Cash Flow analysis, valuation and value

Concepts previously covered Drivers of profitability, five level breakdown Sustainable growth rate and focus on opeartional profitability To be covered 1 Why do companies strive for growth 2 Business valuation and value creation 3 The Discounted cash flow approach and introduction of cash flow 4 Free cash flow and the market value add approach 5 Linking MVA to the core operating activities 6 Does growth always lead to value

Sources of Cash inflow & outflow

Operating activities Sale of goods & services

Investing activities Sal e of fixed assets Sale of long term financial assets (investments) Collection of interest & dividend income Collection of loans made

CASH

Operating activities Purchase of supplies Selling, general & administrative expenses Tax expenses

Investing activities Capital expenditures & acquisitions Long term financial investments

Net cash flow from operating activities

Net cash flow from investing activities

Preliminary cash flow statements Cash flow from operating activities

+ A

Net sales Cost of goods sold Selling, general & administrative expenses Tax expense Change in working capital requirement

Net cash flow from operating activities Cash flow from investing activities + Sale of fixed assets Capital expenditures & acquisitions Net cash flow from investing activities Cash flow from financing activities + Increase in long term borrowings + Increase in short term borrowings

C D E F G

Long term debt repaid Interest payments Dividend payments

Net cash flow from financing activities Total net cash flows (A+B+C) Opening cash Closing cash (E+D) Change in cash position

Mechanics of cash flow from operations Dynamics of a sales transactions Cash flow from operating activities + Net sales Cost of goods sold Selling, general & administrative expenses Tax expense Change in working capital requirement Increase in working capital requirement Decrease in working capital requirement

1 2 3 4

What is business valuation? Is value of a business a unique number? What causes the difference? Why business needs to be valued?

Avoiding the winner's curse / paying the fair value / going public etc.

Methods of valuation 1 Valuation by comparables 2 Discounted cash flow valuation (DCF) 3 Liquidation value / distress sale / fire sale 4 Replacement value

Business valuation using comparable firm's market performance ratios - Market measur Comparable firm 1 2 3 4 5 6 7 Accounting data Earnings after tax (EAT) Cash flow (EAT + Depreciation expense) Book value of equity Number of shares outstanding Earnings per share (EPS), 1/4 Cash flow (cash flow earnings per share), 2/4 Book value per share 3/4 $63.50 121 526 50 million $1.27 2.42 10.52

Financial market data, January 8 Multiples 9 10 11 Price - to - earnings ratio, 8/5 Price - to - cash earnings ratio, 8/6 Price - to - book value ratio, 8/7 Implies that the share of the company trades at 15.75 times its fundamental value Valuing our firm using multiples, in 2010 Value based on price - earnings multiple, 15.75 8.26 1.90 Share price $20

(Price - to - earnings ratio) * (Earnings $ 160.63

Value based on Price - to - cash earnings ratio,

(Price - to - cash earnings ratio) * (Cas $ 150.41 (Price - to - book value ratio) * (Book $ 146.39

Value based on Price - to - book value ratio,

Determinants of earnings and cash - flow multiples DCF = = Or, Share price = (Next year's cash flow per share) / Ke - g =

(Next year's cash flow) / (Required rate of return - Growth ra

Dt/Ke - g

(Share price) / (Next year's cash flow per share)

Impact of change of 'g' on valuation impact of change of 'k' on valuation

Discounted cash flow valuation (DCF) Which cash flow to consider, why? What discount rate to consider, why? Cash flow generated from assets through operating and investing activities Cash flow generated from assets through operating activities

Net operating cash flow (NOCF) = EBIT - Tax expense - change in working capital requirements + depreciat Cash flow generated from assets through investing activities = Net capital expenditures So, Cash flow generated from total assets through operating and investing activities, Free cash flow CFA = = = CFA = EBIT - Tax expense - change in working capital requirements + depreciation

NOPAT - (change in working capital requirements + net capital expend NOPAT - (Net assets + depreciation) NOPAT - change in Invested capital

The free cash flow becomes the basis for estimation of the firm's Market Value added

Driver's of value creation 1 2 3 Firm's operating profitability The firm's cost of capital The firm's ability to grow

1 2

Measures of value add? Market value add Economic value add ROIC = = Linking MVA to the core operating activities Market value added (MVA) = (ROIC - WACC) * Invested capital WACC -Constant growth rate ROIC - WACC EBIT (1-Tax rate) / Invested capital NOPAT / Invested Capital

When growth does not matter Expected ROIC 10% 13%

Firm A Firm B

Expected growth rate 7% 4%

nalysis, valuation and value added measures

ion of cash flow

f Cash inflow & outflow

nterest & dividend

Financing activities Issuance of stocks & bonds Long term borrowings Short term borrowings

nancial investments

Financing activities Purchase of stocks & bonds Repayment of long term debt Repayment of short term debt Interest payment Dividend payment

Net cash flow from financing activities

nary cash flow statements 31/12/2009 31/12/2010

$420 `353 43.7 5.3 4 53 400 48 6.8 14 468.8

$480

53 $367

468.8 $11.2

0 0 0

$2 12 -$10

$0 7 $7 8 $5 2 15

$7

15 -$8 $359 $6 $365

$12 1 $13 8 $7 3.2 18.2

$13

18.2 -$5.2 -$4.0 12 $8.0 $357.00

EBIT

s market performance ratios - Market measures Our firm $10.20 $18.20 77 10 million $1.02 1.82 7.7

Income Statements 31-Dec-08 31-Dec-09 Net sales Cost of goods sold Gross profit Selling, General and Depreciation expenses Operating profits Extraordinary items Earnings before Interest & tax (EBIT) Net interest expense Earnings before tax (EBT) Income tax expense Earnings after tax (EAT) Dividends Retained earnings $ $390 -328 $62 -39.8 -5 $17.2 0 $17.2 -5.5 $11.7 -4.7 $7.0 -$2 5.00 $420 -353 $67 -43.7 -5 $18.3 0 $18.3 -5 $13.3 -5.3 $8.0 -2 $6.0

NA

NA NA NA

(Price - to - earnings ratio) * (Earnings after tax, EAT)

(Price - to - cash earnings ratio) * (Cash flow (EAT + Depreciation expense)

(Price - to - book value ratio) * (Book value of equity)

sh flow) / (Required rate of return - Growth rate)

sh flow per share) / Ke - g 1/ Ke - g

e in working capital requirements + depreciation

activities = Net capital expenditures

investing activities, Free cash flow

n working capital requirements + depreciation - Net capital expenditures

king capital requirements + net capital expenditure - depreciation)

PAT - (Net assets + depreciation)

PAT - change in Invested capital

n of the firm's Market Value added MVA = = = MVAE + MDAD (MVE - BVE) + (MVD - BVD) (MVE + MVD) - (BVE +BVD)

MV(D+E) - Total capital employed

T (1-Tax rate) / Invested capital

PAT / Invested Capital

OIC - WACC) * Invested capital WACC -Constant growth rate =

Proof in next worksheet

Return spread

Estimated WACC 13% 10%

Expected return spread -3% 3%

Invested capital $100 $100

MVA $ (50.00) $ 50.00

31-Dec-10 $480 -400 $80 -48 -$8 $24 $0 $24 -$7 $17 -6.8 $10.2 -$3.20 $7.00

Is value created? No Yes

Linking MVA, EVA, ROIC Market Value Added = Market value of Capital - Capital employed

Value that a firm generates from its assets contributes to its "Free Cash Flows" So, Market Value of the firm's assets = = Also, CFA = =

Cash flows generated by its assets / (WACC-Growt CFA / (WACC - G)

Free Cash Flows to the firm Free cash flow from operating activities + Free cash flows from investment activities EBIT (1-T) + Depreciation - change in WCR - Capital Expenditures NOPAT - (change in WCR + Capital Expenditures - Depreciation) NOPAT - [change in WCR + (Capex - Depreciation) NOPAT - Change in Invested Capital

= = = =

Replacing CFA in equation 2, Market Value of the firm's assets = (NOPAT - Change in Invested Capital) / (WACC - G)

Deducting Invested capital from both sides Market Value of the firm's assets - Invested capital Or, (from previous worksheet) Factoring out the term "Invested Capital" = = = MVA = =

[(NOPAT - Change in Investe

{NOPAT - Change in Invest

MVA MVA MVA

{(NOPAT/Invested Capital) - (C WACC +G}In

{(ROIC - G -WACC + G)Investe

(ROIC - WACC) Invested Ca

Economic Value added Factoring out the term "Invested Capital"

EVA

NOPAT - (WACC * Invested Capita

EVA EVA =

{NOPAT/Invested Capita Capita

(ROIC -WACC)*Invested C

MVA

EVA / (WACC - G)

pital - Capital employed

o its "Free Cash Flows" Gordon's Model

ws generated by its assets / (WACC-Growth rate) 2

ties + Free cash flows from investment ivities

nge in WCR - Capital Expenditures

xpenditures - Depreciation)

hange in Invested Capital) / (WACC - G)

[(NOPAT - Change in Invested Capital) / (WACC - G)] - Invested capital {NOPAT - Change in Invested Capital - Invested capital (WACC - G)}/ (WACC - G)

{(NOPAT/Invested Capital) - (Change in Invested Capital/Invested Capital) WACC +G}Invested Capital/(WACC - G) {(ROIC - G -WACC + G)Invested Capital}/WACC - G (ROIC - WACC) Invested Capital / (WACC - G)

NOPAT - (WACC * Invested Capital)

{NOPAT/Invested Capital) - [(WACC*Invested Capita)/Invested Capital)]}*Invested Capital (ROIC -WACC)*Invested Capital

EVA / (WACC - G)