• Free cash flows to the firm are based on after-tax operating earnings
  • Free cash flow to equity estimates commence with net income
  • We consider operating lease expenses to be financial expenses and R&D expenses to be capital expenses
  • To get from earnings to cash flows, we also need estimates of how much firms reinvest back to generate future growth
  • The cash flows to equity represent cash flows to just the equity investors in the business and are thus after all cash flows associated with debt. Dividends represent one easily observable measure of these cash flows
  • Free cash flow to equity = Net income - (Capital expenditures - Depreciation) - Change in noncash working capital + (New debt raised - Debt repayment)
  • The cash flows to the firm are cash flows generated for all claim holders in the firm and are predebt cash flows
  • Free cash flow to firm = Operating income (1 - Tax rate) - (Capital expenditures - Depreciation) - Change in noncash working capital
  • A more recent estimate of key items in the financial statements can be obtained by aggregating the numbers over the most recent four quarters (trailing 12-months, TTM)
  • However, firms do not reveal details about options outstanding in quarterly reports, whereas they do reveal them in annual reports. 
  • We can use the options outstanding as of the last annual report or assume that the options outstanding today have changed to reflect changes in the other variables
The expenses incurred by a firm can be categorized into three groups:
  • Operating expenses - like labor and material, which are expected to generate benefits only in the current period
  • Capital expenses - like land, building, and equipment, which are expected to generate benefits over multiple periods
  • Financial expenses - such as interest expenses, which are associated with the use of nonequity financing
  • Neither financial nor capital expenses should be included in the operating expenses in the year that they occur
  • The net income of a firm should be its revenues less both its operating and financial expenses
  • No capital expenses should be deducted to arrive at net income
  • The accounting measures of earnings can be misleading because operating, capital,and financial expenses are sometimes misclassified
Misleading accounting measures of earnings:
  1. The inclusion of capital expenses such as R&D in the operating expenses
  2. Financial expenses such as operating leases expenses that are treated as operating expenses
Capitalized R&D Expenses:
  • To capitalize and value research assets, we make an assumption about how long it takes for R&D to be converted, on average, into commercial products. This is called the amortizable life of these assets
  • Once the amortizable life of R&D expenses has been estimated, the next step is to collect data on R&D expenses over past years ranging back to the amortizable life of the research asset

 Adjusted book value of equity = Book value of equity + Value of the research asset

Adjusted operating income = Operating income + R&D expenses - Amortization of research asset

Adjusted net income = Net income + R&D expenses - Amortization of research asset

Techniques for Managing Earnings
  • Planning Ahead
  • Revenue recognition
  • Book revenues early
  • Capitalize operating expenses
  • Write-offs
  • Use reserves
  • Income from investments
Adjustments to Income
  • One-time expenses or income that is truly one-time
  • Expenses and income that do not occur every year but seem to recur at regular intervals
  • Expenses and income that recur every year but with considerable volatility
  • Items that recur every year that change signs - positive in some years and negative in others
REINVESTMENT NEEDS
  • Two components go into estimating reinvestment:
  1. Net capital expenditure
  2. Investment in working capital
Capital Expenditure
  • Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment. 
  • This type of outlay is made by companies to 
    maintain
    maintain or increase the scope of their operations
  • An expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that improves the useful life of an existing capital asset. 
  • If an expense is a capital expenditure, it needs to be capitalized; this requires the company to spread the cost of the expenditure over the useful life of the asset. 
  • If the expense is one that maintains the asset at its current condition, the cost is deducted fully in the year of the expense.
Net Capital Expenditure
  • In estimating net capital expenditure, we generally deduct depreciation from capital expenditure
  • The positive cash flows from depreciation pay for at least a portion of capital expenditures and it is only the excess that represents a drain on the firm's cash flow
  • When estimating the capital expenditures to use for forecasting future cash flows, we should normalize capital expenditures

Method: by averaging capital expenditures over a number of years

  • Estimate the average capital expenditures over the last four or five years for a manufacturing firm and use that number rather than the capital expenditures from the most recent year
  • The number of years will vary across firms and will depend on how infrequently the firm makes large investments
  • Whether or not averaging depreciation as well, unless depreciation is as volatile as capital expenditure, it makes more sense to leave depreciation untouched
  • For firms with a limited history, using industry averages for capital expenditure is an alternative
  • The averages are usually computed with capital expenditure as a percent of a base input
Acqusitions
  • The capital expenditure projections for a firm that makes an acquisition costing $100 million approximately once every five years should include about $20 million, adjusted for inflation, every year
  • We do not distinguish between acquisitions funded with cash versus those funded with stock
Investment in Working Capital

Working Capital = Current Assets - Current Liabilities

  • We will back out cash and investments in marketable securities from current assets
  • Unlike inventory, accounts receivable, and other current assets, cash earns a fair return and should not be included in measures of working capital
  • We will back out all interest-bearing debt - short-term debt and the portion of long-term debt that is due in the current period - from the current liabilities 
  • The noncash working capital as a percent of revenues can be used, in conjunction with expected revenue changes each period, to estimate projected changes in noncash working capital over time
  • For firms where inventory and accounts receivable behave in very different ways as revenues grow, it clearly makes sense to break working capital down into detail
  • Method 1: Compute by dividing the change in noncash working capital in the most recent year into the change in revenues in the most recent year and expected revenue growth in future years
  • Method 2: To base our changes on the noncash working capital as a percent of revenues over a historical period
  • Method 3: To base the projections on the industry average for noncash working capital as a percent of revenues
FROM FIRM TO EQUITY CASH FLOWS

  • Whereas cash flows to the firm measure cash flow to all claim holders in the business, cash flows to equity focus only on cash flows received by equity investors in that business
  • An estimate of equity value may require us to estimate the potential dividends - the cash flow that could have been paid out as a dividend
Free cash flow to equity = Net income - (Capital expenditures - Depreciation) - (Change in noncash working capital) + (New debt issued - Debt repayment)

  • If d is the proportion of the net capital expenditures and working capital changes that is raised from debt financing:
Free cash flow to equity = Net income - (Capital expenditure - Depreciation)(1 - d) - (Change in noncash working capital)(1 - d)

Cash to stockholders to FCFE ratio = (Dividends + Equity repurchases)/FCFE

  • We can observe the tendency of firms to pay out less to stockholders than they have available in free cash flows to equity by examining cash returned to stockholders paid as a percentage of free cash flow to equity
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