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Cash Flow Estimation

Three key valuation components

The three key components of valuation are
Cash flow
You cant eat earnings

Long term
Not a one year measure, but the PV of entire future stream of CFs

via the expected value cash flows and via the opportunity cost of

Valuation by components

Shareholder Value
Corporate Value

Present value
of Free Cash

Market value of debt

and other

Shareholder value based on value drivers: links SHV to operating,

investment and financing decisions

Free Cash Flow



Sales growth
Profit Margin
Tax rate

Fixed capital
Working cap

Cost of






Equity Valuation
The value of equity is obtained by discounting
expected cashflows to equity, i.e., the residual
cashflows after meeting all expenses, tax
obligations and interest and principal payments, at
the cost of equity, i.e., the rate of return required
by equity investors in the firm.
The dividend discount model is a specialized case
of equity valuation, and the value of a stock is the
present value of expected future dividends.

Measuring Potential Dividends

Some analysts assume that the earnings of a firm represent
its potential dividends. This cannot be true for several
Earnings are not cash flows, since there are both noncash revenues and expenses in the earnings calculation
Even if earnings were cash flows, a firm that paid its
earnings out as dividends would not be investing in new
assets and thus could not grow
Valuation models, where earnings are discounted back
to the present, will over estimate the value of the equity
in the firm
The potential dividends of a firm are the cash flows left
over after the firm has made any investments it needs to
make to create future growth and net debt repayments
(debt repayments - new debt issues)

Free Cash Flow to Equity (FCFE) = Net Income - (Capital
Expenditures - Depreciation) - (Change in Non-cash
Working Capital) + (New Debt Issued - Debt Repayments)
This is the cash flow available to be paid out as dividends
or stock buybacks.

If we assume that the net capital expenditures and working capital changes
are financed using a fixed mix of debt and equity. If d is the proportion
that is raised from debt financing,
Free Cash Flow to Equity
= Net Income
- (Capital Expenditures - Depreciation)(1 - d)
- (Change in Working Capital)(1-d)

If there is preference dividend
Free Cash Flow to Equity (FCFE) =
Net Income - (Capital Expenditures -Depreciation) - (Change
in Non-cash Working Capital) + (New Debt Issued - Debt
Repayments) Preferred Dividends + New Preferred Stock

Leverage, FCFE and Value

In a discounted cash flow model, increasing the debt/equity ratio will
generally increase the expected free cash flows to equity investors
over future time periods and also the cost of equity applied in
discounting these cash flows.
Which of the following statements relating leverage to value would
you subscribe to?
Increasing leverage will increase value because the cash flow
effects will dominate the discount rate effects
Increasing leverage will decrease value because the risk effect
will be greater than the cash flow effects
Increasing leverage will not affect value because the risk effect
will exactly offset the cash flow effect

Leverage, FCFE and Value

Any of the above, depending upon what company you are
looking at and where it is in terms of current leverage

A free cash flow to equity model is a model where we
discount potential rather than actual dividends
Assumptions when we replace dividends with FCFE
There will be no future cash build-up in the firm, since
the cash that is available after debt payments and
reinvestment needs is paid out to stockholders each
The expected growth in FCFE will include growth in
income from operating assets and not growth in income
from increases in marketable securities.

Expected Growth rate = Retention Ratio * Return on Equity
The use of the retention ratio in this equation implies that
whatever is not paid out as dividends is reinvested back into the
This is not consistent with the assumption that free cash
flows to equity are paid out to stockholders which underlies
FCFE models
Consistent to replace the retention ratio with the equity
reinvestment rate, which measures the percent of net
income that is invested back into the firm

Equity Reinvestment Rate

= 1 [ FCFE / Net Income]


Non-cash ROE
(Net Income - After tax income from cash and marketable securities) / (Book
Value of Equity - Cash and Marketable Securities)
Expected Growth in FCFE = Equity Reinvestment Rate * Non-cash ROE

FCFE Constant Growth Model

Designed to value companies that are growing at a stable rate
and hence in a steady state
Ve = FCFE1 / (ke gn)
very similar to the Gordon growth model in its underlying
assumptions and works under some of the same constraints
a 'stable' growth rate cannot exceed the growth rate of the
economy in which the firm operates by more than one or
two percent
Capital expenditures, relative to depreciation, are not
disproportionately large and the firm is of 'average' risk

FCFE Constant Growth Model

best suited for firms growing at a rate comparable to or lower
than the nominal growth in the economy
better model to use for stable firms that pay out dividends that
are unsustainably high (because they exceed FCFE by a
significant amount) or are significantly lower than the FCFE
if the firm is stable and pays outs its FCFE as dividend, the value
obtained from this model will be the same as the one obtained
from the Gordon growth model

Two Stage FCFE Model

designed to value a firm which is expected to grow much
faster than a stable firm in the initial period and at a stable
rate after that

Two Stage FCFE Model

FCFEt = Free Cashflow to Equity in year t
Pn = Value at the end of the extraordinary growth period
ke = Cost of equity in high growth (hg) and stable growth (st)
The terminal price is generally calculated using the infinite
growth rate model,
Pn = FCFEn+1 / (ke gn)

Two Stage FCFE Model

the assumptions made to derive the free cashflow to
equity after the terminal year have to be consistent with
the assumption of stability. For instance, while capital
spending may be much greater than depreciation in the
initial high growth phase, the difference should narrow
as the firm enters its stable growth phase
The beta and debt ratio may also need to be adjusted in
stable growth to reflect the fact that stable growth firms
tend to have average risk (betas closer to one)

Two Stage FCFE Model

FCFE 3 Stage Model

designed to value firms that are expected to go
through three stages of growth - an initial phase
of high growth rates, a transitional period where
the growth rate declines and a steady state period
where growth is stable

FCFE 3 Stage Model

FCFE 3 Stage Model

Pn2 = Terminal price at the end of transitional
= FCFE n2+1 / (r gn)

FCFE 3 Stage Model

Since the model assumes that the growth rate goes
through three distinct phases -high growth, transitional
growth and stable growth - it is important that
assumptions about other variables are consistent with
these assumptions about growth
As the growth characteristics of a firm change, so do its
risk characteristics. In the context of the CAPM, as the
growth rate declines, the beta of the firm can be
expected to change


Firm Valuation
The value of the firm is obtained by discounting expected
cashflows to the firm, i.e., the residual cashflows after
meeting all operating expenses and taxes, but prior to debt
payments, at the weighted average cost of capital, which is
the cost of the different components of financing used by
the firm, weighted by their market value proportions.

FCFF = Free Cashflow to Equity + Interest Expense (1 - tax rate) +
Principal Repayments - New Debt Issues + Preferred Dividends
FCFF = EBIT (1 - tax rate) + Depreciation - Capital Expenditure -
Working Capital
FCFF = PAT + Int (1 - tax rate) + Depreciation - Capital Expenditure Working Capital

FCFF General Model

FCFF Stable Growth Model

FCFF Stable Growth Model

the growth rate used in the model has to be less than or
equal to the growth rate in the economy
the characteristics of the firm have to be consistent with
assumptions of stable growth. In particular, the
reinvestment rate used to estimate free cash flows to the
firm should be consistent with the stable growth rate
Reinvestment rate in stable growth
= Growth rate / Return on capital
The cost of capital should also be reflective of a stable
growth firm. In particular, the beta should be close to one
- between 0.8 and 1.2

FCFF Steady State after some years

FCFF Suitable for

Firms that have very high leverage or are in the
process of changing their leverage
The calculation of FCFE is much more difficult in these cases
because of the volatility induced by debt payments (or new issues)
and the value of equity, which is a small slice of the total value of
the firm, is more sensitive to assumptions about growth and risk.
cashflows relating to debt do not have to be considered explicitly,
since the FCFF is a pre-debt cashflow, while they have to be taken
into account in estimating FCFE
where the leverage is expected to change significantly over time,
this is a significant saving, since estimating new debt issues and
debt repayments when leverage is changing can become
increasingly messy the further one goes into the future

FCFF Problems
free cash flows to equity are a much more intuitive
measure of cash flows than cash flows to the firm.
most of us look at cash flows after debt payments (free
cash flows to equity), because we tend to think like
business owners and consider interest payments and the
repayment of debt as cash outflows.
free cash flow to equity is a real cash flow that can be
traced and analyzed in a firm.
free cash flow to the firm is the answer to a hypothetical
question: What would this firms cash flow be, if it had no
debt (and associated payments)?

FCFF Problems
focus on pre-debt cash flows blinds the real problems with
a firm has free cash flows to the firm of $100 million
but because of its large debt load makes the free cash
flows to equity equal to -$50 million. This firm will
have to raise $50 million in new equity to survive and,
if it cannot, all cash flows beyond this point are put in
Using free cash flows to equity would have reflected
this problem, but free cash flows to the firm are
unlikely to reflect this.

FCFF Problems
the use of a debt ratio in the cost of capital to incorporate
the effect of leverage requires making implicit assumptions
that might not be feasible or reasonable
assuming that the market value debt ratio is 30% will
require a growing firm to issue large amounts of debt in
future years to reach that ratio. In the process, the book
debt ratio might reach stratospheric proportions and
trigger covenants or other negative consequences

Equity and Firm Valuation

Value of equity = Value of Firm in FCFF Model Debt
Will be same as given by FCFE Model if we make
consistent assumption about firms leverage

Estimating Value
Long forecast period has own problems
Error of false precision
A detailed forecast for 5 years where complete
balance sheets and income statements are
developed with as much linkage to real
variables as possible
A simplified forecast for remaining years,
focussing on a few important variables, such as
revenue growth, margins and capital turnover.

Estimating Value
Usually a number of years are forecast explicitly
Called the forecast period
The company generally has some value remaining after the
forecast period: that value is often referred to as
Continuing value (McKinsey)
Residual value (Alcar)
Terminal value (usually implies liquidating)
Exit value (usually used in LBO deals, or interim financing deals.

Build the revenue forecast. This should be based on volume
growth and price changes.
Forecast operational items such as operating costs, working
capital, PP&E by linking them to revenues or volumes.
Project non-operating items
Project the equity accounts. Equity should be equal to last
years equity plus net income and new share issues less
dividends and share repurchases.

Use the cash and/or debt accounts to balance the
cash flows and balance sheet
Calculate the ROIC tree and key ratios to pull
elements together and check for consistency

Consistency and Alignment

Is the companys performance on the value drivers
consistent the companys economics and industry
competitive dynamics?
Is the revenue growth consistent with the industry growth?
If the companys revenue is growing faster than the
industrys, which competitors are losing share. Will they
retaliate? Does the company have the resources to mange
the rate of growth?

Consistency and Alignment

Is the return on invested capital consistent with the
industrys competitive structure? If the entry barriers are
coming down, shouldnt expected returns decline? If the
customers are becoming more powerful, will margins decline?
Conversely, if the companys position in the industry is
becoming much stronger,should you expect returns to
increase? How will the returns look relative to competition?

Consistency and Alignment

How will technology affect the returns? Will they
affect risk?
Can the company manage all the investments it is

How the Financial Statements Are Projected

Income statement

Forecast method

Net sales
Cost of goods sold (COGS)
Selling, general & administrative (SGA)
Operating profit

Percent of sales
Percent of sales
Percent of net PPE
Calculated: Sales-COGS-SGADepreciation.
Interest rate on short-term
investments multiplied by the
amount of short-term investments at
the beginning of the year.
Interest rate on short-term and longterm debt multiplied by the amount
of the debt at the beginning of the
Calculated: Operating profit +
Interest income-Interest expense.
Calculated: Tax rate (EBT)
Calculated: EBT- Taxes.
Constant growth relative to previous
Calculated: Net income Dividends.

Interest income

Interest expense

Earnings before taxes (EBT)

Net income
Additions to retained earnings


How the Financial Statements Are Projected (continued)

Balance sheet

Forecast method

Short-term investments

Account receivable (AR)
Total current assets
Total assets

Percent of sales
Plug: zero if operating assets are
greater than sources of funding;
otherwise, it is the amount required
to make the sheets balance (i.e., the
excess of funding over operating
Percent of sales
Percent of sales
Calculated: Cash + Short-term
investments + Inventory + AR.
Percent of sales
Calculated: Total current assets +
Net PPE.

Liabilities & Owners Equity

Account payable (AP)
Accrued expenses
Short-term debt

Total current liabilities

Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and equity


Percent of sales
Percent of sales
Plug: zero if sources of funding are
greater than operating assets;
otherwise, it is the amount required
to make the sheets balance (i.e., the
excess of operating assets over other
Calculated: AP + Accrued expenses
+ Short-term debt.
Percent of operating assets
Calculated: Total current liabilities +
Long term debt.
Constant (same as previous year)
Calculated: Prior years retained
earnings + (Net income - Projected
Calculated: Common stock +
Retained earnings.
Calculated: Total liabilities +
Common equity.

Estimating Value
Value = PV of CF during explicit period + PV of CF
after explicit forecast period

The Analysis of Profitability

ROCE=Earning / CSE
Interest expense and MI

Level 1





Level 2

Level 3

PM = OI / sales

Sales PM

Gross margin Expense Ratios


ATO = sales / NOA

Dell, Oracle,

Other items PM

Other OI / sales Individual asset and

liability turnovers

Borrowing cost

Financial statement line items:

Earnings = Comprehensive income, CSE = Common shareholders equity, OI = Operating Income ( after tax), NOA = Net operating Assets, NFE = Net financial
expenses, NFO = Net Financial obligations.

ROCE = Return on equity, RNOA = Return on net operating Assets, ROOA = Return on operating Assets, NBC= Net borrowing cost, OLLEV= Operating liability
leverage, OLSPREAD= Operating Liability leverage spread, FLEV= Financial leverage, SPREAD= Operating spread, PM= Operating profit margin, ATO= Asset

Performance Indicators
Leverage : pipelines, utilities, hotels
Low leverage : business services, printing and publishing and chemicals
Low leverage but high operating leverage : business services
High financial and operating leverage : airlines, trucking
High margins and high turnovers : printing and publishing and chemicals
Low turnovers and high margins : pipelines, shipping, utilities and communications
High turnovers and low margins : food stores, apparels, retail stores

Key Drivers : Select Industries


Key economic factors

Key ReOI drivers


Model design and production


Sales and margins


Brand management and production



Cellular phones

Population covered and churn rates

Sales and ATO

Commercial real estate

Square footage and occupancy rates

Sales and ATO


Technology path and competition

Sales and margins

Fashion clothing

Brand management and design

Sales and advertising/sales

Internet commerce

Hits per hour

Sales and ATO

Non fashion clothing

Production efficiency



Research and development



Retail space and sales per square foot

Sales and ATO