here is on stock-based compensation. As I said, this is a controversial item. [09:54] The issue here is that if you think about depreciation and amortization, what s really going on with those is that on the company s cash flow statement, they spend something on property and equipment with capital expenditures. Then with amortization of intangibles, they may spend something on buying intangibles or acquiring other companies or getting those in some way, shape or form. But the point is

5 that in either case they spend cash up front in the beginning. Then it gets recognized as an expense on the financial statements over time. When we include these and we add them back in our analysis, it s not really like we re cheating because the company is spending cash. We re reflecting that because we include capital expenditures in our analysis or if they make acquisitions, then we ll also have to include them if we want to include amortization resulting from those acquisitions. But the problem is that stock-based compensation is not really like this. This is just an alternate way to pay employees at your company. There is no big, upfront cash payment here. Instead employees just receive shares in the company or options or restricted stock or something like that. [11:03] Now as a result of that, the company now has more shares outstanding. If you go up and look at their income statement, for example, as a result of this, they re weighted average diluted shares will go up as they issue more and more of these. The per-share value of the company is going to decrease as a direct result of issuing this stock-based compensation. The problem is that if we add this back, if we keep it on the cash flow statement, essentially we re saying that we re getting a free lunch. We re getting something for nothing here because we re saying, You know what? Instead of paying employees in cash, we can pay them in stock. We can reduce our taxes that way. It s not going to make any impact on the model. Technically it is more correct to leave it out entirely; or another approach would be to go back down to our assumptions and output. [12:00] Wherever we ve calculated the diluted shares outstanding perhaps to adjust this for the expected future issuances and the additional shares that will be created from stock-based compensation. Both of those would be better ways to deal with this. In this model, I m going to leave it up to you what to do. The fact is that it is controversial. A lot of bankers don t really understand this concept or why you do it this way. So in an interview, you may actually get someone who doesn t really understand this. You do not want to get into an argument in that case. You just want to go along with what they say even if it s not quite correct. Moving on now to the next part of the cash flow statement, the changes in assets and liabilities or the change in working capital, the change in operating assets and liabilities, here, it s very easy because you pretty much want to include everything that s listed there. If a company considers an item to be operationally-related, you should take their word for it. You should just include everything there.

6 [12:59] In the future, you should include your projections for how these items might change. This section tends to create a lot of confusion as well. I also want to explain a bit more about what goes into this. With working capital, the idea, and I think the easiest way to think of it, is to think of these two items, inventory and accounts receivable. With inventory, you have to spend cash up front but it doesn t appear as an income statement expense until you actually sell those products. However, you have to front the cash up-front and spend something to eventually earn something. You re spending cash in advance of actually selling the products that you have purchased these supplies or parts for. With accounts receivable, you ve listed something as revenue but you haven t actually received it in cash from the customer yet. So if this is increasing, you have to adjust your actual cash flow down on the cash flow statement. If inventory s increasing, it s the same idea. You have to adjust your actual cash flow down because you re spending something in advance of actually being able to sell the product associated with it. [14:04] Now we cover this in a detailed lesson in our full course, but I just wanted to give you the high-level overview for what goes into this item and why and how it matters for now. The same applies to many of these other items that comprise working capital. So if we go to the company s financial statements, for example, you can apply similar logic to items like accounts payable and accrued liabilities. These are for the cases where something has shown up on the income statement but it hasn t yet been paid out in cash. If this keeps increasing each year, which it does in most years here, it means the company is accruing more and more in expenses but is waiting for a while to actually pay them out in cash. The working capital section really refers to those timing differences and what type of impact they have on the company s overall cash flow. [14:55] The overall rules here are that if an asset goes up, cash flow goes down. If an asset goes down, cash flow goes up. Then if the liability goes up, cash flow goes up. If the liability goes down, cash flow goes down. The easiest way to think about all of these is to go back and think about the examples with inventory on the asset side. You have to spend something on it, which means you re losing cash because you re spending it on the inventory. But then when it goes, it means you ve sold the product, so now your cash flow s going to go up. On the liability side if you think about an item like accounts

7 payable, where you re delaying cash payment so your cash flow goes up, then when you finally pay out, that s when your cash flow goes down. What items do you actually include in working capital? The general rule of thumb is that you want to include current assets, because they tend to be operationally-related, except for cash and cash equivalents such as short-term investments, for example. You keep those out because they re not related to the company s operations. Then you include any long-term operational items that factor in here. [16:02] On the liability side, you include current liabilities except for debt, and then any long-term items that are more related to the company s operations. You have to be really careful here because a lot of sources define this imprecisely. They say that it s current assets and current liabilities. That s not really true at all because you exclude some of these items. Then you may include some long-term items that are not included in the exceptions. The litmus test really is: Is something related to the company s operations or not? That s the best way to think about it and the best way to decide what goes in here. Continuing with this example for Jazz with their current assets, we re going to eliminate cash and cash equivalents because those are not related to core business. They don t actually need that much cash to continue running. Then on the liability side we re going to eliminate debt, contingent consideration, and the deferred tax liability. [16:57] Contingent consideration would also be classified as not related to the core business, and it s reflected elsewhere in the cash flow statement. And the deferred tax liability, the issue here is that, this is also reflected elsewhere on the cash flow statement so we don't want to be double counting it and so we're not going to include it in our working capital section. Everything else, though, corresponds to operationally-related line items. Then if you look at their long-term assets and long-term liabilities, we re going to cross out most of the long-term assets because these are not operationally-related. Financing cost, for example, clearly has nothing to do with the everyday running of the business. Other noncurrent assets, though, we ll include. Then on the liability side we will include deferred revenue. We will not include debt, the contingent consideration, or the deferred tax liability for many of the same reasons, but we will include other noncurrent liabilities because that is operationally related. [17:58]

8 Now, deferred revenue you might have gotten, but you might be wondering now, How did you know that other noncurrent assets and other noncurrent liabilities are actually related to the company s operations? The easiest way to tell is to actually look at their financial statements and see what they say. Looking at this, for example, we see these items for other long-term assets and then other noncurrent, in other words other long-term, liabilities. This is a dead giveaway that we have items that are operationally related that should be included here. That s a bit about how you can decide what goes into this. Now the next few sections of the cash flow statement, we have investing activities. Typically here we cross out everything except for purchases of property and equipment, also called capital expenditures or CapEx. The reason being is that that s typically the only required recurring item, a company investing in buildings or land or factories or other assets. [19:02] It could even be computer systems or servers for an IT company. That s usually the only required recurring item. We leave out these other types of items like acquisitions or the sale of securities or the purchase of securities that are optional and tend not to follow a predictable schedule. Now with pharmaceutical companies, you could make the argument that maybe acquiring intangible assets should be an actual recurring item. You could also make the argument that perhaps even acquisitions themselves should be recurring. You will see people say that but in general it s better just to say that CapEx goes into it in an interview or a case study. Otherwise, you re going to get a lot of questions about how to justify what you ve done. [19:52] Then in the next section, financing activities, this is easy because we just cross out everything here, items like debt issuances, debt repayments, share issuances, and share repurchases the logic being that most of these items are non-recurring and optional. We re just going to leave them out. They re not related to the company s core business either. So these have nothing to do with the everyday running of their business; selling to customers, collecting cash, developing new products and so on and so forth. The only items here that really is recurring and is required would be mandatory debt repayments, but remember, we re leaving out financing items when we calculate unlevered free cash flow anyway. Now that we ve done that, I m going to go into Excel. We re going to go through this exercise and enter all these items for Jazz Pharmaceuticals. Our unlevered free cash flow projections here start on row

9 360. Above this we have a detailed model for the company as a whole. We go through this step by step in our full course. We don t really have time to get into it here without turning this into an eight-hour tutorial, but there is significantly more detail there. This is just a very, very small part of what we do in the course. [21:03] Let s start with revenue and start entering these numbers. We ll go up to the company s income statement and take their total revenue right from there. Then we also want to get their operating income or EBIT earnings before interest and taxes. I have also copied down the growth rates and the margins for both of those. Then we could now copy this across. We can see that the revenue goes up to a certain point but then falls dramatically in the final two years because their patent s on Xyrem, one of their key drugs, actually expired then. If you look at the revenue model for them, Xyrem sales fall off dramatically between 2021 and 2022 whereas everything else pretty much stays the same or goes up slightly. [21:56] We have that. Then moving down remember how I said that we want to start with a modified version of net income, known as NOPAT. That s what we re going to do here. With this, we take our operating number. Then we multiply it by our tax rate. The tax rate, if you re wondering, I ve defined up here at the top. It s only 18% because the company s based in Ireland, which has a significantly lower tax rate than a country like the US, for example. Let's take this and copy it across. Then for net operating profit after taxes, we ll take our operating income and subtract our taxes. Really we add them because it s already negative. We can copy this across as well. Now this next section on non-cash charges, remember we re always going to add back depreciation and amortization. The rest of these, we do have some other times here but a lot of these are going to be set to zero. We re not going to stress out too much. [23:01] Generally speaking, even if something is in a previous period, if it is not recurring, then we re just going to set it to zero in future periods even if we do still list the item here, for example. So for the amortization of intangible assets, let s go up to their cash flow statement because we have all these items listed right here. Then we can copy down everything else from that section and then add up our total adjustments for non-cash charges. Once again, we can copy this one across.

10 Now one thing you may have noticed if you re being really observant is that I included stock-based compensation for now. This one, again I would emphasize, is controversial. I m including it here because in most cases and in most interviews people will argue that you should have it because it s a non-cash charge. They don t really understand that it creates dilution and it s much different from depreciation and amortization. [24:08] It would be more correct actually to leave it out. In the finished file, I m going to keep this in and include it just because it s going to match up better with some of the documents that we look at in the final lesson. Now moving down, the changes in operating assets and liabilities so far remember we ve been recreating the company s cash flow statement with a few modifications. Here we really just want to take everything that s here and go from there. There isn t much to it. We ve calculated all these changes in future periods. Again, that s covered in the full course. We don t really have time to get into all of this right now. But essentially the company spends something on many of these items. They will have to invest in these items on their balance sheet in advance of their growth in most cases. [24:55] Let s go up to their cash flow statement once again. Let s get all of these items and then add up the total down here and copy this across. You can see that, on average, the company is actually spending a good amount in advance of its growth, primarily because accounts receivable keeps going up as does their prepaid expenses. Even their inventory goes up by a fair amount each year. That s what this section is saying. Then the next part here, I m just going to group these again so you can see everything a little better. For capital expenditures, this is the one item that we want to take from the cash flow from investing section. Remember, we re going to exclude the cash flow from financing section altogether. For now though, let s take our capital expenditures right from here. Then we can copy this across. [25:58] So we have that. That really almost takes us to the end here. The last step is to calculate our unlevered free cash flow. Notice how I haven t really presented you with a formula yet. If you want to get right down to it, yes, the formula would be operating income times (1 minus the tax rate) to get to NOPAT. Then you adjust for non-cash charges, changes in working capital or operating assets and liabilities and subtract capital expenditures, but we think the approach of looking at a company s cash

11 flow statement, taking what you want, modifying a few items and then leaving out the majority what's on here is a little bit easier to think about and to explain in an interview. For the unlevered free cash flow, let s take NOPAT. Let s take those non-cash charge adjustments and then the total changes in operating assets and liabilities and then capital expenditures as well and copy this across. [26:55] So now we have this. We have our free cash flow projections each year. You can see what we re doing at the bottom which is that we re taking the net present value of free cash flow in each of these periods. The basic formula we set up is really almost the same as what we had in our much simpler model, because, remember there we took a net present value of free cash flow each year by taking that free cash flow dividing by ((1 + Discount Rate) ^ # of Years). It s the same exact thing here, except the inputs get more complicated. There s more that goes into free cash flow. The discount rate we go through a number of steps to calculate. Also the exact period we use is a little bit tricky because this analysis is taking place midway through the year. But fundamentally it s still the same type of formula where you re still looking at the discount rate, the free cash flow and the amount of time that has passed from the beginning to the year that you re in. [28:00] So that s what we have there. Then based on all of this, you can see how it feeds into the analysis because ultimately we get to the NPV of the company s free cash flows, which again, takes us back to everything we covered in lesson number one. The net present value of cash flows right here. Then the second part, the terminal value, we skipped over here because we just don t have time to get into it for this company in this case study. But we ve calculated that as well based on the discount rate, the terminal value and in this case we ve done it based on a multiple. We could also, of course, base it on a long-term growth rate. It s really a matter of personal preference which one you pick and also the data that s available. You can see our conclusion that the company is substantially undervalued. Even when you do subtract stock-based compensation, in other words, you leave it out and you do not have it as a non-cash add-back, the company appears to be undervalued in this base case by around 30% to 40%. [28:59]

12 That gets you ultimately to how you use the DCF in real life because the share price that we would be willing to pay is around $170 to $180. But if you go up to what they re currently trading at, it s only around $130. So this seems to be a clear case of the company being undervalued. It might be potentially interesting for us to invest in the company or for bankers advising them to give them some very specific advice about their options. Now before we go back, for now, I m going to input the stock-based compensation here again, not because it s really correct but just so that it lines up with some of our other documents and earlier versions of this course and case study, we went back and forth on this. I just want to make it a little bit more consistent. You can see the effect. It bumps up the value by about $15 or $16 per share. Now it looks even more undervalued. That s it for Excel tutorial there. [30:00] To summarize how this works, with unlevered free cash, you want to get more specific and more precise than just saying cash flow or free cash flow. Specifically, you want to include items that are only related to the core business. They should be mandatory items, so optional acquisitions, optional equity or debt issuances, and things of that nature should be out. You want items that will recur from year to year. If an item you re looking at does not meet these criteria and you see it on the financial statements, you should leave it out. To avoid the confusion, we think the easiest way to think about it is to start with the company s own cash flow statement, make some of the modifications we discussed, remove those non-recurring items. Then if something is financing-related, so just interest paid on debt or earned on cash or net income, which includes those, take out the item or modify it to exclude, for example, interest on debt or cash. That tends to be a lot easier to think about and to think through versus just memorizing formulas. [31:01] Now we also saw a few issues that are specific to a discounted cash flow analysis for healthcare and pharmaceutical companies. Issue #1 is that we need to make sure that our cash flow projections reflect patent expirations. In this model, for example, one of the issues is that the patent on their key drug, Xyrem, expires at some point in the future. We assume that it expires in 2021 or At that point, that s when their cash flow from that drug will drop down dramatically because their prices will fall substantially. If you take a look at some of our pricing assumptions here, the drug s price is almost $120,000 per year but then in 2022 and 2023 it just drops to $10,000 per patient per year. So there s a dramatic drop because the patents expire and generic drugs enter the market.

13 [31:58] Stock-based compensation is a major issue for these types of companies because they tend to pay employees especially early employees often with a lot of stock-based compensation options, stock, RSUs, and so on and so forth. You really need to think about the proper treatment in this type of analysis. Then, finally, you also want to think about whether acquisitions or intangible purchases are, in fact, recurring items for this type of company. Those are a few of the issues we explored in this analysis. I hope you feel more comfortable now with applying the DCF and calculating this one crucial part, unlevered free cash for a real company, Jazz Pharmaceuticals, over 10 years into the future and using it in our analysis. In this tutorial, you ve seen how to modify a company s financial statements to calculate unlevered free cash flow. You ve learned some of the finer points, such as how stock-based compensation really works, and you can demonstrate your real-world skills and financial modeling and valuation. [33:00] Some of these points are new even to professionals working in the industry, so in that sense you re already one step ahead. In the next tutorial, you ll learn how to put together all the pieces and use a DCF analysis to create an investment banking pitch book, an equity research report and a hedge fund stock pitch for the same company. And yes, you ll get the real templates for all those documents. Stay tuned for all of that and more coming up in the next tutorial. Attention: New Features and Planned Price Rise We re in the process of launching significant new features, including a brand new version of the Financial Modeling Fundamentals course with 4x more content and 8+ global case studies, as well as transcripts, quizzes, certifications, and a brand new case study for the industry-specific courses (with more cases coming soon). This also means prices will increase on December 19 th at 5pm NYC time. If you join now, you ll save $100+ and get ALL the new features and future upgrades, FREE. Click here to find out more.