Summary Valuation
WEEK 1 – Estimating Cash Flows
DCF and NPV Formula
CF 1 C F2 C F3 C Fn
Value of asset= 1
+ 2
+ 3
+ …+
( 1+r ) ( 1+r ) ( 1+r ) ( 1+ r )n
Recall: NPV formula is basis of DCF valuation. Today’s goal is to estimate inputs for numerator →
the firm’s cash flows. Two challenges:
- Firm financials do not accurately reflect current cash flows – you have to calculate expected
cash flows. This is not too hard for the upcoming quarter, but gets harder when you move
further in time. So, we have to take earnings and convert them into cash flows;
- Value relies largely on future cash flows that must be estimated – firm will not live forever.
C3 ( 1−g )
So, what people do in practice, add: . So stop with future cash flows, and add how
r −g
much cash flows are gonna grow. Talk about this next week .
Why do we only care about cash flows and not about earnings or profit? As investor, the only money
you get back is cash dividend or cash from repurchases. That’s why cash flows matter, but not
especially the earnings of the company. So, accounting measure, we care about them to the extent they
say something about the cash flows.
Steps in Estimating Cash Flows
1. Collect current data from firm’s most recent financial statements;
- If valuing entire firm, start with operating earnings after taxes (but before interest
payments);
- If valuing equity, use net income (earnings after interest).
2. Adjust earnings for various accounting conventions;
- E.g., some investments misclassified as ordinary business costs.
3. Calculate firm’s net investment spending;
4. Convert earnings into cashflows.
- Subtract investment spending, add back depreciation;
- For equity, also add cash flows from issuing/repaying debt.
Measuring Cash Flows
There exist two different ways how to measure cash flows (firm and equity). The difference is the
creditors.
1
,1. Collect Current Data
Annual financial statements are often outdated, partly reflect firms’ conditions from a year ago.
Updating matters most for firms that have changed recently (smaller/volatile firms or firms that have
undergone significant restructuring). Update using trailing data from past 12 months, constructed from
quarterly earnings reports. All you need is one 10K (annual) and one 10Q (quarterly).
Trailing 12 month revenue=Annual revenues ( ¿ last 10 K ) −Revenues ¿ first 3 quarters of last year ( ¿ 10 Q ) + Reve
Example Google
Trailing 12-month revenues:
$ 45,375−$ 16,338+ $ 63,521=$ 92,555 (see notes)
About twice those reported in the last annual report (10K). Thus, this shows how much firm can
change in short-time period. Yields for young firms and firms that made a major change.
2. Adjusting Accounting Earnings
Accounting data is not perfect and we have to correct it in several ways.
1. Make sure no financial expenses are mixed in with operating expenses:
- Financial expense: Any commitment that is tax deductible and must be paid, or else you lose
control of the business. We don’t want to treat this as operating, because it goes to the
investors in your firm. Operating expense is just day-to-day business costs (employees,
materials).
- Example: Operating leases are treated by accounting rules as business expense, but really
should be reclassified as financial expense.
2. Make sure investment is not classified as operating expenses:
- Any spending that is expected to generate benefits over multiple periods is investment;
- R&D is investment, but accounting rules classify as operating expense. Lab materials are for
example no investments, because you use it only once. Same yields for electricity, or fuel.
You use those in a short-time period, so don’t get a benefit in the long-term.
2a. Adjusting Lease Expenses
So the problem is that they are basically a financial expense. If you miss a rental payment, there are
consequences. Thus is similar as missing interest payment on your debt. You need to make the
expense otherwise your business might be forced to shut down. Goal: Treat leases as any other type of
debt.
How: Add leases to total debt on balance sheet, re-calculate operating earnings without lease costs.
Capitalization is a valuation term for taking an expense from the income statement and create an asset
to put on the balance sheet. To capitalize lease expenses:
- Collect data on current and future lease commitments from 10-Ks;
- Calculate present value of future commitments, discounting at pre-tax cost of debt;
- Sum up present values to obtain debt value of operating leases.
2
,Add debt value to balance sheet as liability, crease asset of same value.
- Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses –
Depreciation on Leased Asset;
- As approximation, can use Operating Earnings + Pre-tax cost of Debt × PV of Operating
Leases.
How accounting versus finance people think about leases:
Accounting Finance
- leases are subtracted from earnings - lease should not be subtracted
- leases not on balance sheet - leases are a liability, thus on balance sheet.
Operating Leases at the Gap
The Gap has conventional debt of $1.97b. Its pre-tax cost of debt is 6%. Lease payments in 2003
were $978m, and future commitments are:
Main point, get the data, is
column commitment.
Discount the data is
column present value, then
we sum up the present
values. This goes on the
balance sheet as a
liability. Thus, we also
have to create an asset of
the same amount. What do we do with the earnings? Depreciate lease by certain amount divided by
certain amount of years. Thus, we only subtract the lease depreciation to get the EBIT instead of the
total lease.
Debt value of leases = $4,397m (sum of PV of future commitments).
4397
Change in Operating Earnings = Lease expense this year – Depreciation ¿ 978− =$ 350 m (7-
7
year life for leases).
3
, 2b. Adjusting R&D Expenses
Goal: Treat R&D the same as capital expenditures. Capex is not on the balance sheet, thus not
subtracted from the earnings by accountants. It does appear in earnings in one stage, which is
depreciation. Why? Accountants like to smooth out earnings over time, want earnings to be relatively
consistent. So they pretend that each year a x% of the building is losing its value. Actually a term that
accountants made up, and not what the firm is spending. We want to do the same thing with R&D.
R&D is subtracted from earnings, but there is no depreciation, we want to undo this. So, goals is to
create a R&D asset, and add back the R&D spending to earnings and then subtract amortization.
How: Add value of R&D asset to balance sheet, calculate earnings without subtracting net R&D
spending (amortization of R&D is similar to depreciation of tangible asset).
To capitalize R&D investment:
- Specify an amortizable life for R&D (2-10 years);
- Collect past R&D expenses over amortizable life (from past 10-Ks);
- Calculate amount of past R&D that has not yet amortized;
- Sum up unamortized past R&D to obtain value of R&D asset;
- Calculate amount of past R&D that is amortized in current year.
Adjust operating earnings by adding back current R&D expense, and subtracting amount amortize in
current year. Also need to add back ignored tax benefit of expensing R&D.
Capitalizing R&D Expenses: SAP
R&D assumed to have a 5-year life (20% amortizes per year).
Last column: R&D expense
multiplied by (1-fraction
unamortized). We are adding
back the amount of the
original R&D expense minus
the amortization.
Thus on income statement:
only subtract amortization.
4
WEEK 1 – Estimating Cash Flows
DCF and NPV Formula
CF 1 C F2 C F3 C Fn
Value of asset= 1
+ 2
+ 3
+ …+
( 1+r ) ( 1+r ) ( 1+r ) ( 1+ r )n
Recall: NPV formula is basis of DCF valuation. Today’s goal is to estimate inputs for numerator →
the firm’s cash flows. Two challenges:
- Firm financials do not accurately reflect current cash flows – you have to calculate expected
cash flows. This is not too hard for the upcoming quarter, but gets harder when you move
further in time. So, we have to take earnings and convert them into cash flows;
- Value relies largely on future cash flows that must be estimated – firm will not live forever.
C3 ( 1−g )
So, what people do in practice, add: . So stop with future cash flows, and add how
r −g
much cash flows are gonna grow. Talk about this next week .
Why do we only care about cash flows and not about earnings or profit? As investor, the only money
you get back is cash dividend or cash from repurchases. That’s why cash flows matter, but not
especially the earnings of the company. So, accounting measure, we care about them to the extent they
say something about the cash flows.
Steps in Estimating Cash Flows
1. Collect current data from firm’s most recent financial statements;
- If valuing entire firm, start with operating earnings after taxes (but before interest
payments);
- If valuing equity, use net income (earnings after interest).
2. Adjust earnings for various accounting conventions;
- E.g., some investments misclassified as ordinary business costs.
3. Calculate firm’s net investment spending;
4. Convert earnings into cashflows.
- Subtract investment spending, add back depreciation;
- For equity, also add cash flows from issuing/repaying debt.
Measuring Cash Flows
There exist two different ways how to measure cash flows (firm and equity). The difference is the
creditors.
1
,1. Collect Current Data
Annual financial statements are often outdated, partly reflect firms’ conditions from a year ago.
Updating matters most for firms that have changed recently (smaller/volatile firms or firms that have
undergone significant restructuring). Update using trailing data from past 12 months, constructed from
quarterly earnings reports. All you need is one 10K (annual) and one 10Q (quarterly).
Trailing 12 month revenue=Annual revenues ( ¿ last 10 K ) −Revenues ¿ first 3 quarters of last year ( ¿ 10 Q ) + Reve
Example Google
Trailing 12-month revenues:
$ 45,375−$ 16,338+ $ 63,521=$ 92,555 (see notes)
About twice those reported in the last annual report (10K). Thus, this shows how much firm can
change in short-time period. Yields for young firms and firms that made a major change.
2. Adjusting Accounting Earnings
Accounting data is not perfect and we have to correct it in several ways.
1. Make sure no financial expenses are mixed in with operating expenses:
- Financial expense: Any commitment that is tax deductible and must be paid, or else you lose
control of the business. We don’t want to treat this as operating, because it goes to the
investors in your firm. Operating expense is just day-to-day business costs (employees,
materials).
- Example: Operating leases are treated by accounting rules as business expense, but really
should be reclassified as financial expense.
2. Make sure investment is not classified as operating expenses:
- Any spending that is expected to generate benefits over multiple periods is investment;
- R&D is investment, but accounting rules classify as operating expense. Lab materials are for
example no investments, because you use it only once. Same yields for electricity, or fuel.
You use those in a short-time period, so don’t get a benefit in the long-term.
2a. Adjusting Lease Expenses
So the problem is that they are basically a financial expense. If you miss a rental payment, there are
consequences. Thus is similar as missing interest payment on your debt. You need to make the
expense otherwise your business might be forced to shut down. Goal: Treat leases as any other type of
debt.
How: Add leases to total debt on balance sheet, re-calculate operating earnings without lease costs.
Capitalization is a valuation term for taking an expense from the income statement and create an asset
to put on the balance sheet. To capitalize lease expenses:
- Collect data on current and future lease commitments from 10-Ks;
- Calculate present value of future commitments, discounting at pre-tax cost of debt;
- Sum up present values to obtain debt value of operating leases.
2
,Add debt value to balance sheet as liability, crease asset of same value.
- Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses –
Depreciation on Leased Asset;
- As approximation, can use Operating Earnings + Pre-tax cost of Debt × PV of Operating
Leases.
How accounting versus finance people think about leases:
Accounting Finance
- leases are subtracted from earnings - lease should not be subtracted
- leases not on balance sheet - leases are a liability, thus on balance sheet.
Operating Leases at the Gap
The Gap has conventional debt of $1.97b. Its pre-tax cost of debt is 6%. Lease payments in 2003
were $978m, and future commitments are:
Main point, get the data, is
column commitment.
Discount the data is
column present value, then
we sum up the present
values. This goes on the
balance sheet as a
liability. Thus, we also
have to create an asset of
the same amount. What do we do with the earnings? Depreciate lease by certain amount divided by
certain amount of years. Thus, we only subtract the lease depreciation to get the EBIT instead of the
total lease.
Debt value of leases = $4,397m (sum of PV of future commitments).
4397
Change in Operating Earnings = Lease expense this year – Depreciation ¿ 978− =$ 350 m (7-
7
year life for leases).
3
, 2b. Adjusting R&D Expenses
Goal: Treat R&D the same as capital expenditures. Capex is not on the balance sheet, thus not
subtracted from the earnings by accountants. It does appear in earnings in one stage, which is
depreciation. Why? Accountants like to smooth out earnings over time, want earnings to be relatively
consistent. So they pretend that each year a x% of the building is losing its value. Actually a term that
accountants made up, and not what the firm is spending. We want to do the same thing with R&D.
R&D is subtracted from earnings, but there is no depreciation, we want to undo this. So, goals is to
create a R&D asset, and add back the R&D spending to earnings and then subtract amortization.
How: Add value of R&D asset to balance sheet, calculate earnings without subtracting net R&D
spending (amortization of R&D is similar to depreciation of tangible asset).
To capitalize R&D investment:
- Specify an amortizable life for R&D (2-10 years);
- Collect past R&D expenses over amortizable life (from past 10-Ks);
- Calculate amount of past R&D that has not yet amortized;
- Sum up unamortized past R&D to obtain value of R&D asset;
- Calculate amount of past R&D that is amortized in current year.
Adjust operating earnings by adding back current R&D expense, and subtracting amount amortize in
current year. Also need to add back ignored tax benefit of expensing R&D.
Capitalizing R&D Expenses: SAP
R&D assumed to have a 5-year life (20% amortizes per year).
Last column: R&D expense
multiplied by (1-fraction
unamortized). We are adding
back the amount of the
original R&D expense minus
the amortization.
Thus on income statement:
only subtract amortization.
4
