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BUSINESS ANALYSIS AND

VALUATION: FINA2207

Lecture 3: Cash Accounting, Accrual Accounting,

and Discounted Cash Flow Valuation

Stephen H. Penman: Chapter 4

Prepared and delivered by Dr. Mahmoud Agha, CFA

Chapter 4
Cash Accounting, Accrual Accounting, and Discounted
Cash Flow Valuation

The Big Picture in This Chapter

• A valuation model is a method of accounting for value

• Discounted cash flow (DCF) valuation employs cash accounting for

valuation such as dividends and cash flows

• However, DCF Valuation – and cash accounting for value – does not work
because they do not capture value added in a business.

• Move to accrual accounting for value in Chapters 5 and 6

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A Reminder :Valuation Models for Going Concerns

A Firm
0 1 2 3 4 5
CF1 CF2 CF 3 CF4 CF5
Equity

0 1 2 3 4 5 T

Dividend
Flow d1 d2 d3 d4 d5 dT
TVT

The terminal value, TVT is the price payoff PT , when the share is sold

Valuation issues :
• The forecast target: dividends, cash flow, earnings?
• The time horizon: T = 5, 10, ? 
• The terminal value, PT, How to calculate it?
• The discount rate: assumed to be the same for all periods?

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The Dividend Discount Model: Forecasting Dividends

d1 d2 d3 d4
V0E      ...
E  E2  E3  E4

Clearly, forecasting dividends for many infinite periods in the future is a

problem.

Hence, we need to define an investment horizon T, but still we face the

problem of finding the terminal stock price at time T. Circularity problem!

d1 d2 d3 dT PT
V0E     ...  
E  2
E  3
E  T
E  ET

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The Dividend Discount Model: Forecasting

Dividends

Terminal Values for the DDM

To find the TV at the end of our forecasting horizon (T) we have two methods:

A. Capitalize expected terminal dividends if you believe that dividends at the

forecast horizon will be the same forever afterward. (Perpetuity)

d T 1
TVT  PT 
E  1

B. Capitalize expected terminal dividends with growth if you believe that

dividend at forecast horizon will grow at a constant growth rate afterward.
(Growing perpetuity)
d T 1
TVT  PT 
E  g
Where g = (1+ forecasted growth rate)

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Dividend Discount Analysis: Advantages

and Disadvantages
Advantages
• Easy concept: dividends are
what shareholders get, so
forecast them
• Predictability: dividends are
usually fairly stable in the short
run, so dividends are easy to
forecast (in the short run)
Disadvantages
• Relevance: dividends payout is not
related to value, at least in the short
run; dividend forecasts ignore the
capital gain component of payoffs.
• Forecast horizons: typically requires
forecasts for long periods; terminal
values for longer periods are hard to
calculate with any reliability

When It Works Best

When payout is permanently tied to the value generation in the firm.

For example, when a firm has a fixed payout ratio (dividends/earnings).

Dividends are cash flows paid out of the firm (to shareholders)
 Can we focus on cash flows within a firm instead?

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Cash Flows Within a Firm: Free

Cash Flow
Free cash flow: is cash flow from operations that results from
investments minus cash used to make investments.

Cash flow from operations C1 C2 C3 C4 C5

(inflows)

Cash investment (outflows) I1 I2 I3 I4 I5

Free cash flow C1-I1 C2-I2 C3-I3 C4-I4 C5-I5

Time, t
1 2 3 4 5

The value of the firm = value of its investing and operating activities =
value of the operations = the enterprise value.

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The Discounted Cash Flow (DCF)

Model
• One can value firm equity by forecasting free cash flow to
equityholders, then discount these cash flows to the present as
we did with DDM.

• Alternatively, we can forecast the free cash flow to the whole

firm, find the present value of these cash flows, then subtract the
value of net debt and preferred equity claims on these cash flows.
The discount rate here is the cost of capital. We can use book
value of net debt.

• We shall use the second method due to the simplicity of

calculating the free cash flow to the firm.

• See the next slide for more details.

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The Discounted Cash Flow (DCF) Model

Cash flow from

operations (inflows) C1 C2 C3 C4 C5 --->

Cash investment I1 I2 I3 I4 I5 --->

(outflows)

Free cash flow C1  I1 C2  I2 C3  I3 C4  I4 C5  I5 --->

________________________________________________ --->

Time, t 1 2 3 4 5

VND = debt obligations + preferred equity-debt assets

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The Continuing Value (CV) for the

DCF Model

Similar to the DDM, we can calculate the continuing value of the firm by
the end of our investment horizon using one of two methods:

A. Capitalize expected terminal free cash flow if you believe the free
cash flow at the forecast horizon will be the same forever afterward
(Perpetuity).
C T 1  I T 1
CVT 
ρF 1

B. Capitalize expected terminal free cash flow with growth if you

believe that the free cash flow at forecast horizon will grow at a
constant growth rate afterward (Growing perpetuity).
C T 1  I T 1
CVT 
ρF  g

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DCF Valuation: The Coca-Cola Company

Example: Assume we are standing by end of 1999 and the figures up to

2004 are forecasted (figures are in millions of dollars except share and
per-share numbers). Required return for the firm is 9%. Assume that
the estimated growth rate in free cash flow after 2004 is 5%p.a. What
was the stock value of Coca-Cola at that time?

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DCF Valuation: The Coca-Cola Company

1999 2000 2001 2002 2003 2004

Cash from operations 3,657 4,097 4,736 5,457 5,929

Cash investments 947 1,187 1,167 906 618
Free cash flow 2,710 2,910 3,569 4,551 5,311

Discount rate (1.09)t 1.09 1.1881 1.2950 1.4116 1.5386

Present value of free cash flows 2,486 2,449 2,756 3,224 3,452
Total present value to 2004 14,367
Continuing value (CVT)* 139,414
Present value of CV 90,611
Enterprise value 104,978
Book value of net debt 4,435
Value of equity 100,543

Shares outstanding 2,472

Value per share $40.67

*CVT = 5,311 x 1.05 = 139,414 Present value of CV = 139,414 = 90,611 = CV0

1.09 - 1.05 1.5386

The actual stock price by end of 1999 was $57, Was it overpriced?

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Steps for a DCF Valuation

Here are the steps to follow for a DCF valuation:

1. Forecast free cash flow to a horizon

2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with an estimated growth rate
4. Discount the continuing value to the present
5. Add 2 and 4
6. Subtract net debt

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Free cash flow and value added: Will DCF

Valuation Always Work?
A Firm with Negative Free Cash Flows: General Electric Company
In millions of dollars, except per-share amounts.
2000 2001 2002 2003 2004

Cash from operations 30,009 39,398 34,848 36,102 36,484

Cash investments 37,699 40,308 61,227 21,843 38,414
Free cash flow (7,690) (910) (26,379) 14,259 (1,930)

Earnings 12,735 13,684 14,118 15,002 16,593

Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60
Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

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Will DCF Valuation Work for these firms?

• The answer is no because the free cash flow does not measure value
added from operations.

• As we can see from the previous examples, the two firms were really
profitable, but their FCFFs were negative because they invest more
than they receive from operations.

• Cash flow from operations (value added) is reduced by investments

(which also add value in the future): investments are treated as value
losses. So, value received is not matched against value surrendered
to generate value.

• So, we need to forecast earnings, not cash flows.

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Discounted Cash Flow Analysis: Advantages

and Disadvantages
Advantages
• Easy concept: cash flows
are “real” and easy to think
about; they are not affected
by accounting rules
• Familiarity: is a straight
application of familiar net
present value techniques
Disadvantages
• Suspect concept:
– Free cash flow does not measure value added
in the short run; value gained is not matched
with value given up.
– Free cash flow fails to recognize value
generated that does not involve cash flows
– Investment is treated as a loss of value
– Free cash flow is partly a liquidation concept;
firms increase free cash flow by cutting back on
investments.

• Forecast horizons: typically requires forecasts for

long periods; terminal values for longer periods are
hard to calculate with any reliability

• Not aligned with what people forecast: analysts

forecast earnings, not free cash flow; adjusting
earnings forecasts to free cash forecasts requires
further forecasting of accruals

When It Works Best

When the investment pattern is such as to produce constant free cash flow
or free cash flow growing at a constant rate.
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The statement of cash flow (SCF)

• Let use have a look at the SCF in the next slide.

– The reported statement of cash flows usually contains some items in

accurate reporting. The next slide show the SCF for Nike, INC.

– The reported free cash flows = $1896.7

• However, the statement as prepared under IAS is not what we want

because some items are not properly classified.

• So, we cannot use the financial statements reported by firms as given; we

need to make necessary adjustments to reflect the true value.

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Corrections to the Reported Cash Flow

from Operations

• Reported cash flows from operations in the U.S. and most countries include
interest, which is a financing rather than an operating cash flow:

Unlevered Cash Flow from Operations =

Reported Cash Flow from Operations (levered) + After-tax Net Interest Payments

After-tax net Interest payment = Net interest payment x (1 - tax rate)

Net interest payment = Interest payments – Interest receipts

Reported cash flow from operations is sometimes referred to as levered cash

flow from operations

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Corrections to the Reported Cash Flow

from investment

• Reported cash investments also include net investments in interest

bearing financial assets (excess cash), which is a financing flow rather
than investment in operations):

Adjusted Cash investment in operations =

Reported cash flow from investing - Net investment in interest-bearing securities

Net investment in interest-bearing securities =

Purchase of interest-bearing securities –sale of interest-bearing securities.

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Calculating Free Cash Flow from the Cash Flow Statement

after making the necessary adjustments: Nike, Inc., 2010

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Converting Earnings to Free Cash Flow

after adjustments : Nike, Inc., 2010

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Tips to the analyst

– Under the IFRS, firms can classify dividends paid and received as either
operating or financing activities. As an analyst, you should make adjustment
such that dividends paid are transferred to the financing section and
dividends received to the operating section.

– Interest paid and received should be adjusted as we have done in the

former example.

– Taxes are in cash flow from operations

– Purchases and sales of interest-bearing securities are to be excluded from

cash investment in operations

– These amendments need to be made before forecasting future free cash

flows. Forecasting future FCFs will be discussed in Chapter 11.

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Cash flow, Earnings and Accrual Accounting

• Forecasting FCFF requires forecasting the firm’s sales and earnings.

• Analysts usually forecast earnings rather than cash flows. The stock price is
very sensitive to earnings announcements. Earnings drive stock prices.

• The difference between earnings and cash flow from operations is the
accruals.

• These accruals capture value added in operations that cash flows do not.

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The Income Statement: Nike, Inc.

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Earnings and Cash Flows

Earnings = Free cash flow*– Net interest payment (after tax) + investments - accruals
= [C - I] – Net interest payment (after tax) + I - accruals
= C – Net interest payment (after tax) - accruals

• The earnings calculation adds back investments and puts them back in the
balance sheet. It also adds accruals.

• C and I in the above formulas are the adjusted ones.

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Earnings and Cash Flows: Nike, Inc.,

2010

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Features of the income statement:

1. Dividends do not appear in the statement because it is a distribution

of value, not a part of value generation.

2. Investment also is not subtracted in the income statement (exception

R&D)
3. There is a matching of value inflows (revenues) and outflows
(expenses) as the result of the matching principles.

4. Accruals are recognized in the statement. So sales made during the

period are recognized even if the value of these sales has not yet
been collected. Similarly, expenses incurred are recognized even if
payment is made later.

• Earnings look like a better basis for valuing a firm than cash flows.
Nevertheless, still accrual accounting and earning calculations are
subject to manipulation.

• Next week we will discuss how earnings are used in valuation.

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Workshop Questions

Penman, “Financial Statement Analysis and Security Valuation”, 5 th Edition

Chapter 4: E4.1, E4.4, E4.5, E4.10, E4.11

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