Lecture 6. Forecasting Cash Flow Statement

Lecture 6 Forecasting Cash Flow Statement

Takeaways from income statement and balance sheet forecasting Elias Rantapuska / Aalto BIZ Finance 2

Note on our discussion today Discussion today: Rather high-level Focuses on indirect method in cash-flow analysis Skips some accounting subtleties Focus on future prediction rather than historical reporting To get the details of cash flow analysis absolutely right and understand how it should be done according to IAS, consider taking the following courses: Cash-flow analysis (22C00900) Financial Statement Analysis (22E00100) Elias Rantapuska / Aalto BIZ Finance 3

Structure of discussion today Three cardinal rules of cash-flow analysis How to prepare cash-flow statement Some tricks of the trade in actual valuation Elias Rantapuska / Aalto BIZ Finance 4

Three cardinal rules of cash-flow analysis 1 Be specific which cash-flow: FCFF or FCFE 2 Use either direct or indirect method to do cash-flow statement 3 Make your cash-flow analysis as simple as possible, but not simpler Elias Rantapuska / Aalto BIZ Finance 5

1 Be specific which cash flow Free Cash Flow to the Firm (FCFF) Free Cash Flow to Equity (FCFE) = Cash flow available to = Cash flow available to Common stockholders Common stockholders Debtholders Preferred stockholders Use WACC in discounting Use return on equity in discounting Elias Rantapuska / Aalto BIZ Finance 6

2 There are two ways to do a cashflow statement Focus of this lecture Direct method Indirect method Typically more detailed approach Uses actual cash flows Breaks cash-flows into operating (OCF), investing, and financing cash flows In practice very rare Coarse, high-level approach Uses net income as a starting point May be regarded as an approximation of true cash flow Often only method available for an external analyst without access to detailed financial data, especially with the case non private companies or with quarterly data Elias Rantapuska / Aalto BIZ Finance 7

3 Make your cash-flow analysis as simple as possible, but not simpler Your FCF(E) forecast and analysis should be as simple as possible: The big things that will drive the value are revenue, margin, terminal value, and discount rate assumptions Modeling a minuscule minority interest or accrual items in quarterly data is more likely to confuse you than add insight When adding additional level of detail ask yourself: is this big and do I have an insight on the item But not simpler: Remember that insight can often be developed so lack of insight is not an excuse to skip a large item One-off items such as restructuring charges, cross-holdings, large tax assets or liabilities must be understood and modeled. Otherwise your baseline may be off for forecasting Elias Rantapuska / Aalto BIZ Finance 8

Direct method OCF illustration FASB and IAS both allow for interest paid and income taxes to be listed either under operating activities or financing activities: Most companies put them under operating activities From valuation and finance theory perspective makes sense to put these cash flows later in the cash flow statement: you want to know first how much the company makes money and later who gets the money (government, debtholders, equityholders) Source: E&Y Statement of cash flows, 2012 Elias Rantapuska / Aalto BIZ Finance 10

Direct method illustration continued Elias Rantapuska / Aalto BIZ Finance 11

Indirect method Finnair forecasted FCFE 1 2 3 4 5 6 7 1 Start with forecasted net income 2 Depreciation added to net income, along with all other noncash expenses. Other non-cash items ignored for simplicity 8 3 Forecasted net interest paid using average interest rate on short- and long-term borrowings 3 For after-tax interest expense, multiply by (1-Tax rate). Alternatively, we could leave out the tax-adjustment in WACC and use pretax interest rates. Be consistent: either do tax-shield adjustment for FCFF or WACC, not both 4 Depreciation is added back to investment in fixed capital. Investment is depreciation plus change in non-current assets (tangible + intangible) 5 Investment in working capital: change in receivables + change in inventory change in payables 6 Add back interest expense 7 Net borrowing: increase in short- and long-term borrowing from forecasted balance sheet 8 FCFE should equal dividend Elias Rantapuska / Aalto BIZ Finance 12

In a more detailed cash-flow analysis, consider also the following items for your baseline year Amortization Restructuring Expense Restructuring Income Capital Gains Capital Losses Employee Option Exercise Deferred Taxes Tax Asset Added back Added back Subtracted out Subtracted out Added back Added back Added back? Subtracted out? Elias Rantapuska / Aalto BIZ Finance 13

Finally, there is your baby DCF estimate for the stock value Elias Rantapuska / Aalto BIZ Finance 14

Forecasting shorthands for FCFF and FCFE FCFF forecasting shorthand FCFF = EBIT(1-Tax rate) MINUS: Capital expenditure (CAPEX) MINUS: Net working capital (NWC) FCFE forecasting shorthand FCFE = Net income MINUS: (1-debt ratio) x (CAPEX depreciation) MINUS: (1-debt ratio) x ( Net working capital) CAPEX and NWC as % sales change leading to % change in the item Allows non-linear growth in capital required for growth, but otherwise simple extrapolation of net income CAPEX and NWC as in FCFF shorthand Assumes constant capital structure Growth in CAPEX and NWC as in FCFF shorthand Elias Rantapuska / Aalto BIZ Finance 16

FCFF and FCFE shorthand example Simplified current income statement Sales 4200 Sales growth 200 EBIT 600 Tax rate 20% Capex 800 Depreciation 700 Change in NWC 50 Net income margin 10% Debt ratio (Debt / Total assets) 40% Inputs to shorthand =>5% sales growth =>14.3% EBIT margin =>+ 100 in capex for 200 sales growth (50% of every in sales growth) =>25% of NWC increase for every in sales Elias Rantapuska / Aalto BIZ Finance 17

FCFF and FCFE shorthand: numbers Simplified forecasted income statement Forecasted sales 4500 EBIT 644 EBIT(1-Tax rate) 515 Tax rate 20% Incremental capex 150 Incremental NWC 75 FCFF 390 FCFE 315 Details Assume 4500 sales forecast 4500 * 14.3% 644*(1-0.2) 0.5* 300 0.25* 300 515-150 - 75 10%* 4500 (1-0.4)* 150 (1-0.4)* 75 Elias Rantapuska / Aalto BIZ Finance 18

Further issues in FCFF and FCFE analysis Excess cash Operating leases R&D and other noncapitalized expenses with future value Nonrecurring charges Tax rate Abnormally low profit Dividend and FCFE Elias Rantapuska / Aalto BIZ Finance 19

Excess cash is not king and should be thrown out from the court Simplest way: verify that there is no excess cash. Some cash is required as part of NWC Simple way: in case of excess cash, keep cash and associated interest income out from valuation and add back book value of cash after you are done Complex way: include interest income from cash. Adjust discount rate to incorporate the low-risk of cash: cash is a zero-beta asset Elias Rantapuska / Aalto BIZ Finance 20

Operating leases once spotted, what then? Operating lease expenses should be treated as financing expenses, with the following adjustments: Debt value of operating Leases = PV of operating lease commitments at the pre-tax cost of debt Add operating lease asset with exactly the same value to assets Adjust operating profit (net income does not change in this simplified case) Adjusted operating profit = Operating profit + Operating lease expenses depreciation of operating lease asset Introducing taxes and detailed depreciation schedule into the equation may change net income as well Shorthand: Adjusted operating profit = Operating profit + pre-tax cost of debt * PV of operating leases Adjusted interest expenses = interest expenses + pre-tax cost of debt * PV of operating leases Elias Rantapuska / Aalto BIZ Finance 21

R&D expenses and other uncapitalized expenses with future value Usually companies err on the side of capitalizing expenses too aggressively However, sometimes research and development that are likely to generate future cash flows that are not capitalized should be moved from operating expenses into capital expenses How to do this: Specify an amortizable life for R&D (2-10 years) Collect past R&D expenses for as long as the amortizable life Sum up the unamortized R&D over the period (i.e., if your amortization life is 5 years, take 1/5 of unamortized R&D 5 years ago, 2/5 unamortized R&D 4 years ago ) Put summed amortized R&D in balance sheet and add corresponding annual values to operating profit Elias Rantapuska / Aalto BIZ Finance 22

Extraordinary items part of business or not? You are valuing a firm that is reporting a operating loss of 200 million, due to a one-time charge of 400 million. Which operating profit to use? a. An operating loss of 200 million b. An operating profit of 200 million Would your answer be any different if the firm had reported one-time losses like these once every five years? a. Yes b. No Submit answer through http://presemo.aalto.fi/valuation6/ Elias Rantapuska / Aalto BIZ Finance 23

Which tax rate should in put in my projections? Effective (=total income taxes paid / net income before taxes) or marginal tax rate (=corporate tax rate)? More conservative to use the marginal tax rate Effective tax rate is driven by tax accountants and taxman Using marginal tax rate understates the after-tax operating income in the earlier years (capital is typically depreciated faster early, possible to do more tax-decreasing choices in growing phase of business) If you use effective tax rate, adjust the tax rate towards the marginal tax rate over time Elias Rantapuska / Aalto BIZ Finance 24

What to do when the company has negative net income? When facing a lossmaking company: Remember that eternal loser is worth nothing and if the cash flows are too far away, nobody will finance the losses meanwhile Use this framework to see where is the problem: If you believe the problem can be solved, adjust forecasts If not, put big fat zero on your valuation model Source: Aswath Damodaran Elias Rantapuska / Aalto BIZ Finance 25

Is FCFE same as dividend? Dividend is money paid into bank account, not bizarre FCFE made up by valuation gurus Actual dividends are set by the managers of the firm and may be much lower than the potential dividends (=FCFE) Dividend smoothing Managers like to hold on to cash to meet unforeseen future contingencies and investment opportunities Excess cash built up from potential dividends that were never paid does build up in the balance sheet Using DDM will understate firm value, if excess cash is piling up FCFE often more accurate DDM works when bird in the hand is only thing that matters (e.g., managers with agency problems, restructuring with fights over the cash flow) Elias Rantapuska / Aalto BIZ Finance 26

Closing thought Number of errors in analyst reports Number of questionable judgments in analyst reports DB JPM MS 4.4 5.4 7.0 3.7 3.7 4.9 Doing valuation right is hard Even pros make (several) mistakes Standards are vey high and analysts get fired all the time for sloppy work Mean 5.4 4.4 Source: Green, Jeremiah, John RM Hand, and Frank Zhang. "A New Perspective on Analyst Sophistication: Errors and Dubious Judgments in Analysts DCF Valuation Models." Elias Rantapuska / Aalto BIZ Finance 27