Equity Valuations

Chapter 2 – Measuring Cash Flows

Measuring Cash Flows

  • Income from accounting has to be adjusted for calculating income for valuation purposes.

  • Operating lease expense is financial expense or operating expense?

    • Operating lease expense has to be treated as debt for valuation purpose. Thus operating income has to be adjusted with present value of the lease commitments multiplied by pretax cost of debt

  • R&D expense has to be capitalized or treated as expense?

    • R&D expense as per accounting standards is to be expensed in the same year but for valuation purposes we have to capitalize it and make adjustments in the operating income. Thus R&D expense has to be added to operating income and amortization on the R&D asset has to be subtracted

  • FCFF vs FCFE both these cash flows are after tax and after reinvestment needs and are thus free for withdrawal from the firm

  • Pretax cash flows vs post tax cash flows. FCFF and FCFE are after corporate taxes but before investor taxes. Stockholders have to pay taxes on dividend and capital gains whereas bondholders have to pay taxes on interests. If FCFF and FCFE are pretax then discount rate also has to be pre tax

  • Three categories of expenses – operating, investing and financing. The net income of a company is revenue less operating and financing expense. Capital expense has not be subtracted from the revenue to calculate net income.

  • Misclassification of operating, investing and financing expenses. Two most common misclassifications are inclusion of capital expenses such as R&D in the operating expense​​ and financial expenses such as operating lease expense that are treated as operating expenses

  • Accounting standards say that expense on R&D has not be capitalized but to be expensed in the same year. The logic behind this is that the product of R&D is too uncertain and difficult to quantify. When this expense is not capitalized there is no asset added in the balance sheet.

  • For an operating expense to be capitalized there should be substantial evidence that the benefits from the expense accrue over multiple periods

  • Some Financial expenses that accountants treat as operating expense like operating lease expense. Capital leases are presented as debt.

  • Future lease commitments are discounted with pretax cost of debt. The present value of this is added back to the debt to get the total debt value.

  • Adjusted operating income is equal to operating income + operating lease expense – depreciation on the leased asset. If it is assumed that depreciation on the leased asset is equal to the principal amount on the leased debt then only interest portion can be added to the operating income to get the adjusted operating income. Operating income + (Present value of leased asset) * (pretax interest rate on debt)

  • Some firms adopt​​ questionable​​ accounting technique to beat analyst estimates of earnings​​ quarter on quarter. When valuing these firms, we have to correct operating income for these manipulations to arrive at the correct operating income.​​ 

  • There are indications of the management of earnings like there is gap between the earnings reported to firm’s internal revenue service and the earnings reported to equity investors and other indication is beating the analyst estimates quarter on quarter for many years.

  • Earnings can be managed by discretion provided in R&D expense to be capitalized or treated as expense, Revenue recognition, Restructuring cost, provisions etc.

  • The operating and net income that is used as a base for​​ projections should​​ reflect continuing​​ operations and​​ should not include any items that are one-time or extraordinary.

  • Examples of above are large restructuring charge occurring once in a decade or one time income. The operating and net income have to be calculated with these components.

  • Is goodwill impairment an operating expense? No this expense is not an operating expense and it is nontax-deductible expense. With this expense in the books we need to look at the earnings before goodwill impairment for the valuation purpose.

  • Writing-off in process R&D….

  • When firm divest assets they make capital gains. If the divestitures is once in a while then it has to be ignored in net income and cash flow calculations but if the divestitures is frequent then it has to be ignored when net income is calculated but it has to be considered in cash flow calculations. Capex has to be adjusted with the cash flow associated with the divestitures net of capital gain taxes

  • Effective tax rate​​ vs.​​ Marginal tax rate. Effective tax rate is tax payable/taxable income. Taxable income is usually before extraordinary items and goodwill amortization.

  • Why the two above are different? Lower strata of income is taxed at a lower rate. Depreciation rate can be different for reporting purpose and tax purpose. Accumulated operating losses can also lower the tax rate in future. Some companies use tax credits.

  • What is the significance of negative effective tax rate and more than 100% effective tax rate

  • In valuing a firm should we use effective tax rate or marginal tax rate? If the same tax rate is to be used for earnings for all periods then safer choice is to use marginal tax rate because none of the reasons of lower effective tax rate will be applicable for perpetuity. Initial year’s cash flows can be taxed at effective tax rate but future cash flows can be taxed at marginal tax rate. It is critical that the tax rate used in perpetuity to compute the terminal value be the marginal tax rate.

  • Value​​ of the firm will be NPV of FCFF​​ adjusted with deferred tax asset/liability

  • Effect of net operating losses. Firm with operating losses will not have to pay the taxes in the initial years of operating gains. Thus, for a firm with net operating losses carried forward, the tax rate used for both the computation of after tax operating income and cost of debt will be zero during the years when the losses shelter income. ​​ The other approach is to value the firm ignoring tax savings from the net operating loss accumulated over the years but add the tax savings in the value of the firm calculated otherwise.

  • When we capitalize R&D expense for valuation purpose, we lose the tax benefit which we get through expending the R&D expense rather when we capitalize we subtract the amortization on R&D only so we would add the tax savings on the difference between the entire R&D expense and the amortized amount of the research asset to the after-tax operating income of the firm. Additional tax benefit (R&D expense) = (Current year’s R&D expense – Amortization on research asset) * Tax Rate

  • Capital expenditure​​ – Three problems with estimating this 1st​​ is these investments are done in chunks and uniformly, 2nd​​ is some of the expenses are not considered capital investment as per accounting definitions and 3rd​​ is acquisitions are not considered capital expenditures

  • Acquisitions​​ ​​ In estimating capital expenditures, we should not distinguish between internal investments (which are usually categorized as capital expenditures in cash flow statements) and external investments (which are acquisitions). Acquisitions cost should also be included in capital expenditure and if it is done once in a five year then the cost should be normalized.

  • Should we distinguish between acquisitions funded with stock versus those funded with cash?

    • The answer is no both are same as acquisition with stock increases the number of outstanding shares which in turn dilutes the EPS

  • If we ignore acquisitions in the valuations then we have to be internally consistent i.e. if a firm has high growth rate because of acquisitions and we are extrapolating that growth rate for future earnings without considering the cost of acquisitions then we are overvaluing the firm.

  • We make two adjustments when calculating working capital for the valuation purposes

    • Cash has not​​ to​​ be included in the current assets​​ because cash is not tied up asset like inventory and account receivables rather cash when invested in treasury bills gives fair return.

    • Short term interest bearing liabilities will also not be included because we include all these in cost of capital calculation so counting this in working capital will be counting it twice

  • Can change in working capital be negative?

    • Yes when firms get the cash tied up in current assets then the change can be negative but it cannot be sustained for longer period as firm has to invest in inventory etc. for revenue growth

  • Is negative working capital good or bad?

    • Negative working capital means that the firm is using supplier credit as a source of capital. Like Wal-Mart and Dell have sustained negative working capital for long. The supplier credit is not generally free, delaying supplier payment may leads to loss of cash discounts and other price breaks thus firms are paying for the negative working capital. Thus a firm that decides to adopt this strategy will have to compare the cost of this capital to more traditional form of borrowings.

    • The negative non-cash working capital is generally viewed by accountants and rating analysts as a source of default risk. To the extent that the firm’s rating drops and interest rates paid by the firm increase.

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Chapter 1 – Estimating Discount Rates (Prev Lesson)
(Next Lesson) Chapter 3 – Forecasting Cash Flows
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