Session 7: Estimating Cash Flows

Summary

This video dives into the essential aspects of estimating cash flows in business valuation. It emphasizes the importance of accurate earnings and tax adjustments, particularly when dealing with cyclical companies and capitalizing on leases. The script highlights the need for careful treatment of reinvestment, including capital expenditures, acquisitions, and R&D. Moreover, the video explains the significance of distinguishing cash flow to equity and cash flow to the firm, incorporating new debt, and debt repayments. By following these guidelines, analysts can avoid common pitfalls and make more accurate predictions of a company's financial health.

Takeaways

• 😀 Start cash flow estimation by identifying whether it's for equity or the entire business, focusing on dividends or stock buybacks for equity cash flows.
• 😀 Begin cash flow estimation with net income and adjust for interest expenses to avoid misleading results from debt payments.
• 😀 Normalize earnings for cyclical or commodity companies to ensure you're not affected by unusually good or bad years.
• 😀 Always capitalize leases to treat them as debt, ensuring accurate calculation of operating income, return on capital, and cost of capital.
• 😀 Capitalizing leases requires calculating the present value of lease commitments, which must be included in the company’s debt ratio.
• 😀 Treat R&D as an investment by capitalizing it and amortizing over a set period, rather than recording it as an operating expense.
• 😀 Use the effective tax rate for short-term analysis but consider the marginal tax rate for long-term projections to understand the tax impact more realistically.
• 😀 Reinvestment needs should be adjusted to include net capex and changes in working capital, excluding cash as it is not a wasting asset.
• 😀 To calculate Free Cash Flow to Equity (FCFE), subtract reinvestment and account for net debt flows (debt issuance minus repayments).
• 😀 FCFE gives insight into the cash available for dividends or stock buybacks after all obligations are met, making it crucial for equity holders.
• 😀 Pay attention to accounting inconsistencies, especially for leases and R&D, to ensure an accurate and fair view of a company’s financial situation.

Q & A

What is the initial step in estimating cash flows for a company?

The initial step is starting with accounting earnings, typically net income, and adjusting it to reflect more accurate and up-to-date figures using trailing 12-month earnings.

How do analysts handle cyclical or commodity-based companies in cash flow estimation?

For cyclical or commodity-based companies, analysts normalize earnings by adjusting them to reflect a 'typical year,' smoothing out the fluctuations caused by industry cycles or commodity price changes.

What is the key adjustment when treating operating leases in cash flow calculations?

Operating leases should be treated as debt because they represent long-term commitments. The present value of lease obligations is added as debt, and lease expenses are added back to operating income.

Why should R&D expenses be capitalized instead of expensed immediately?

R&D expenses should be capitalized because they provide long-term benefits, such as future products or services. This approach better reflects their value and aligns the expense with the revenue generated over time.

How do analysts adjust taxes in cash flow projections?

Analysts use the effective tax rate for the first few years of projection, then gradually adjust to the marginal tax rate to reflect a company's long-term tax obligations.

What are the key components included in reinvestment needs when estimating cash flows?

Reinvestment needs include capital expenditures (capex), changes in working capital, and acquisitions. These are necessary to support the business's future growth and operational needs.

How is Free Cash Flow to Equity (FCFE) calculated?

FCFE is calculated by starting with net income, subtracting reinvestment needs (such as capex and changes in working capital), and accounting for the net cash flow from new debt issues and repayments.

What is the difference between Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE)?

FCFF includes all cash flows necessary to sustain and grow the entire business, including both equity and debt obligations, while FCFE focuses only on cash flows available to equity holders after accounting for debt obligations.

Why is it important to adjust for inconsistencies in accounting practices when estimating cash flows?

Adjusting for inconsistencies in accounting practices, such as leases and R&D, ensures a more accurate representation of the company's financial position, as these items can have significant long-term impacts on a company's cash flow.

What is the purpose of adjusting working capital in cash flow calculations?

Working capital is adjusted to exclude short-term debt and cash, as they do not represent operational capital for long-term investment or business growth. This helps provide a clearer view of the company's operational liquidity.