Equity Valuation Models- A

Comparative Review of Literature

Mahmuda Akter Ph. D

Professor ,
Faculty of Business Studies, Department of Accounting &
Information Systems, University of Dhaka.

Users of Firms Financial Information (Demand Side)

Equity Investors
Investment analysis
Management performance evaluation

Debt Investors
Probability of default
Determination of lending rates
Covenant violations

Management
Strategic planning
Investment in operations
Evaluation of subordinates

Litigants
Disputes over value in the firm

Customers
Security of supply

Governments
Policy making
Regulation
Taxation
Government contracting

Competitors

Employees
Security and remuneration

Investors and management are the primary users of financial statements

Investment Styles
Intuitive investing
Rely on intuition and hunches: no analysis

Passive investing
Accept market price as value: no analysis

Fundamental investing: challenge market prices

Active investing
Defensive investing

Costs of Each Approach

Danger in intuitive approach:
Self deception; ignores ability to check intuition

Danger in passive approach:

Price is what you pay, value is what you get:
The risk of paying too much

Fundamental analysis
Requires work !

Prudence requires analysis: a defense against paying the wrong

price (or selling at the wrong price)
The Defensive Investor

Activism requires analysis: an opportunity to find mispriced

investments
The Enterprising Investor

Alphas and Betas

Beta technologies:
Calculates risk measures: Betas
Calculates the normal return for risk
Ignores any arbitrage opportunities
Example: Capital Asset Pricing Model (CAPM)

Alpha technologies:

Tries to gain abnormal returns by exploiting arbitrage opportunities

from mispricing

Passive investment needs a beta technology (except for

index investing)
Active investing needs a beta and an alpha technology

Passive Strategies: Beta Technologies

Risk aversion makes investors price risky equity at a risk premium
Required return = Risk-free return + Premium for risk

What is a normal return for risk? A technology for pricing risk (asset pricing
model) is needed
Premium for risk = Risk premium on risk factors x sensitivity to risk factors

Among such technologies:

The Capital Asset Pricing Model (CAPM)
One single risk factor: Excess market return on rF
Normal return ( - 1) = rF + (rM - rF)
Only beta risk generates a premium.
Multifactor pricing models
Identify risk factors and sensitivities:

Normal return ( - 1) = rF + 1 (r1 - rF) + 2 ( r2 - rF) +

... + k (rk - rF)

Factor i, i = sensitivity to Risk Factor i)

(ri = Return to Risk

Active Strategies: Alpha Technologies

Anticipates that a stock may be mispriced
Scenario A: Todays price deviates from its intrinsic value V0 P0, but this will be
corrected in the future
VTC P. TC
Cum-dividend
Value
VTC PTC

Normal Return,

PTC V0
V0

Actual Return,

PTC P0

Abnormal Return,

P0 V0
P0

Time
0

Scenario B: Todays price is correct V0 P0, but in the future it will deviate from
its intrinsic value VTC PTC .
Cum-dividend
Value
PTC
Abnormal Return,

Actual Return,

PTC VTC

VTC

PTC P0

Normal Return,

VTC V0

P0 V0

Time
0

To discover these opportunities, a technology for calculating intrinsic values is needed

Fundamental Risk and Price Risk

Fundamental risk is the risk that results from business
operations
Price risk is the risk of trading at the wrong price
Paying too much
Selling for too little

Questions that Fundamental Investors Ask

Dell Computer trades at 76 times earnings (in 1998). Historically,
P/E ratios have averaged about 14. Is Dells P/E ratio too high?
What growth in earnings is required to justify a P/E of 76?
Yahoo! has a market capitalization of $17 billion (in 2003). What
future sales and profits would support this valuation?
Coca-Cola has a price-to-book ratio of 9 (in 2003). Why is its market
value so much more than its book value?
How are business plans and strategies translated into a valuation?

Investing in a Business

Cash from share issues

Dividends and cash from

share repurchases

S
D eco
eb n
th da
ol ry
de
rs

Interest and loan

repayments

Cash from sale of

debt

Cash from sale of

shares

Sh Se c
ar on
eh da
ol ry
de
rs

Financing
Activities

Investing
Activities

Operating
Activities

Cash from loans

D
eb
th
ol
de
rs

The investors:
The claimants on value

Sh
ar
eh
ol
de
rs

The firm:
The value generator

The capital market:

Trading value

Business investment and the firm: Value is surrendered by investors to the firm, the firm adds or losses value, and
value is returned to investors. Financial statements inform about the investments. Investors trade in capital markets
on the basis of information on financial statements.

Business Activities
Financing Activities: Raising cash from investors and
returning cash to investors
Investing Activities: Investing cash raised from investors
in operational assets
Operating Activities: Utilizing investments to produce
and sell products

The Firm and Claims on the Firm

Households and Individuals

Firms
Business
Assets

Business
Debt

Business Debt
(Bonds)

Household
Liabilities

Business Equity

Business Equity
(Shares)

Net
Worth

Other
Assets

Value of the firm = Value of Assets

= Value of Debt +Value of Equity

Valuation of debt is a relatively easy task

The Business of Analysis: The Professional Analyst

The outside analyst understands the firms value in order to

advise outside investors
Equity analyst
Credit analyst

The inside analyst evaluates plans to invest within the firm

to generate value
The outside analyst values the firm.
The inside analyst values strategies for the firm.

Value-Based Management
Test strategic ideas to see if they generate value
1. Develop strategic ideas and plans
2. Forecast payoffs from the strategy
3. Use forecasted payoffs to discover value creation

Applications
Corporate strategy
Mergers & acquisitions
Buyouts & spinoffs
Restructurings
Capital budgeting

Manage implemented strategies by examining decisions in terms of

the value added
Reward managers based on value added

Investing Within a Business:

Inside Investors
Business Ideas (Strategy)

Investment Funds: Value In

Apply Ideas with Funds

Value Generated: Value Out

The Analysis of Business

Understand the business
Understand the business model (strategy)
Master the details
The financial statements are a lens on the business.
Financial statement analysis focuses the lens.

Knowing the Business:

Know the Firms Products
Types of products
Consumer demand for the product
Price elasticity of demand for the product
Substitutes for the product. It is differentiated? On price?
On quality?
Brand name association of the product
Patent protection for the product

Knowing the Business:

Know the Technology
Production process
Marketing process
Distribution channels
Supplier network
Cost structure
Economies of scale

Knowing the Business:

Know the Firms Knowledge Base
Direction and pace of technological change and the firms
grasp of it
Research and development programs
Tie-in to information networks
Managerial talent
Ability to innovate in product development
Ability to innovate in production technology
Economies from learning

Knowing the Business:

Know the Industry Competition
Concentration in the industry, the number of firms and their sizes
Barriers to entry in the industry and the likelihood of new entrants
and substitute products
The firms position in the industry. It is the first mover or a
follower in the industry? Does it have a cost advantage?
Competitiveness of suppliers. Do suppliers have market power?
Do labor unions have power?
Capacity in the industry? Is there excess capacity or under
capacity?
Relationships and alliances with other firms

Knowing the Business: Know the Political, Legal and

Regulatory Environment
The firms political influence
Legal constraints on the firm including the antitrust law,
consumer law, labor law and environment law
Regulatory constraints on the firm including product and
price regulations
Taxation of the business
The firms ethical charter and the propensity for violating
it

Tenets of Sound Fundamental Analysis

One does not buy a stock, one buys a business.
2. When buying a business, know the business.
3. Value depends on the business model, the strategy.
4. Good firms can be bad buys.
5. Price is what you pay, value is what you get.
6. Part of the risk in investing is the risk of paying too much for a stock.
7. Ignore information at your peril.
8. Dont mix what you know with speculation.
9. Anchor a valuation on what you know rather than speculation.
10. Beware of paying too much for growth.
11. When calculating value to challenge price, beware of using price in
the calculation.
12. Stick to your beliefs and be patient; prices gravitate to fundamentals,
but that can take some time.
1.

Valuation Technologies:
Methods that do not Involve Forecasting
Method of Comparables
Multiple Screening
Asset-Based Valuation

Valuation Technologies:
Methods that Involve Forecasting
Dividend Discounting
Discounted Cash Flow Analysis
Pricing Book Values: Residual Earnings Analysis
Pricing Earnings: Earnings Growth Analysis

Classifying and Ordering Information

Order information in terms of how concrete it is:
Separate concrete information from speculative
information
The fundamentalists creed: Dont mix what you know
with what you dont know
Anchor valuation on hard information

Anchoring Valuation in the Financial Statements

Value = Anchor + Extra Value
For example,
Value = Book value + Extra value
Value = Earnings + Extra Value
The valuation task: How to calculate the Extra Value

Sneak Preview
Dividend Capitalization:

P0

d1 d 2 d3
2 3 ....
E E E

Accounting:
Bt Bt 1 earnt d t

and it is obvious (!!) that:

Residual Income Model:
earn1 E 1 B0 earn2 E 1 B1
P0 B0

...
2
E
E

A Framework for Valuation Based on Financial Statement Data

FORECASTS OF
CASH FLOWS

DISCOUNTED
CASH FLOWS

VALUE OF
THE FIRM/
DIVISION

FORECASTS OF EARNINGS
(and Book Values)

BUDGETS,
TARGETS,
FORECASTED EVA
* Performance Evaluation
*Benchmarking

DISCOUNTED
RESIDUAL EARNINGS
FORECASTING

CURRENT AND PAST

FINANCIAL STATEMENTS
(analysis of information,
trends, comparisons, etc.)

Residual Income and EVA

Residual Income
NET INCOME
generated by the
division/firm

Cost of
Capital

BOOK VALUE of
Investment in the
Firm

ADJUSTED
BOOK VALUE of
Investment in the
Firm

Economic Value Added

ADJUSTED NET
INCOME
generated by the
division/firm

Cost of
Capital

Are the Adjustments Necessary?

Distinguishing Form from

Content in Financial Statements
Form is the way in which the statements and
their components parts fit together.
Content is the measurement of the line items that
are reported within the component parts of
financial statements.
The form gives the overall story that the
statements are telling.
The content puts numbers into the story.

The Four Financial Statements

1. Balance Sheet/ Statement of Financial Position
2. Income Statement/ Statement of
Comprehensive Income
3. Cash Flow Statement
4. Statement of Shareholders Equity

The Balance Sheet: Dell

Computer Corporation

The Form of the Balance Sheet

Assets = Liabilities + Shareholders Equity
or
Shareholders Equity = Assets Liabilities

Compare to:
Value of Equity = Value of Firm Value of Debt

The Income Statement: Dell

Computer Corporation

The Form of the

Income Statement
Net Revenue Cost of Goods Sold = Gross Margin
Gross Margin Operating Expenses = Operating Income before Tax (EBIT)
Operating Income before Tax Interest Expense = Income before Taxes
Income before Taxes Income Taxes = Income after Taxes (and before
Extraordinary Items)
Income before Extraordinary Items + Extraordinary Items = Net Income
Net Income Preferred Dividends = Net Income Available to Common

The Statement of Cash

Flows : Dell Computer
Corporation

The Form of the

Cash Flow Statement
Change in Cash = Cash from Operations
+ Cash from Investing
+ Cash from Financing

The Statement of Stockholders Equity:

Dell Computer Corporation
Common stock
And Capital in
Excess of Par Value

Balances at
February 2, 2001
Net income
Change in unrealized gain on
investments, net of taxes
Foreign currency translation
adjustments
Net unrealized gain on
derivative instruments, net of
taxes
Total comprehensive income
for fiscal 2002
Stock issuances under
employee plans, including tax
benefits
Purchases and
retirements
Others
Balances at
February 1,2002

Treasury Stock
Other
Comprehensive
Income

Other

Shares

Amount

Shares

Amount

Retained
Earnings

2,601
-

4,795
-

839
1,246

62
-

(74)
-

(65)

(65)

39

__39

1,222

69

843

10

(16)
____
2,654

(30)
(3)
____
$5,605

52
__
52

(2,249)
_______
$(2,249)

(721)
______
$1,364

___
$38

___
$(64)

Total
5,622
1,246

853
(3,000)
(3)
_____
$4,694

The Stocks and Flow Equation

Ending equity = Beginning equity +
Total (comprehensive) income
Net payout to shareholders

Comprehensive income = Net income +

Other comprehensive income
Net payout to shareholders = Dividends +
Share repurchases Share issues

The Articulation of the Financial Statements

Beginning stocks

Flows

Ending stocks

Cash Flow Statement

Cash from operations

Beginning Balance Sheet

Cash from investing

Ending Balance Sheet

Cash from financing

Cash

Net change in cash

Cash
+ Other Assets

Other Assets +
Statement of Shareholders Equity
Total Assets
- Liabilities

Total Assets
Investment and disinvestment by owners

- Liabilities

Net income and other earnings

Owners equity

Net change in owners equity

Income Statement
Revenues
Expenses
Net income

Owners equity

Form is Given by Accounting Relations

Accounting for a Savings Account

Amount invested: $100
Earnings rate:
5%

Intrinsic Value and Book Value

Intrinsic Premium:
Intrinsic Value of Equity Book Value of Equity

Market Premium:
Market Value of Equity Book Value of Equity

Intrinsic Price-to-Book Ratio:

Intrinsic Value of Equity
Book Value of Equity

Price-to-Book Ratio:

Market Value of Equity

Book Value of Equity

Measurement in the Balance Sheet

Historical Cost Accounting
Fair Value Accounting

Measuring Value Added

Value added = Ending Value Beginning Value + Dividend

Stock Return =

Pt Pt 1 d t

Accounting value added = Ending book value Beginning book

value + Net dividend = Comprehensive earnings

Principles of Earnings Measurement

Recognize only value added from sales to customers
Revenue recognition principles
Add value when it has been earned (usually
when a sale is made)
Matching principle
Match expenses against revenue for which they
are incurred

Accounting value added (earnings) = Revenue Expenses

Guiding Principles for Recognizing

Accounting Value Added
The fundamentalist creed: Dont mix what you
know with speculation
The accountants restatement of the creed (the
reliability criterion):
Accounting numbers should be based on objective
evidence, free of opinion and bias.

How Financial Statements are Used

in Valuation

Simple (and Cheap) Approaches to Valuation

Fundamental analysis is detailed and costly.
Simple approaches avoid forecasting and minimize
information analysis. But they lose precision.
Simple methods:
Method of Comparables
Screening on Multiples
Asset - Based Valuation

The Method of Comparables

1. Identify comparable firms that have similar operations to the firm
whose value is in question.
2. Identify measures for the comparable firms in their financial
statements earnings, book value, sales, cash flow and calculate
multiples of those measures at which the firms trade.
3. Apply these multiples to the corresponding measures for the
target to get that firms value.

The Method of Comparables:

An Example for Biotechnology Firms

The Method of Comparables:

Dell, Gateway 2000 and Compaq, 1998

How cheap is this Method?

Conceptual problems:
Circular reasoning: How do you value the comparable companies?
If the market is efficient for the comparable companies....Why is it not for
the target company ?
Implementation problems:
Finding the comparables that match precisely
Different accounting methods for comps and target
Different prices from different multiples
What about negative denominators?
Applications:
IPOs; firms that are not traded

Unlevered Multiples (that are Unaffected

by the Financing of Operations)
Some multiples are affected by leveragethe amount of debt
financing a firm has relative to equity financing. So, to control for
differences in leverage between the target firm and comparison firms,
these multiples are unlevered.

Variations of the P/E Ratio

Dividend Adjusted P/E

Screening Analysis
Technical screens: identify positions based on trading indicators.
Some of them:
-

Price screens
Small stock screens
Neglected stocks screens
Seasonal screens
Momentum screens
Insider trading screens

Fundamental screens: identify positions based on fundamental

indicators of the firms operations relative to price
-

Price/Earnings (P/E) ratios

Market/Book Value (P/B) ratios
Price/Cash Flow (P/C) ratios
Price/Dividend (P/d) ratios

Any combination of these methods is possible

Screening Analysis
Price screens: Buy stocks whose prices have dropped a lot
relative to the market and sell stocks whose prices have
increased a lot

How Multiple Screening Works

1.
2.
3.

Identify a multiple on which to screen stocks.

Ranks stocks on that multiple, from highest to lowest.
Buy stocks with the lowest multiples and (short) sell stocks
with the highest multiples.

Fundamental Screening:
Return to Price-to-Book

Average Monthly Returns and Estimated Betas from July 1963 to December 1990 for Ten Price/Book Groups.

Problems with Screening

You could be loading up on a risk factor
You need a risk model
You are in danger of trading with someone who knows more than
you
You need a model that anticipates future payoffs
A full-blown fundamental analysis supplies this

Asset Base Valuation

Values the firms assets and then subtracts the value of debt:

The balance sheet does this calculation, but imperfectly:

Shareholders Equity = Total Assets -Total Liabilities
Problems with this approach:
Getting the value of operating assets when there is not a market for them
Identifying value in use for a particular firm
Getting the value of intangible assets (brand names, R&D)
Getting the value of synergies of assets being used together
Applications:
Asset-base firms such as oil and gas and mineral products

Strategy

2
Analyzing Information
In Financial Statements
Outside of Financial Statements

Forecasting Payoffs
Measuring Value Added
Forecasting Value Added

Convert Forecasts to a
Valuation

Trading on the Valuation

Outside Investor
Compare Value with Price to
BUY, SELL or HOLD
Inside Investor
Compare Value with Cost to
ACCEPT or REJECT Strategy
Figure 1.2 The Process of Fundamental Analysis

The Process of Fundamental

Analysis

1
Knowing the Business
The Products
The Knowledge Base
The Competition
The Regulatory Constraints

How Financial Statements are Used in Fundamental

Analysis
The analyst forecasts future financial statements and converts
forecasts in the future financial statements to a valuation. Current
financial statements are used to extract information for forecasting.

Current Financial Statements

Financial Statements

Year 1
Financial Statements

Year 2
Financial Statements

Forecasts

Year 3

Other Information

Valuation of
Equity

Convert forecasts to a valuation

The Architecture of Fundamental Analysis: The

Valuation Model
Role of a valuation model:
1. Directs what is to be forecasted (Step 3)
2. Directs how to convert a forecast to a valuation (Step 4)
3. Points to information for forecasting (Step 2)

Pay offs to Investing: Terminal Investments

and Going - Concern Investments
The first investment is for a terminal investment; the second is for a going-concern
investment in a stock. The investments are made at time zero and held for T periods
when they terminate or are liquidated.
For a terminal investment

I0

Initial investment

Investment horizon: T

Io

T-1

0
CF1

CF2

CF3

CFT-1
Cash flows

CFT
Terminal cash flow

Pay offs to Investing: Terminal Investments

and Going - Concern Investments
For a going concern investment in equity

P0

Initial price

T-1

d1

d2

d3

dT-1

Investment
horizon When
stock is sold

Dividends

For terminal investment,

I 0 = amount invested at time zero
CF = cash flows received from the investment
For investment in equity,
P0 = price paid for the share at time zero
d = dividend received while holding the stock
PT = price received from selling the share at time T.

PT +dT
Selling price at T + Dividend (if
sold at T)

Two Terminal Investments:

A Bond and a Project
A Bond:
Periodic cash coupon
Cash at redemption
Purchase price
Time, t

100

100

100

100

100
1000

430

460

460

380

250
120

(1080)
0

A Project:
Periodic flow
Salvage value
Initial investment
Time, t

(1200)
0

The Valuation Model: Bonds

D is the required return on the debt

Valuation issue: Discount rate D

The Valuation Model: A Project

p is the required return (hurdle rate) for the project)

Valuation issues: Forecasting cash flows Discount rate

Value Creation: V0 > I0

The Bond (no value created):
V0

1,079.85

I0

1,079.85

NPV

0.00

The Project (value created):

V0

1,529.50

I0

1,200.00

NPV

329.50

Valuation Models: Going Concerns

A Firm
0

CF 1

CF 2

CF 3

CF 4

5
CF 5

Equity
0

Dividend
Flow

d1

d2

d3

d4

d5

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

T
dT
TVT

Criteria for Practical Valuation

To be practical, we require:
1. Finite horizon forecasting
Forecasting over infinite horizons is impractical
2. Validation
Whatever we forecast must be observable ex post
3. Parsimony
Information gathering & analysis should
be straightforward
The fewer pieces of information, the better

The Question for Forecasting:

What Creates Value in a Firm
Equity Financing Activities ?
Share Issues ?
Share Repurchases ?
Dividends ?
Debt Financing Activities ?
Investing and Operating Activities?
Distinguish anticipated (exante) value in investing activities
from realized (expost) value in operations
Value is created in product and factor markets

The Dividend Discount Model: Targeting Dividends

DDM:

V0E

d1
d2
d
2
33
E
E
E

Problems: How far does one project?

Does V0E d1 d22 d33
E

dT
T
E

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 yet ... does this create value?
(iii) Liquidating firms?
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.

Terminal Values for the DDM

A. Capitalize expected terminal dividends

T VT P T

d T 1

E 1

B. Capitalize expected terminal dividends with growth

d T 1
TVT P T
E g
Will it work?

Dividend Discount Analysis:

Advantages and Disadvantages

Some Terminologies
Accrual is a noncash value flow recorded in the financial statements.
Annuity the annual amount in a constant stream of payoffs.
Continuing value is the value calculated at a forecast horizon that captures value added after the
horizon.
Terminal value is what an investment is expected to be worth in the future when it terminates or
when it may be liquidated.
Dividend conundrum refers to the following puzzle: The value of a share is based on expected
dividends but forecasting dividends (over finite horizons) does not yield the value of the share.
Historical cost accounting measures investments at their cash cost and adjusts the cost with
accruals.
Matching principle is the accounting principle that recognizes expenses when the revenue for
which they are incurred is recognized.

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)
Free cash flow

C1

C2

C3

C4

C5

I1

I2

I3

I4

I5

C1-I1

C2-I2

C3-I3

C4-I4

C5-I5

Time, t

The Discounted Cash Flow Model (DCFM)

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

C1

C2

C3

C4

C5 --->

I1

I2

I3

I4

I5

C1 I1

C2 I2

C3 I3

C4 I4

C5 I5 --->

________________________________________________
Time, t

V0E V0F V0D

V0E

C1 I1 C 2 I 2 C 3 I 3
C T I T C VT

T V0D
2
3
T
F
F
F
F
F
F
VO

--->

--->

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?

DCF Valuation: New York State Electric and Gas

Simple Valuations as per DCF

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

Book Value of debt

1,875 million

E
V1996

1,703 million

Value per share on 69.67 million shares

24.44

Price per share, 1996

21 5 8

Another simple valuation

F
V1996

322
1.09 g

where g is a growth rate

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

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

10

16

27

32

26

25

24

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

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.

Statement of Cash Flows: Dell Computer

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

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

Calculating Free Cash Flow:

Dell Computer, 2002
Reported cash flow from operations3,797
Interest payments
Interest income*
(314)
Net interest payments
(283)
Taxes (35%)
99
Net interest payments after tax (65%)
Cash flow from operations3,613

31

(184)

Reported cash used in investing activities2,260

Purchases of interesting-bearing securities 5,382
Sales of interest-bearing securities
(3,425)
Cash investment in operations
303
Free cash flow 3,310

1,957

*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.

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.Forecast after-tax net interest payments
v. Calculate unlevered cash flow from operations by
adding after-tax
net interest (Step (iii) + Step (iv))
vi.Forecast cash investments in operations, excluding net investment in
interest-bearing securities
vii.Calculate forecasted free cash flow, C - I (Step (v) - Step (vi))

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

34
(158)
(124)
43

2000
1,666
2,260

2001
2,177
2,018

2002
1,246
2,551

3,926

4,195

3,797

(81)
3,845
(401)
3,444

49
(305)
(256)
90

(166)
4,029
(482)
3,547

31
(314)
(283)
99

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

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

The Income Statement: Dell

Computer

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

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

Earnings and Cash Flows

Earnings = Free cash flow Net cash interest + Investments + Accruals
Earnings = [C - I] - i + I + Accruals
= (C - i )+ Accruals
= Levered cash flow from operations + Accruals
The earnings calculation adds back investments and puts them back in the
balance sheet. It also adds accruals.

Earnings and Cash Flows:

Wal-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 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

The Balance Sheet: Dell

Computer

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