The
Little Book of Valuation
Cash Flows
Cash
flows can be estimated to either just equity investors (cash flows to equity)
or to all suppliers of capital (cash flows to the firm). In this section, we
will begin with the strictest measure of cash flow to equity, i.e. the
dividends received by investors, and then progressively move to more expansive
measures of cash flows, which generally require more information.
Dividends
When
an investor buys stock, he generally expects to get two types of cash flows -
dividends during the holding period and an expected price at the end of the
holding period. Since this expected price is itself determined by future
dividends, the value of a stock is the present value of just expected
dividends. If we accept this premise, the only cash flow to equity that we
should be considering in valuation is the dividend paid, and estimating that
dividend for the last period should be a simple exercise. Since many firms do
not pay dividends, this number can be zero, but it should never be negative.
Augmented Dividends
One
of the limitations of focusing on dividends is that many companies, especially
in the United States but increasingly around the world, have shifted from
dividends to stock buybacks as their mechanism for returning cash to
stockholders. While only those stockholders who sell their stock back receive
cash, it still represents cash returned to equity investors. In 2007, for
instance, firms in the United States returned twice as much cash in the form of
stock buybacks than they did in dividends, and focusing only on dividends will
result in the under valuation of equity. One simple way of adjusting for this
is to augment the dividend with stock
buybacks and look at the cumulative cash returned to stockholders.
Augmented Dividends = Dividends +
Stock Buybacks
One problem, though, is that unlike dividends that are
smoothed out over time, stock buybacks can spike in some years and be followed
by years of inaction. We therefore will have to normalize buybacks by using
average buybacks over a period of time (say, 5 years) to arrive at more
reasonable annualized numbers.
Potential Dividends (Free Cash flow to Equity)
With
both dividends and augmented dividends, we are trusting managers at publicly
traded firms to return to pay out to stockholders any excess cash left over
after meeting operating and reinvestment needs. However, we do know that
managers do not always follow this practice, as evidenced by the large cash
balances that you see at most publicly traded firms. To estimate what managers
could have returned to equity investors, we develop a measure of potential
dividends that we term the free cash flow
to equity. Intuitively, the free cash flow to equity measures the cash left
over after taxes, reinvestment needs and debt cash flows have been met. It is
measured as follows:
FCFE = Net Income
– Reinvestment Needs – Debt Cash flows
= Net Income + (Capital
Expenditures - Depreciation + Change in non-cash working Capital –
Principal) - (Repayments + New Debt
Issues)
Consider the equation in pieces. We begin with net income,
since that is the earnings generated for equity investors; it is after interest
expenses and taxes. We compute what the firm has to reinvest in two parts:
- Reinvestment in long-lived assets is measured as the
difference between capital expenditures (the amount invested in long lived
assets during the period) and depreciation (the accounting expense
generated by capital expenditures in prior periods). We net the latter
because it is not a cash expense and hence can be added back to net
income.
- Reinvestment in short-lived assets is measured by the change
in non-cash working capital. In effect, increases in inventory and
accounts receivable represent cash tied up in assets that do not generate
returns – wasting assets. The reason we done consider cash in the
computation is because we assume that companies with large cash balances
generally invest them in low-risk, marketable securities like commercial
paper and treasury bills; these investments earn a low but a fair rate of
return and are therefore not wasting assets.[1]
To the extent that they are offset by the use of supplier credit and
accounts payable, the effect on cash flows can be muted. The overall
change in non-cash working capital therefore is investment in short-term
assets.
Reinvestment reduces cash flow to equity investors, but it
provides a payoff in terms of future growth. We will come back and consider
whether the net effect is positive or negative after we consider how best to
estimate growth. The final input into the process are the negative cash flows
associated with the repayment of old debt and the positive cash flows to equity
investors from raising new debt. If old debt is replaced with new debt of
exactly the same magnitude, this term will be zero, but it will generate
positive (negative) cash flows when debt issues exceed (are less than) debt
repayments.
Focusing on just debt cash flows
allows us to zero in on a way to simplify this computation. In the special case
where the capital expenditures and the working capital are expected to be
financed at a fixed debt ratio d, and
principal repayments are made from new debt issues, the FCFE is measured as
follows:
FCFE = Net Income + (1-d)
(Capital Expenditures - Depreciation) + (1-d)
D Working Capital
In effect, we are assuming that a firm with a 30% debt ratio
that is growing through reinvestment will choose to fund 30% of its
reinvestment needs with new debt and replace old debt that comes due with new
debt.
There is one more way in which we
can present the free cash flow to equity. If we define the portion of the net
income that equity investors reinvest back into the firm as the equity
reinvestment rate, we can state the FCFE as a function of this rate.
Equity Reinvestment Rate
= 
FCFE =
Net Income (1 – Equity Reinvestment Rate)
A final note on the contrast between the first two measures
of cash flows to equity (dividends and augmented dividends) and this measure.
Unlike those measures, which can never be less than zero, the free cash flow to
equity can be negative for a number of reasons. The first is that the net
income could be negative, a not uncommon phenomenon even for mature firms. The
second is that reinvestment needs can overwhelm net income, which is often the
case for growth companies, especially early in the life cycle. The third is that large debt repayments
coming due that have to funded with equity cash flows
can cause negative FCFE; highly levered firms that are trying to bring their
debt ratios down can go through years of negative FCFE. The fourth is that the
quirks of the reinvestment process, where firms invest large amounts in
long-lived and short-lived assets in some years and nothing in others, can
cause the FCFE to be negative in the 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 FCFE is negative, it
is indicative of the firm needing to raise fresh equity.
Cash Flow to the
Firm
The
cash flow to the firm that we would like to estimate should be both after taxes
and after all reinvestment needs have been met. Since a firm raises capital
from debt and equity investors, the cash flow to the firm should be before
interest and principal payments on debt. The cash flow to the firm can be
measured in two ways. One is to add up the cash flows to all of the different
claim holders in the firm. Thus, the cash flows to equity investors (estimated
using one of the three measures described in this section) are added to the
cash flows to debt holders (interest and net debt payments) to arrive at the
cash flow. The other approach is to start with operating earnings and to
estimate the cash flows to the firm prior to debt payments but after
reinvestment needs have been met:
Free Cash flow to firm (FCFF) = After-tax Operating Income -
Reinvestment
= After-tax Operating
Income– (Capital Expenditures –Depreciation + Change in non-cash
Working Capital)
It is easiest to understand FCFF by contrasting it with
FCFE. First, we begin with after-tax operating income instead of net income;
the former is before interest expenses whereas the latter is after interest
expenses. Second, we adjust the operating income for taxes, computed as if you
were taxed on the entire income, whereas net income is already an after-tax
number.[2]
Third, while we subtract out reinvestment, just as we did to arrive at free
cash flows to equity, we do not net out the effect of debt cash flows, since we
are now looking at cash flows to all capital and not just to equity.
Another
way of presenting the same equation is to cumulate the net capital expenditures
and working capital change into one number, and state it as a percentage of the
after-tax operating income. This ratio of reinvestment to after-tax operating
income is called the reinvestment rate, and the free cash flow to the firm can
be written as:
Reinvestment Rate = 
Free Cash Flow to the Firm = EBIT (1-t) (1 –
Reinvestment Rate)
Note that the reinvestment rate can exceed 100%[3],
if the firm has substantial reinvestment needs. The reinvestment rate can also
be less than zero, for firms that are divesting assets and shrinking capital.
A
few final thoughts about free cash flow to the firm are worth noting before we
move on to discount rates. First, the free cash flow to the firm can be
negative, just as the FCFE can, but debt cash flows can no longer be the
culprit; even highly levered firms that are paying down debt will report
positive FCFF while also registering negative FCFE. If the FCFF is negative,
the firm will be raising fresh capital, with the mix of debt and equity being
determined by the mix used to compute the cost of capital. Second, the cash
flow to the firm is the basis for all cash distributions made by the firm to
its investors; dividends, stock buybacks, interest payments and debt repayments
all have to be made out of these cash flows.