Advanced Cash Flow Analysis

Free cash flow (FCF) is the cash flow available to a company after all expenses and investments are considered. Understanding FCF is crucial for valuing a company. We'll explore two primary FCF concepts:

• FCF to Firm (FCFF): Represents the cash flow available to all investors – both debt and equity holders. It's used to value the entire firm.

  • Formula: FCFF = Net Income + Net Interest Expense + Depreciation & Amortization - Investments in Fixed Capital - Investments in Working Capital

• FCF to Equity (FCFE): Represents the cash flow available to equity holders only. Used to value the equity portion of the firm.

  • Formula: FCFE = Net Income + Depreciation & Amortization - Investments in Fixed Capital - Investments in Working Capital + Net Borrowing

  Example: Let's say a company has:

  • Net Income: $10 million
  • Interest Expense: $2 million
  • Depreciation & Amortization: $5 million
  • Capital Expenditures (Investments in Fixed Capital): $4 million
  • Increase in Working Capital: $2 million

  • Net Borrowing (Debt Issued): $1 million

  • FCFF Calculation: $10 million + $2 million + $5 million - $4 million - $2 million = $11 million

  • FCFE Calculation: $10 million + $5 million - $4 million - $2 million + $1 million = $10 million

  Understanding the difference and the nuances of each formula is critical to accurate valuation. Factors such as tax rates and capital structure also influence the calculations, and we'll discuss these complexities as the lesson progresses.

Forecasting future cash flows is a crucial aspect of valuation. Several methods can be used, depending on data availability and the industry.

• Historical Trend Analysis: Projecting future cash flows based on historical performance. This involves analyzing past cash flow patterns and growth rates.

  • Pros: Simple to implement, readily available data.
  • Cons: Doesn't account for changes in the business environment or future growth opportunities.

• Industry-Specific Driver Analysis: Identify and use key industry drivers to forecast cash flows. For example, in the retail industry, sales forecasts might be driven by same-store sales growth, market share, and consumer spending trends.

  • Pros: Accounts for external factors and provides a more realistic view.
  • Cons: Requires detailed industry knowledge, forecasting drivers can be complex.

• Percentage of Sales Method: Projects various line items in the income statement and balance sheet as a percentage of sales. This method assumes that certain items fluctuate directly with sales.

  • Pros: Easy to use and provides a basic forecast.
  • Cons: It assumes static relationship with sales and may be inaccurate in volatile business environment.

  Example: If historical sales grew at 5% annually, you might initially project future sales at 5% growth. Then, adjust for factors like industry outlook, company-specific initiatives, and planned investments.

The quality of earnings refers to the sustainability and reliability of a company's reported profits. It is crucial to determine if a company’s net income accurately reflects its true economic performance. One of the most important comparisons is between net income and cash flow from operations (CFO).

• CFO vs. Net Income: A strong CFO typically supports a company’s reported net income.

  • Positive Signs: CFO consistently exceeds net income, especially in the long run.
  • Red Flags: CFO significantly lower than net income, especially if the trend continues. This could indicate aggressive accounting practices or unsustainable earnings.

• Potential Manipulations: Be vigilant for practices that may inflate net income artificially.

  • Accelerated Revenue Recognition: Recognizing revenue prematurely to boost income.
  • Capitalizing Expenses: Treating operating expenses as capital expenditures.
  • Changes in Depreciation Methods: Altering depreciation methods to inflate net income. These manipulations will often impact both income statements and cash flow statements, but analysis of both will indicate any inconsistencies.

• Key Metrics:

  • CFO to Net Income Ratio: CFO/Net Income; A ratio above 1 generally suggests healthy earnings quality. A persistently low ratio (e.g., below 0.8) should warrant further investigation.
  • Accruals: The difference between Net Income and CFO. Large and increasing accruals may indicate aggressive accounting practices.

  Example: If a company reports consistent net income growth, but CFO is stagnant or declining, it's a major red flag, potentially pointing to issues in revenue recognition or other manipulations.

Cash flow analysis is a cornerstone of valuation. The most common valuation method is the discounted cash flow (DCF) analysis.

• Discounted Cash Flow (DCF) Analysis: The process of valuing an asset based on the present value of its future cash flows. Here's a simplified version:

  • Step 1: Forecast Cash Flows: Project the future cash flows (FCFF or FCFE) for a defined period (e.g., 5-10 years).
  • Step 2: Determine the Discount Rate: The discount rate represents the required rate of return. It is often calculated using the Weighted Average Cost of Capital (WACC) for FCFF or the Cost of Equity for FCFE.
  • Step 3: Calculate the Present Value: Discount the projected cash flows back to the present using the discount rate.
  • Step 4: Calculate the Terminal Value: Estimate the value of the company beyond the explicit forecast period. This is often calculated using the Gordon Growth Model or other methods.
  • Step 5: Calculate the Enterprise Value (FCFF) or Equity Value (FCFE): Sum the present values of all future cash flows and the terminal value. For FCFF, this gives you Enterprise Value. For FCFE, this gives you Equity Value.
  • Step 6: Determine Per-Share Value: Divide Equity Value by the number of outstanding shares to arrive at the intrinsic value per share.

• Inputs and Considerations:

  • Growth Rates: The assumed growth rates in the forecast period and the terminal growth rate are critical assumptions.
  • Discount Rate: Accurately estimating the cost of capital is essential.
  • Sensitivity Analysis: Perform sensitivity analyses on key assumptions (e.g., revenue growth, discount rate) to understand their impact on the valuation.

  Example: Imagine projecting FCFF for a company and discounting them back to the present using WACC. Summing these present values, along with the present value of a terminal value, provides an estimated firm value. If this value significantly exceeds the company's current market capitalization, it may be undervalued.