Session 7: Estimating Cash Flows

Introduction

In this session, the speaker discusses how to estimate cash flows in four steps. The first step is to decide who you're estimating the cash flows for, either equity investors or the entire business.

Estimating Cash Flows

• Start with accounting earnings and tweak it to get a better measure of what it's supposed to measure.

• Determine how much of those earnings have to go towards paying taxes and reinvestment for future growth.

• Focus on estimating expected cash flows rather than discount rates because errors usually occur in the numerator.

• Decide whether you are estimating cash flows for equity investors or the entire business.

Estimating Cash Flows for Equity Investors

• Estimate cash flows by looking at dividends, stock buybacks, or potential dividends.

• Potential dividends refer to how much cash is left over after every other conceivable need has been met.

Estimating Cash Flows for the Entire Business

• Start with operating income and act like you pay taxes on it (even if you don't).

• Subtract out reinvestment needs to come up with pre-debt cash flows.

Accounting Earnings

• Use updated earnings when valuing a company as of today.

• Normalize earnings if necessary, especially for commodity or cyclical companies.

Overall, estimating accurate cash flows is crucial in valuation since errors often occur in the numerator rather than the discount rate.

Estimating Lease Commitments

In this section, the speaker discusses how to estimate lease commitments and why it is important to do so.

Categorizing Expenses

• Accountants are not always consistent in categorizing expenses.

• Two items that need to be recategorized in income are leases and operating leases.

• Retail firms and restaurants often lease their assets, which accountants categorize as operating expenses.

Future Lease Commitments

• Many of these leases have multi-year commitments, such as 10, 12 or 15 years.

• Companies must break down their lease commitments for the next five years and beyond five years they have to give a lump sum.

• These are contractual commitments that companies have entered into already.

Capitalizing Lease Commitments

• The present value of those lease commitments needs to be taken from the table and discounted back to today using the pre-tax cost of debt as my discount rate.

• By capitalizing these commitments, you increase your debt ratio but lower your cost of capital.

• When you capitalize leases, it becomes part of your invested capital. This affects your return on capital.

Consequences of Capitalizing Leases

• Capitalized leases increase operating income and duration while lowering cost of capital.

• However, when capitalized leases become part of invested capital, it affects return on capital.

• The net effect can be positive for some companies neutral for some and negative for some depending upon what happens to the return on capital relative to the cost of capital.

Accounting for R&D Expenses

In this section, the speaker discusses how to account for research and development (R&D) expenses in a company's financial statements.

Treating R&D as Capital Expense

• R&D is a capital expense because it creates benefits over many periods.

• To treat R&D as a capital expense, you need to amortize it over its useful life.

• The three-step process to capitalize R&D is:

• Determine the amortizable life of the R&D

• Allocate expenses each year for that amortizable life going back in time

• Write off the R&D over that period by keeping track of how much is left over.

Effects on Financial Statements

• Capitalizing R&D increases operating income because it adds back the previously expensed amount and subtracts out depreciation on the capitalized amount.

• Including unamortized portion of R&D in capital changes return on capital, which can have positive, negative or neutral effects on net value per share.

Computing Taxes

• To compute taxes, you need to determine your effective tax rate or marginal tax rate.

Tax Rates and Reinvestment

In this section, the speaker discusses tax rates and reinvestment in relation to cash flows.

Effective vs Marginal Tax Rates

• The effective tax rate should be used for the first few years of projections.

• As time goes on, move towards using the marginal tax rate.

• Being too conservative is better than not being conservative enough.

Reinvestment

• Net capex is calculated by subtracting capital expenditures from depreciation.

• Change in working capital looks at investment in short-term assets.

• Expand the definition of capex to include acquisitions.

• Use non-debt current liabilities for working capital and exclude cash.

Free Cash Flow Equity

• Net income is used as a starting point for free cash flow equity.

• Interest expenses are taken out, followed by net capex and change in working capital.

• Subtract net cash flow from new debt to get free cash flow equity.