CHAPTER FOUR

McGraw-Hill/Irwin
Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Cash Accounting,
Accrual Accounting,
and Discounted Cash Flow
Valuation
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

4-3
Valuation Models: Going Concerns
CF
1
CF
2
CF
3
CF
4
CF
5
A Firm
1 2 3 4 5
0
d
1
d
2
d
3
d
4
d
5
Dividend
Flow
1 2 3 4 5
0
TV
T

T
d
T

Equity
The terminal value, TV
T
is the price payoff, P
T
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

4-4
The Dividend Discount Model: Targeting
Dividends
DDM:

Problems: How far does one project?

Does


provide a good estimate of V
E
0
?

(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.
3 1 2
0
2 3
E
E E E
d d d
V


3 1 2
0
2 3
E
T
T
E E E E
d d d d
V


4-5
Terminal Values for the DDM
A. Capitalize expected terminal dividends



B. Capitalize expected terminal dividends
with growth



Will it work?
T 1
T T
E
d
TV P
1

T 1
T T
E
d
TV P
g

4-6
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. The periodic payoff in the 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 =
1
1
0

E
E
d
V

g
d
V
E
E

1
0
4-7
Dividend Discount Analysis:
Advantages and Disadvantages
Advantages
Easy concept: dividends are
what shareholders get, so
forecast them
Predictability: dividends are
usually fairly stable in the short
run so dividends are easy to
forecast (in the short run)


Disadvantages
Relevance: dividends payout is
not related to value, at least in
the short run; dividend
forecasts ignore the capital
gain component of payoffs.
Forecast horizons: typically
requires forecasts for long
periods; terminal values for
shorter periods are hard to
calculate with any reliability
When I t Works Best
When payout is permanently tied to the value generation in the firm.
For example, when a firm has a fixed payout ratio
(dividends/earnings).

4-8
Cash Flows for a Going Concern
Cash flow from operations (inflows)


Cash investment (outflows)


Free cash flow


Time, t

C
1
C
2
C
3
C
4

I
1
I
2
I
3
I
4

C
1
-I
1
C
2
-I
2
C
3
-I
3
C
4
-I
4

C
5

I
5

C
5
-I
5

1 2 4 3 5
Free cash flow is cash flow from operations that results from investments minus cash
used to make investments.
4-9
The Discounted Cash Flow (DCF) Model
Cash flow from
operations (inflows) C
1
C
2
C
3
C
4
C
5
--->

Cash investment I
1
I
2
I
3
I
4
I
5
--->
(outflows)
Free cash flow C
1
I
1
C
2
I
2
C
3
I
3
C
4
I
4
C
5
I
5
--->
________________________________________________ --->
Time, t 1 2 3 4 5





D
0
T
F
T
T
F
T T
3
F
3 3
2
F
2 2
F
1 1 E
0
V
V C I C I C I C I C
V

F
O
V
D
0
F
0
E
0
V V V
4-10
The Continuing Value for the DCF Model
A. Capitalize terminal free cash flow




B. Capitalize terminal free cash flow with growth




Will it work?

1
I C
CV
F
1 T 1 T
T

g
I C
CV
F
1 T 1 T
T

4-11
DCF Valuation: The Coca-Cola Company
In millions of dollars except share and 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 flows 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

Value per share $40.67

*CV = 5,311 x 1.05 = 139,414
1.09 - 1.05

Present value of CV = 139,414 = 90,611
1.5386


4-12
Steps for a DCF Valuation
Here are the steps to follow for a DCF valuation:

1. Forecast free cash flow to a horizon
2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with an estimated
growth rate
4. Discount the continuing value to the present
5. Add 2 and 4
6. Subtract net debt
4-13
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 36,484
Cash investments 37,699 40,308 61,227 21,843 38,414
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
4-14
DCF Valuation and Speculation
Formal valuation aims to reduce our uncertainty about value and
to discipline speculation

The most uncertain (speculative) part of a valuation is the
continuing value. So valuation techniques are preferred if they
result in a smaller amount of the value attributable to the
continuing value

DCF techniques can result in more than 100% of the valuation in
the continuing value: See General Electric.


4-15
Reverse Engineering: What Forecasts are Implied by the
Current Market Price?
million $140,904
shares million 2,472 x 57 P Coke, For
$
o

$4,435 - 1.5386
g - 1.09
g x 311 , 5
5386 . 1
311 , 5
4116 . 1
551 , 4
2950 . 1
569 , 3
1881 . 1
910 , 2
1.09
2,710
million 140,904 $





Reverse engineer as follows:








Can Coke maintain this growth rate?

rate) growth % 6.2 a ( 062 . 1 g
4-16
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







Debt Net
g
I C
V
E
E
O

1 1
315 , 63 $
05 . 1 09 . 1
710 , 2

$4,435
4-17
Reverse Engineering a Simple Valuation: Coca-Cola
435 , 4 $ $
0

g - 1.09
2,710
140,904 P

Applying the simple model to reverse engineer Cokes stock price,

%) 7.13 is rate (growth g 0713 . 1
4-18
The DCF Model:
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 6 8 10 16 27 32 26 25 24

4-19
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

4-20
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 I t Works Best
When the investment pattern is such as to produce constant free cash
flow or free cash flow growing at a constant rate.
4-21
Partial Statement
of Cash Flows:
Dell Inc., 2008
4-22
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

4-23
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


4-24
Calculating Free Cash Flow from the Cash Flow
Statement: Dell Inc., 2008
Reported cash flow from operations 3,949
Interest payments 54
Interest income* (387)
Net interest payments (333)
Taxes (35%) 117
Net interest payments after tax (65%) (216)
Cash flow from operations 3,733

Reported cash used in investing activities 1,763
Purchases of interesting-bearing securities 2,394
Sales of interest-bearing securities (3,679) 1,285
Cash investment in operations 3,048
Free cash flow 685

*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.


4-25
From Earnings to 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))
4-26
Converting Earnings to Free Cash Flow:
Dell Inc., 2008
4-27
A Common Approximation
4-28
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
4-29
The Income Statement:
Dell Inc.
4-30
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

4-31
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

4-32
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.

4-33
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
4-34
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
4-35
The Balance Sheet:
Dell Inc.
4-36
The articulation of the financial statements
through the recording of cash flows and accruals

Investment and disinvestment by owners
Earnings
Net change in owners equity
S St ta at te em me en nt t o of f S Sh ha ar re eh ho ol ld de er rs s E Eq qu ui it ty y
y ye ea ar r 1 1
Cash from operations
+ Accruals
Net income
I In nc co om me e S St ta at te em me en nt t y ye ea ar r 1 1
Cash from operations
Cash from investing
Debt financing
Net change in cash
C Ca as sh h F Fl lo ow w S St ta at te em me en nt t y ye ea ar r 1 1
Cash0

+ Other Assets0

Total Assets0

- Liabilities0

Owners equity0

Cash1

+ Other Assets1

Total Assets1

- Liabilities1

Owners equity1

E En nd di in ng g B Ba al la an nc ce e S Sh he ee et t
y ye ea ar r 1 1
Beginning stocks Flows Ending stocks
E En nd di in ng g B Ba al la an nc ce e S Sh he ee et t
y ye ea ar r 0 0
Equity financing
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

4-37