C10.1. Why might cash flow analysis be important for valuing firms?
The use of discounted-cash-flow (DCF) methods for investment decision making and valuation is well
entrenched in finance theory and practice. This rigorous treatment dates back at least to the Old Babylonian period of 1800-1600 B.C. While originally conceived primarily in response to compound interest problems, the modern literature has broadened application of DCF techniques, most notably to capital budgeting and security valuation problems.
More recent extensions of the DCF concepts to security valuation using so-called "free-cash-flow" techniques and to managerial performance evaluation using an "economic value added" concept have stirred interest in the application of DCF methods to a broader range of practical business problems. Financial performance assessment using the concept of residual income known as economic value added, has received much attention in the recent academic literature. These extensions, however, have also raised a number of concerns related to putting DCF theory into practice.
The users of DCF methods should clearly set forth the relationship of free-cash-flow (FCF) and economic value added (EVA ) concepts to each other and to the more traditional applications of DCF thinking such as net present value (NPV).
Although EVA and NPV are equivalent, current approach is more general in that it links the problems of security valuation, enterprise valuation, and investment project selection. Additionally, this approach relates more directly to use of standar 959i81j d financial accounting information.
Though the FCF approach discounts cash flow, whereas the EVA approach discounts profits, can be demonstrated in the familiar terminology of cash flow analyses that the two approaches are conceptually equivalent.
Some people think that the value of a firm is found in the financial statements. Value will never be found in accounting statements. Value arises from expectations. And where are these expectations? They are in the future cash flows.
To understand these ideas assume that there is a box with a machine inside. Anyone could buy it, if she pays the price listed on the price tag. However, if that machine is accompanied by a strategy, a plan and a team led by an outstanding manager, it has the capacity to create wealth and value, greater that its price. In fact, if somebody asks the owner of that project not to develop it, she will ask for a premium in order not to start the project. When valuing a firm the idea is to measure that value. And this value is based on expectations of what the machine and the team could do in terms of wealth creation.
The problems arise because what is sold is the value that can be created in the future. Just remember the boom of the dot com firms. Not even a dollar was earned and they sold the stocks for skyrocketed prices. What were they buying? Just value expectations.
In a M & M world, the equity value is the present value of the Free Cash Flow FCF at the Weighted Average Cost of Capital WACC minus debt and it should be identical to the present value of the CFE (cash flow to equity) discounted at the cost of equity capital, e.
Several approaches to the firm value calculations are presented.
Discounting the free cash flow FCF, for the firm at the Weighted Average Cost of Capital and subtracting the debt or discounting the cash flow to equity holders CFE, at the cost of equity, measures this future value. In a M & M world, these two values must be equal. However, current practice find that this does not happens. These two values are not
equal.
Some background on WACC
In the literature we find the traditional presentation for WACC for discounting the FCF excluding tax savings from interest payments. It is expressed as
WACC = eE% + d(1-T)D% (1)
Where e is the cost of equity, E% is the proportion of equity in the total value, d is the cost of debt before taxes, D% is the proportion of debt in total value and T is tax rate.
In the traditional presentation, e is calculated as
e = r + (1-T) (r - d)D%/E% (2)
And the discount rate for the tax shield is d. We will call this the MM WACC.
The assumption is that there are no losses and there are no losses carried forward (LCF) and taxes are paid the same year as accrued. Unfortunately, this traditional formulation does not work in the finite period cash flows.
C10.5. Do you consider the direct method to be more informative than the indirect method of presenting cash flow from operations?
The direct method, also referred to as the income statement method, reports major classes of operating cash receipts and payments. Supporters of the direct method contend that it is more revealing of a company's ability to generate sufficient cash from operations to pay debts, reinvest in operations, and make distributions to owners. Detractors point out that many corporate providers of financial statements do not currently collect information that would allow them to determine the information necessary to prepare the direct method. More important, the direct method effectively presents income statement information on a cash rather than an accrual basis and may erroneously suggest that net cash flow from operations is as good as, or better than, net income as a measure of performance.
The indirect, or reconciliation, method focuses on the difference between net income and net cash flow from operations. Advocates of the indirect method note that it provides a useful link among the statement of cash flows, the income statement, and the balance sheet. Critics point out that the direct method requires a supplemental disclosure to present a reconciliation of net income and net cash. The incremental cost of providing the additional information disclosed in the direct method is, however, not significant.
The operating section starts with net income for the current period. Then, all noncash transactions are negated. Finally, the changes in the balance sheet accounts that relate to operations are reconciled. For example, when accounts receivable increases, sales included in net income must be reconciled for the additional uncollected amounts. Ultimately, the operating section reconciles net income with net cash provided by operations. Operating cash receipts and payments and their sources are presented.
Cash Flow Format and Decision Making
Research has shown that a relationship exists between the presentation of financial information and users' decisions.
Cash flow information is integral to investment and credit decisions. While earnings information is extremely important, balance sheet and cash flow items have value to financial analysts as well. A survey of investors revealed that investors' appreciation for the value of the cash flow information has increased significantly and is useful in the assessment of investment decisions.
The debate still continuing over the virtues of the direct versus the indirect format. Advocates for the direct format claim it better fulfills clients' information needs because of the breakdown of major classes of cash inflows and outflows. In addition, the format is simpler to understand and provides performance evaluation via the expected and actual cash flows. Those in favor of the indirect method point out requiring a statement of cash flows is to assist the users in determining the reasons for the difference between net income and associated cash receipts and payments to provide a basis for evaluating the quality of income.
Survey of User Preferences
In the manager category, 82% of CEOs, CFOs, and managers preferred the indirect method, compared with 70.3% of investors and analysts.
Overall, 78.9% of users prefer the indirect method. Although investors reported a preference for the indirect method, they showed a greater preference for the direct method than managers (29.7% versus 18%).
Findings
An analysis of the five possible reasons for the preferred format is summarized as follows:
Familiarity with the format was more important to those preferring the indirect method. This may be because the indirect format more closely resembles the statement of change in financial position previously required. Managers considered familiarity slightly more important than did investors (85.7% versus 80.8%). For those preferring the direct method, however, investors placed more importance on familiarity than did managers (50% versus 39%).
Regarding the ability to see the difference between net income and cash from operations, 82.7% of managers ranked this factor as important, compared with only 72% of investors. Investors preferring the direct method also placed importance on seeing the difference between net income and cash from operations. This information would appear in the supplemental reconciliation of net income and net cash.
The main difference between the indirect and direct methods is that cash paid can be determined using the direct method. It is no surprise that, for those preferring the direct method, this feature was considered very important (95.6% for managers and 100% for investors). For respondents preferring the indirect method, seeing cash paid was not important (30.8%).
Whether the indirect or direct method is preferred, one might expect consistency to be somewhat important. Respondents that preferred the direct method, however, did not put much emphasis on consistency (52.2% and 50%). Perhaps the need to see items such as cash paid is considered more important than the need for consistency.
Regardless of the method preferred, investors seemed to place more importance than did managers on change in accounts receivable and payable (92.3% versus 78.8% for indirect and 60.0% versus 38.1% for direct).
Respondents in different business sectors emphasized different factors. Of the four items that most likely reflect a preference for the indirect method, familiarity is, on average, more important (84%) than consistency (82.2%), seeing change in accounts receivable and payable (80.8%), and understanding the difference between net income and cash from operations (80.6%).
When examining by business types, the following trends were found:
In Manufacturing, which favors the indirect method (85.9%), ranked familiarity most important (86.9%). Understanding the difference between net income and cash from operations (77%) and knowing the change in accounts receivable and payable (78.7%) were somewhat less important.
Merchandising prefers the indirect method, but by a much lesser percentage than do other business types (63.6%), and reported knowing the change in accounts receivable and payable most important (100%) versus understanding the difference between net income and cash from operations (85.7%) and familiarity (85.7%).
Financial companies equally preferred the indirect and direct methods. But for those preferring the indirect method, familiarity is most important (100%), followed by knowing the change in accounts receivable and payable (75%) and understanding the difference between net income and cash from operations (66.7%). For those preferring the direct method, familiarity was least important (25%).
Services preferred the indirect method by 76.7%, but ranked familiarity (69.7%) lower than did all other business types. For those preferring the direct method, only 30% placed importance on consistency.
Utilities, which are required to use the direct method, strongly preferred the indirect method (88.9%). All utility companies that preferred the direct method agreed on the importance of consistency, while only 75% of those preferring the indirect method thought consistency was important. Familiarity is the most important (100%) for those preferring the indirect method, followed by understanding the difference between net income and cash from operations (87.5%) and knowing the change in accounts receivable and payable (71.4%). For those preferring the direct method, other reasons for the preference equally as important as consistency included understanding the difference between net income and cash from operations, and seeing cash paid.
For those preferring the direct method, seeing cash paid is very important. All firms except financial firms (75%) agree unanimously. For utilities preferring the indirect method, 50% want to see cash paid. This is higher than any other sector, with financial companies in second (33.3%).
Analysis
A sufficient number of users prefer the direct method (over 20% overall and almost 30% of investors) to warrant further investigation of, comment on, or changes to the operating cash flow statement. One can argue that "familiarity with format" and "consistency for comparison with prior years" are weak positions to defend. The usability of financial statements should be driven by market needs and evolving financial models. The familiarity issue is one that disappears over time as users become familiar with new presentations, as occurred when the working capital definition of funds was abandoned.
The consistency issue is easily addressed by recasting previous years' cash flow statements using the current method, as is now done on the income and financial position statements with changes in accounting principles. The argument that providers of financial statements do not collect information in a manner that allows them to determine the information necessary to apply the direct method is no longer legitimate. The integrated software in use by many companies allows data to be mined for myriad purposes, including direct cash flows from operations.
C10.8. Is a firm in a strong growth stage more likely to have positive or negative free cash flow?
Free cash flow is the essence and life-blood of any organization, particularly a small growing company. The common definition of free cash flow is the level of remaining cash available to a company after all expenses, including investments have been paid. Financial management texts define free cash flow as operating cash flow minus gross investment in operating assets, or net operating profit after taxes minus net investment in operating assets.
Free cash flow provides the means for financial managers to enhance their company's value, and provide a positive cash flow statement.
Corporations that have too much free cash flow may run the risk of being cash-rich but investment-poor in terms of building the corporate infrastructure; not investing sufficiently in plant, equipment and human resources necessary for developing and sustaining growth.
Conversely, insufficient free cash flow makes it difficult to cover necessary investment in the corporate infrastructure.
However, this balance is the parody of free cash flow; a company with a negative free cash flow position is not always an indication of a poorly run company. A company having a positive cash flow position that makes large investments in its infrastructure could produce a short-term negative free cash flow position.
The important point to remember is that no matter the size of a company, the financial focus must be on establishing a positive free cash flow position. Sound financial management practices which yield strong earnings per share are a good indication of a well managed company. However, it is the level of free cash flow which signifies the financial viability of any sized-company.
As a start-up transitions to the small growth company status, fundamental activities such as understanding market demand, identifying the competition, assessing customer needs and producing products or services that meet customer needs should provide the revenue and the subsequent free cash flow to sustain growth.
C10.9. Why might an analysis not put much weight on a firm's current free cash flow as an indication of future free cash flow?
Free cash flow measures a firm's net increase in
Operating cash flow (this includes the reduction for interest),
less the dividends paid to preferred shareholders, and
less expenditures necessary to maintain assets (often referred to as "capital expenditures" or "Capex").
Increases in non-cash current assets may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.
Uses of the metric
Free cash flow measures the ease with which businesses can grow and pay dividends to shareholders. Even profitable businesses may have negative cash flows. Their requirement for increased financing will result in increased financing costs reducing future income.
According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flows are used to pay dividends to the shareholders. Bear in mind the lumpiness discussed below.
Some investors prefer using free cash flow instead of net income to measure a company's financial performance, because free cash flow is more difficult to manipulate than net income. The problems with this presumption are itemized at cash flow and return of capital.
The payout ratio is a metric used to evaluate the sustainability of distributions. The distributions are divided by the free cash flow. Distributions may include any of income, flowed-through capital gains or return of capital.
Problems with CapEx
The expenditures for maintenance of assets is only part of the capex reported on the Statement of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a requirement under GAAP, and is not audited. Management is free to disclose maintenance capex or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis for some people's dismissal of 'free cash flow'.
A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their nature, expenditures for capital assets that will last decades may be infrequent, but costly when they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will be a 'norm' that can be expected to be repeated. For companies that have stable capital expenditures, free cash flow will (over the long term) be roughly equal to earnings.
C10.10. What factors produce growth in free cash flow?
Forecasting Variables:
The goal is to estimate the growth of FCF for the indefinite future. This is where we get into the voodoo of valuation. The key here is to be conservative. The growth of the factors should be considered over four stages: Years 1-5, Years 6-10, Years 11-20, and thereafter.
In choosing these numbers, the goal is to capture a rate of growth that's in the ballpark of reality, and low enough to capture some years of higher growth and some years of lower growth. Hopefully these estimates reflect Company's ability, as a small company with a lightweight business model, to grow both its market share and its scale as a business. (Sometimes it's useful to look at a range of growth rates, but I won't go to that level of complexity in this example.)
Therefore the forecasting variables are:
Revenues growth factor
Expected gross profit margin
S, G, & A expense % of revenue
Depr. & Amort. % of revenue
Capital expenditure growth factor
Net working capital to sales ratio
Assumed long-term sustainable growth rate
Discount rate
Income tax rate
These forecasting variables can produce both growth and decrease in the free cash flow.
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