The Little Book of Valuation

CashFlows
Cashflowscanbeestimatedtoeitherjustequityinvestors(cashflowstoequity)ortoall
suppliersofcapital(cashflowstothefirm).Inthissection,wewillbeginwiththestrictest
measureofcashflowtoequity,i.e.thedividendsreceivedbyinvestors,andthenprogressively
movetomoreexpansivemeasuresofcashflows,whichgenerallyrequiremoreinformation.

Dividends
When aninvestor buys stock, hegenerallyexpects toget twotypes ofcashflows
dividendsduringtheholdingperiodandanexpectedpriceattheendoftheholdingperiod.Since
thisexpectedpriceisitselfdeterminedbyfuturedividends,thevalueofastockisthepresent
valueofjustexpecteddividends.Ifweacceptthispremise,theonlycashflowtoequitythatwe
shouldbeconsideringinvaluationisthedividendpaid,andestimatingthatdividendforthelast
periodshouldbeasimpleexercise.Sincemanyfirmsdonotpaydividends,thisnumbercanbe
zero,butitshouldneverbenegative.

AugmentedDividends
Oneofthelimitationsoffocusingondividendsisthatmanycompanies,especiallyinthe
UnitedStatesbutincreasinglyaroundtheworld,haveshiftedfromdividendstostockbuybacks
astheirmechanismforreturningcashtostockholders.Whileonlythosestockholderswhosell
theirstockbackreceivecash,itstillrepresentscashreturnedtoequityinvestors.In2007,for
instance,firmsintheUnitedStatesreturnedtwiceasmuchcashintheformofstockbuybacks
thantheydidindividends,andfocusingonlyondividendswillresultintheundervaluationof
equity.Onesimplewayofadjustingforthisistoaugmentthedividendwithstockbuybacksand
lookatthecumulativecashreturnedtostockholders.
AugmentedDividends=Dividends+StockBuybacks
Oneproblem,though,isthatunlikedividendsthataresmoothedoutovertime,stockbuybacks
can spike in some years and be followed by years of inaction. We therefore will have to
normalizebuybacksbyusingaveragebuybacksoveraperiodoftime(say,5years)toarriveat
morereasonableannualizednumbers.

PotentialDividends(FreeCashflowtoEquity)
With both dividends and augmented dividends, we are trusting managers at publicly
tradedfirmstoreturntopayouttostockholdersanyexcesscashleftoveraftermeetingoperating
andreinvestmentneeds.However,wedoknowthatmanagersdonotalwaysfollowthispractice,
asevidencedbythelargecashbalancesthatyouseeatmostpubliclytradedfirms.Toestimate
what managers could have returned to equity investors, we develop a measure of potential
dividendsthatwetermthefreecashflowtoequity.Intuitively,thefreecashflowtoequity
measuresthecashleftoveraftertaxes,reinvestmentneedsanddebtcashflowshavebeenmet.It
ismeasuredasfollows:
FCFE=NetIncomeReinvestmentNeedsDebtCashflows
=NetIncome+(CapitalExpendituresDepreciation+Changeinnoncashworking
CapitalPrincipal)(Repayments+NewDebtIssues)
Considertheequationinpieces.Webeginwithnetincome,sincethatistheearningsgenerated
forequityinvestors;itisafterinterestexpensesandtaxes.Wecomputewhatthefirmhasto
reinvestintwoparts:
a. Reinvestment in longlived assetsis measured as the difference between capital
expenditures(theamountinvestedinlonglivedassetsduringtheperiod)anddepreciation
(theaccountingexpensegeneratedbycapitalexpendituresinpriorperiods).Wenetthe
latterbecauseitisnotacashexpenseandhencecanbeaddedbacktonetincome.
b. Reinvestment in shortlived assetsis measured by the change in noncash working
capital.Ineffect,increasesininventoryandaccountsreceivablerepresentcashtiedupin
assetsthatdonotgeneratereturnswastingassets.Thereasonwedoneconsidercashin
thecomputationisbecauseweassumethatcompanieswithlargecashbalancesgenerally
investtheminlowrisk,marketablesecuritieslikecommercialpaperandtreasurybills;
theseinvestmentsearnalowbutafairrateofreturnandarethereforenotwastingassets.
[1]Totheextentthattheyareoffsetbytheuseofsuppliercreditandaccountspayable,the

effect on cash flows can be muted. The overall change in noncash working capital
thereforeisinvestmentinshorttermassets.
Reinvestmentreducescashflowtoequityinvestors,butitprovidesapayoffintermsoffuture
growth.Wewillcomebackandconsiderwhethertheneteffectispositiveornegativeafterwe
considerhowbesttoestimategrowth.Thefinalinputintotheprocessarethenegativecashflows
associatedwiththerepaymentofolddebtandthepositivecashflowstoequityinvestorsfrom
raisingnewdebt.Ifolddebtisreplacedwithnewdebtofexactlythesamemagnitude,thisterm
willbezero,butitwillgeneratepositive(negative)cashflowswhendebtissuesexceed(areless
than)debtrepayments.
Focusing on just debt cash flows allows us to zero in on a way to simplify this
computation.Inthe special casewherethe capital expenditures andthe working capitalare
expectedtobefinancedatafixeddebtratio,andprincipalrepaymentsaremadefromnewdebt
issues,theFCFEismeasuredasfollows:
FCFE = Net Income + (1) (Capital Expenditures Depreciation) + (1
)WorkingCapital
Ineffect,weareassumingthatafirmwitha30%debtratiothatisgrowingthroughreinvestment
willchoosetofund30%ofitsreinvestmentneedswithnewdebtandreplaceolddebtthatcomes
duewithnewdebt.
Thereisonemorewayinwhichwecanpresentthefreecashflowtoequity.Ifwedefine
theportionofthenetincomethatequityinvestorsreinvestbackintothefirmastheequity
reinvestmentrate,wecanstatetheFCFEasafunctionofthisrate.
EquityReinvestmentRate

=

FCFE=NetIncome(1EquityReinvestmentRate)
Afinalnoteonthecontrastbetweenthefirsttwomeasuresofcashflowstoequity(dividends
andaugmenteddividends)andthismeasure.Unlikethosemeasures,whichcanneverbeless
thanzero,thefreecashflowtoequitycanbenegativeforanumberofreasons.Thefirstisthat
thenetincomecouldbenegative,anotuncommonphenomenonevenformaturefirms.The
secondisthatreinvestmentneedscanoverwhelmnetincome,whichisoftenthecaseforgrowth
companies,especiallyearlyinthelifecycle.Thethirdisthatlargedebtrepaymentscomingdue
thathavetofundedwithequitycashflowscancausenegativeFCFE;highlyleveredfirmsthat
aretryingtobringtheirdebtratiosdowncangothroughyearsofnegativeFCFE.Thefourthis
thatthequirksofthereinvestmentprocess,wherefirmsinvestlargeamountsinlonglivedand
shortlivedassetsinsomeyearsandnothinginothers,cancausetheFCFEtobenegativeinthe
big reinvestment years and positive in others. As with buybacks, we have to consider
normalizing reinvestment numbers across time when estimating cash flows to equity. If the
FCFEisnegative,itisindicativeofthefirmneedingtoraisefreshequity.

CashFlowtotheFirm
Thecashflowtothefirmthatwewouldliketoestimateshouldbebothaftertaxesand
afterallreinvestmentneedshavebeenmet.Sinceafirmraisescapitalfromdebtandequity
investors,thecashflowtothefirmshouldbebeforeinterestandprincipalpaymentsondebt.The
cashflowtothefirmcanbemeasuredintwoways.Oneistoaddupthecashflowstoallofthe
differentclaimholdersinthefirm.Thus,thecashflowstoequityinvestors(estimatedusingone
ofthethreemeasuresdescribedinthis section)areaddedtothecashflowstodebtholders
(interestandnetdebtpayments)toarriveatthecashflow.Theotherapproachistostartwith
operatingearningsandtoestimatethecashflowstothefirmpriortodebtpaymentsbutafter
reinvestmentneedshavebeenmet:
FreeCashflowtofirm(FCFF)=AftertaxOperatingIncomeReinvestment
= Aftertax Operating Income (Capital Expenditures
Depreciation+ChangeinnoncashWorkingCapital)
ItiseasiesttounderstandFCFFbycontrastingitwithFCFE.First,webeginwithaftertax
operatingincomeinsteadofnetincome;theformerisbeforeinterestexpenseswhereasthelatter
isafterinterestexpenses.Second,weadjusttheoperatingincomefortaxes,computedasifyou
weretaxedontheentireincome,whereasnetincomeisalreadyanaftertaxnumber. [2]Third,
whilewesubtractoutreinvestment,justaswedidtoarriveatfreecashflowstoequity,wedo
notnetouttheeffectofdebtcashflows,sincewearenowlookingatcashflowstoallcapitaland
notjusttoequity.
Anotherwayofpresentingthesameequationistocumulatethenetcapitalexpenditures
and working capital change into one number, and state it as a percentage of the aftertax
operating income. This ratio of reinvestment to aftertax operating income is called the
reinvestmentrate,andthefreecashflowtothefirmcanbewrittenas:

ReinvestmentRate=

FreeCashFlowtotheFirm=EBIT(1t)(1ReinvestmentRate)
Notethatthereinvestmentratecanexceed100%[3],ifthefirmhas substantialreinvestment
needs.Thereinvestmentratecanalsobelessthanzero,forfirmsthataredivestingassetsand
shrinkingcapital.
Afewfinalthoughtsaboutfreecashflowtothefirmareworthnotingbeforewemoveon
todiscountrates.First,thefreecashflowtothefirmcanbenegative,justastheFCFEcan,but
debtcashflowscannolongerbetheculprit;evenhighlyleveredfirmsthatarepayingdowndebt
willreportpositiveFCFFwhilealsoregisteringnegativeFCFE.IftheFCFFisnegative,thefirm
willberaisingfreshcapital,withthemixofdebtandequitybeingdeterminedbythemixusedto
compute the cost of capital. Second, the cash flow to the firm is the basis for all cash
distributionsmadebythefirmtoitsinvestors;dividends,stockbuybacks,interestpaymentsand
debtrepaymentsallhavetobemadeoutofthesecashflows.

[1]Notethatwedonotmakethedistinctionbetweenoperatingandnonoperatingcashthatsomeanalystsdo(they
proceedtoincludeoperatingcashinworkingcapital).Ourdistinctionisbetweenwastingcash(whichwouldinclude
currencyorcashearningbelowmarketratereturns)andnonwastingcash.Weareassumingthattheformerwillbe
asmallornegligiblenumberatapubliclytradedcompany.
[2]Ineffect,whencomputingtaxesonoperatingincome,weactlikewehavenointerestexpensesortaxbenefits
fromthoseexpenseswhilecomputingthecashflow.Thatisbecausewewillbecountingthetaxbenefitsfromdebt
inthecostofcapital(throughtheuseofanaftertaxcostofdebt).Ifweuseactualtaxespaidorreflectthetax
benefitsfrominterestexpensesinthecashflows,wewillbedoublecountingitseffect.
[3]Inpracticalterms,thisfirmwillhavetoraiseexternalfinancing,eitherfromdebtorequityorboth,tocoverthe
excessreinvestment.