Cash Accounting, Accrual Accounting, and Discounted Cash Flow Analysis

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Cash Accounting, Accrual Accounting,
and Discounted Cash Flow Analysis
Chapter 4
2
Cashing Accounting, Accrual Accounting, and
Discounted Cash Flow Analysis
Chapter 3 outlined the process of fundamental
analysis and depicted valuation as a matter of
forecasting future financial statements
Link to pervious chapter
This chapter introduces discounted cash flow
valuation, a method that involves forecasting
future cash flow statements. The chapter also
shows how cash flows differ from accrual earnings
in the income statement, and how ignoring
accruals in discounted cash flow valuation can
cause problems.
This Chapter
What form of accounting best captures value added
in operations cash accounting or accrual
accounting?
What is the difference between cash accounting
and accrual accounting?
What is the discounted cash flow model? Does it
work?
What is the dividend discount model? Does it
work?
Chapter 5 and 6 together lay out valuation
methods that forecast accrual accounting income
statements and balance sheets.
Link to next chapter
This web page provides further explanation and
additional examples of discounted cash flow
analysis, cash accounting, and accrual accounting.
Link to web page
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What you will learn from this Chapter

• How the dividend discount model works (or does
  not work)
• What is meant by cash flow from operations
• What is meant by cash used in investing
  activities
• What is meant by free cash flow
• How discounted cash flow valuation works
• Problems that arise in applying cash flow
  valuation
• Why free cash flow may not measure value added in
  operations
• Why free cash flow is a liquidation concept
• How discounted cash flow valuation involves cash
  accounting for operating activities
• Why cash flow from operations reported in U.S.
  financial statements does not measure operating
  cash flows correctly
• Why cash flows in investing activities reported
  in U.S. financial statements does not measure
  cash investment in operations correctly
• How accrual accounting for operations differs
  from cash accounting for operations
• The difference between earnings and cash flow
  from operations
• The difference between earnings and free cash
  flow
• How accruals and the accounting for investment
  affect the balance sheet as well as the income
  statement
• Why analysts forecast earnings rather than cash
  flows
• How a valuation model is a model of accounting
  for the future
• How reverse engineering works as an analysis tool
  
• What a simple valuation is

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A Reminder Valuation Models for Going Concerns
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
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The Dividend Discount Model Targeting Dividends

• DDM
• Problems How far does one project?
• Does
• 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 this
  does not create value
• (iii) Think of a firm that pays no dividends
• 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.

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Terminal Values for the DDM
A. Capitalize expected terminal
dividends B. Capitalize expected terminal
dividends with growth Will it work?
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Some Math The Value of a Perpetuity and a
Perpetuity with Growth

• The Value of a Perpetuity
• A perpetuity is a constant stream that continues
  without end. A constant stream is sometimes
  referred to as an annuity, so a perpetuity is an
  annuity that continues forever. To value that
  stream, one capitalizes the constant amount
  expected. If the dividend expected next year is
  expected to be a perpetuity, the value of the
  dividend stream is
• Value of a perpetual dividend stream
  
• The Value of a Perpetuity with Growth
• If an amount is forecasted to grow at a constant
  rate, its value can be calculated by capitalizing
  the amount at the required return adjusted for
  the growth rate
• Value of a dividend growing at a constant rate
  

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Dividend Discount Analysis Advantages and
Disadvantages
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Cash Flows for a Firm
Free cash flow is cash flow from operations that
results from investments minus cash used to make
investments.
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The Discounted Cash Flow (DCF) Model
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The Continuing Value for the DCF Model

• A. Capitalize terminal free cash flow
• B. Capitalize terminal free cash flow with growth

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DCF Valuation The Coca-Cola Company

• In millions of dollars except per-share numbers.
  Required return for the firm is 9
• 1999 2000 2001
  2002 2003 2004
• Cash from operations 3,657
  4,097 4,736 5,457
  5,929
• Cash investments
  947 1,187 1,167
  906 618
• Free cash flow
  2,710 2,910 3,569
  4,551 5,311
• Discount rate (1.09)t
  1.09 1.1881 1.2950
  1.4116 1.5386
• Present value of free cash flow
  2,486 2,449 2,756
  3,224 3,452
• Total present value to 2004 14,367
• Continuing Value (CV) 139,414
• Present value of CV 90,611
• Enterprise value 104,978
• Book value of net debt 4,435
• Value of equity 100,543
• Shares outstanding 2,472

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Will DCF Valuation Always Work?

• A Firm with Negative Free Cash Flows General
  Electric Company
• In millions of dollars, except per share amounts.
  
• 2000 2001 2002 2003 2004
• Cash from operations 30,009 39,398 34,848 36,102 3
  6,484
• Cash investments 37,699 40,308 61,227 21,843 38,41
  4
• Free cash flow (7,690) (910)
  (26,379) 14,259 (1,930)
• Earnings 12,735 13,684 14,118 15,002 16,593
• Earnings per share (eps) 1.29 1.38
  1.42 1.50 1.60
• Dividends per share (dps) 0.57 0.66
  0.73 0.77 0.82

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Reverse Engineering What Forecasts are Implied
by the Current Market Price?
Reverse engineer as follows Ca
n Coke maintain this growth rate?
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Simple Valuations

• Simple valuations use very short forecasts
  horizons, and isolate more speculative, long-term
  forecasts. Accordingly, they anchor on what we
  know or are relatively sure about.
• A simple DCF for Coca-Cola, 2000

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Reverse Engineering a Simple Valuation Coca-Cola
Applying the simple model to reverse engineer
Cokes stock price,
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The DCF Model Will it work for Wal-Mart Stores?
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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
• 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

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Discounted Cash Flow Analysis Advantages and
Disadvantages
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Partial Statement of Cash Flows Dell Computer
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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

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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

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Calculating Free Cash Flow Dell Computer, 2002
Reported cash flow from operations 3,797
Interest payments
31 Interest income
(314) Net interest payments
(283) Taxes (35)
99 Net interest payments after tax (65)
(184) Cash flow from
operations 3,613 Reported cash used in
investing activities 2,260 Purchases of
interesting-bearing securities 5,382 Sales
of interest-bearing securities (3,425) 1,957 Cas
h investment in operations 303 Free cash
flow 3,310 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.
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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) Calculate unlevered cash flow from
  operations by adding after-tax net interest
• (v) Forecast cash investments in operations
• (vi) Calculate forecasted free cash flow, C - I
  (Step (iv) -
• Step (v))

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Forecasting Free Cash Flow Dell Computer
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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

Revenue Accruals
Value added that is not cash flow
Adjustments to cash flows that are not value added
Expense Accruals
Value decreases that are not cash flows
Adjustments to cash outflows that are not value
decreases
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The Income Statement Dell Computer
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The Revenue Calculation

• Revenue Cash receipts from sales
• New sales on credit
• ? Cash received for previous
  periods' sales
• ?
  Estimated sales returns and rebates
• ? Deferred revenue for cash received in
• advance of sale
• Revenue previously deferred

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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

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Earnings and Cash Flows

• Earnings C - I - i I accruals
• C - i accruals
• The earnings calculation adds back
  investments and puts
• them back in the balance sheet. It also adds
  accruals.

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Earnings and Cash Flows Wal-Mart Stores
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Accruals, Investments and the Balance Sheet

• Accruals and investments are put in the balance
  sheet

Shareholders equity Cash Other Assets -
Liabilities
Cash from Operations
Accruals
Free cash flow
Cash from Operations
Investments
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The Balance Sheet Dell Computer
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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