Free Cash Flow and Residual earnings

1
ForecastingPart I

• Free Cash Flow and Residual earnings
• Capitalization Modeling of Equity Value
• Simple Forecasting

2
The Goal of Forecasting

• To support the valuation modeling of equity
  shares by producing an estimate of what expected
  free cash flows and/or residual earnings will be
  going forward.

3
Definitions

• Free cash flows (to equity) Cash from
  operations capital expenditures needed to
  maintain operational capacity /-cash related to
  debt \- cash needed to maintain corporate
  liquidity.
• Residual earnings Operating income less a
  capital charge for equity capital.
• Both of these metrics, or their derivatives, will
  become key inputs in the two kinds of valuation
  models we use.

4
Free Cash Flows

• The idea behind the concept of free cash flows
  is that firms must re-invest back into the
  business. Equity shareholders have access only to
  the residual cash that remains after this
  investment is made, net of debt related cash
  flows.
• This is very related to the simple case of cash
  dividends, in which firms pay dividends using all
  available free cash.

5
Residual Earnings

• The idea of residual earnings has become an
  important tool in Business Valuation using
  Financial Statement data.
• The idea of residual earnings derives from the
  notion that stocks (balance sheet numbers) and
  flows (income statement numbers) are really two
  forms of the same thing.
• Because of this they are interchangeable.

6
Residual Earnings

• The magic that makes balance sheet and income
  statement data interchangeable is the discount
  rate. Discount rates are a function of a number
  of factors, including uncertainty, inflation,
  opportunity cost, etc.
• The discount rate converts future cash flows
  (flows) to a present value (stocks).
• So stock information can be stated as a flow, and
  flow data can be stated as a value, or stock.

7
A simple example

• Assume company X has an expected earnings stream,
  X, of 100 per year into perpetuity.
• The appropriate discount rate, r, for this
  earnings stream is 10.
• The present value, PV, of this earnings stream is
  PV X/r 100/.10 1,000.
• This is an example of converting a flow (100)
  into a stock (1,000).

8
A simple example (Cont.)

• Now, assume the equity invested in a given firm
  is 1,000. The discount rate is 10.
• For now, assume there is no debt.
• The flow represented by the equity is 100 (1000
  x .10). This is an example of a stock being
  transformed into a representative flow.

9
A simple Example (Cont.)

• If the firm earns 100, there will be no
  residual earnings. It has earned exactly what was
  expected.
• If the firm earns 110, the residual earnings is
  10. It has earned 10 over and above the cost of
  equity capital. In this case, the flow is worth
  1,100 (110/.10).

10

• Many things can increase earnings and residual
  earnings, but not all of these things result in
  more wealth for shareholders. Examples include
  new investment at the required rate of return,
  the taking on of debt, and changes in accounting
  methods.
• Residual operating earnings, however, does, in
  many cases, drive equity value.
• with the exception of certain accounting
  effects, but valuation models correct for this.

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Forecasting and Residual Earnings

• The forecast task can thus be conceptualized
  around the idea of predicting residual earnings.
• This approach allows us to understand how balance
  sheet and income statement data can be used
  together to value equity shares.
• A key question What is the pattern of residual
  earnings going forward?

12

• What drives residual earnings?
• The degree to which the balance sheet is well
  specified.
• RNOA
• New investment to the extent that it earns more
  than the required rate of return.
• Leverage when the rate of return on investment
  exceeds the cost of borrowing, however
• Leverage does not normally drive equity value.
  For that reason, in the following examples, we
  focus on residual operating earnings

13
The Pattern of Residual Operating Earnings

• Four forecast possibilities
• SF1 Zero residual operating earnings
• SF2 A constant level of residual operating
  earnings
• SF3 A constantly growing level of residual
  operating earnings.
• FF A level and/or growth rate of residual
  operating earnings that will be unrelated to past
  results.

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The Perfect Balance Sheet
Equity cost of capital 12 Debt cost of
capital 10
15
A note on nomenclature

• 1Discount rate on debt
• 1Discount rate on equity
• 1 Discount rate for the firms business
  operation

16
Simple Forecasts Forecasting from Book Values
(SF1)
The required return for operations weights the
equity cost of capital (12) and the cost of debt
(10) by their respective values given in the
fair value balance sheet Required return for
operations
17
SF1 Valuation
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In Summary- SF1

• Presumes that balance sheet is perfectly
  specified as to value.
• Presumes that the firm will earn exactly its rate
  of return on all assets.
• Presumes a continuous and stable earnings stream.

19
The Imperfect Balance Sheet
20
The Income Statement
21
The Cash Flow Statement
22
Simple Forecasts Forecasting from Earnings and
Book Values (SF2)
23
SF2 ReOI Valuation
24
SF2 Valuation Nike
25
Summary-SF2 Forecasts

• Presumes the existence of residual earnings that
  will remain constant.
• Thus presumes that all new investment by the firm
  will return only the required rate of return
  expected by the market for this type of business
  operation.

26
Simple Forecasts Forecasting from Current
Accounting Rates of Return (SF3)
For PPE, Inc. the current RNOA, NBC and ROCE
(with beginning of year amounts in the
denominator) are 14.02, 10.00 and 14.02
respectively
27
SF3 ReOI Valuation (with Constant RNOA)

• If RNOA1 RNOA0
• If RNOA is constant for all future periods,
• (g is growth rate in NOA RNOA0 is Core RNOA0)

28
SF3 Valuation of PPE Inc

• V 69.9 (.1402-.1134)x 69.9 / (.1134-.0644)
• 108.06

29
SF3 Valuation Nike
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Summary-SF3 forecasts

• Presumes that all new investment will earn as
  much as all prior investment.
• Thus presumes that the firms RNOA will remain
  constant.
• Thus presumes that residual operating income will
  grow at a systematic and constant rate.
• What will drive this change is the change in the
  level of new investment.

31
Simple Forecasts of Growth in NOA

• If ATO is constant,
• Forecast growth in NOA with forecasted sales
  growth rate

32
A Simple Valuation with ReOI Growth Coca Cola
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A Simple Valuation with ReOI Growth Coca Cola

• If required return for operations is 10

34
Price-to-Book Ratios and ROCE, 1968 - 1985
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Residual Operating Income Patterns 1965 - 1996
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RNOA Patterns, 1965 - 1996
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Growth in NOA Patterns, 1965 1996



60

50

40


30
Growth in NOA

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10

0

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10







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20
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0
1
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Year Ahead

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Simple Forecasting as an Analytical Device
Sensitivity Analysis

• As If Questions
• Effect of changes in RNOA on forecasts and values
• Effect of changes in PM and ATO
• Effect of changes in investment (growth in NOA)
• Effect of leverage on forecasts of net income

39
Market Forecast Pairs Nike
What combination of RNOA and growth in NOA
justify the market price?
Market Forecast Pairs Nike, Inc., 1996 Price
104 _________________________________ RNOA
Growth in
NOA _________________________________ 15 10.15
16 9.94 17 9.72 18 9.51 19 9.30
20 9.09 21 8.87 22 8.66 23 8.45
24 8.24 25 8.02 26 7.81 27 7.60
28 7.39 29 7.17 30 6.96
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In Summary

• Forecasting is an art.
• The simpler the better, all else equal.
• Its sometimes good to begin with simple
  forecasting, e.g., SF1, SF2 and SF3 modeling.
• All forecasting involves assumptions.
• Much of the price can often be explained with
  simple forecasting methods.
• Full information forecasting attempts to address
  what cannot be explained or assumed via simple
  forecast relationships.