EstimatingCashFlows

DCFValuation

Aswath Damodaran

StepsinCashFlowEstimation

Estimatethecurrentearningsofthefirm

Considerhowmuchthefirminvestedtocreatefuturegrowth

Iflookingatcashflowstoequity,lookatearningsafterinterestexpensesi.e.net
income
Iflookingatcashflowstothefirm,lookatoperatingearningsaftertaxes
Iftheinvestmentisnotexpensed,itwillbecategorizedascapitalexpenditures.To
theextentthatdepreciationprovidesacashflow,itwillcoversomeofthese
expenditures.
Increasingworkingcapitalneedsarealsoinvestmentsforfuturegrowth

Iflookingatcashflowstoequity,considerthecashflowsfromnetdebtissues
(debtissueddebtrepaid)

Aswath Damodaran

MeasuringCashFlows
Dividends
EBIT(1taxrate)
Allclaimholdersinthefirm
NetIncome
JustEquityInvestors
Cashflowscanbemeasuredto
(CapitalExpendituresDepreciation)
(CapitalExpendituresDepreciation)
+StockBuybacks
Changeinnoncashworkingcapital
ChangeinnoncashWorkingCapital
=FreeCashFlowtoFirm(FCFF)
(PrincipalRepaidNewDebtIssues)
PreferredDividend

Aswath Damodaran

MeasuringCashFlowtotheFirm

EBIT(1taxrate)
(CapitalExpendituresDepreciation)
ChangeinWorkingCapital
=Cashflowtothefirm
Wherearethetaxsavingsfrominterestpaymentsinthiscashflow?

Aswath Damodaran

FromReportedtoActualEarnings

Comparable
Update
Normalize
Cleanse
Operating
R&D
Firms
Expenses
operating
leases
items of
Measuring
Earnings
-Earnings
history
Firms
Trailing Earnings
Financial
Convert
into
Expenses
debt
asset
- Adjust
Unofficial
Capital
operating
Expenses
numbers
income
- Non-recurring expenses

Aswath Damodaran

I.UpdateEarnings

Whenvaluingcompanies,weoftendependuponfinancialstatementsfor
inputsonearningsandassets.Annualreportsareoftenoutdatedandcanbe
updatedbyusing

Trailing12monthdata,constructedfromquarterlyearningsreports.
Informalandunofficialnewsreports,ifquarterlyreportsareunavailable.

Updatingmakesthemostdifferenceforsmallerandmorevolatilefirms,as
wellasforfirmsthathaveundergonesignificantrestructuring.
Timesaver:Togetatrailing12monthnumber,allyouneedisone10Kand
one10Q(examplethirdquarter).UsetheYeartodatenumbersfromthe10Q:
Trailing12monthRevenue=Revenues(inlast10K)Revenuesfromfirst3quarters
oflastyear+Revenuesfromfirst3quartersofthisyear.

Aswath Damodaran

II.CorrectingAccountingEarnings

Makesurethattherearenofinancialexpensesmixedinwithoperating
expenses

Financialexpense:Anycommitmentthatistaxdeductiblethatyouhavetomeetno
matterwhatyouroperatingresults:Failuretomeetitleadstolossofcontrolofthe
business.
Example:OperatingLeases:Whileaccountingconventiontreatsoperatingleases
asoperatingexpenses,theyarereallyfinancialexpensesandneedtobereclassified
assuch.Thishasnoeffectonequityearningsbutdoeschangetheoperating
earnings

Makesurethattherearenocapitalexpensesmixedinwiththeoperating
expenses

Aswath Damodaran

Capitalexpense:Anyexpensethatisexpectedtogeneratebenefitsovermultiple
periods.
R&DAdjustment:SinceR&Disacapitalexpenditure(ratherthananoperating
expense),theoperatingincomehastobeadjustedtoreflectitstreatment.

TheMagnitudeofOperatingLeases
Operating Lease expenses as % of Operating Income
60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Market

Aswath Damodaran

Apparel Stores

Furniture Stores

Restaurants

DealingwithOperatingLeaseExpenses

OperatingLeaseExpensesaretreatedasoperatingexpensesincomputing
operatingincome.Inreality,operatingleaseexpensesshouldbetreatedas
financingexpenses,withthefollowingadjustmentstoearningsandcapital:
DebtValueofOperatingLeases=PresentvalueofOperatingLease
Commitmentsatthepretaxcostofdebt
Whenyouconvertoperatingleasesintodebt,youalsocreateanassetto
counteritofexactlythesamevalue.
AdjustedOperatingEarnings
AdjustedOperatingEarnings=OperatingEarnings+OperatingLeaseExpenses
DepreciationonLeasedAsset
Asanapproximation,thisworks:
AdjustedOperatingEarnings=OperatingEarnings+PretaxcostofDebt*PVof
OperatingLeases.

Aswath Damodaran

OperatingLeasesatTheGapin2003

TheGaphasconventionaldebtofabout$1.97billiononitsbalancesheetand
itspretaxcostofdebtisabout6%.Itsoperatingleasepaymentsinthe2003
were$978millionanditscommitmentsforthefuturearebelow:

Year
Commitment(millions)
PresentValue(at6%)
1
$899.00
$848.11
2
$846.00
$752.94
3
$738.00
$619.64
4
$598.00
$473.67
5
$477.00
$356.44
6&7 $982.50eachyear
$1,346.04
DebtValueofleases=
$4,396.85(Alsovalueofleasedasset)
DebtoutstandingatTheGap=$1,970m+$4,397m=$6,367m

AdjustedOperatingIncome=StatedOI+OLexpthisyearDeprecn
=$1,012m+978m4397m/7=$1,362million(7yearlifeforassets)
ApproximateOI=$1,012m+$4397m(.06)=$1,276m

Aswath Damodaran

10

TheCollateralEffectsofTreatingOperatingLeasesasDebt
Conventional Accounting
Income Statement
EBIT& Leases = 1,990
- Op Leases
= 978
EBIT
= 1,012

Balance Sheet
Off balance sheet (Not shown as debt or as an
asset). Only the conventional debt of $1,970
million shows up on balance sheet
Cost of capital = 8.20%(7350/9320) + 4%
(1970/9320) = 7.31%
Cost of equity for The Gap = 8.20%
After-tax cost of debt = 4%
Market value of equity = 7350
Return on capital = 1012 (1-.35)/(3130+1970)
= 12.90%

Aswath Damodaran

Operating Leases Treated as Debt

Income Statement
EBIT& Leases = 1,990
- Deprecn: OL=
628
EBIT
= 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet
Asset
Liability
OL Ass et
4397
OL Debt 4397
Total debt = 4397 + 1970 = $6,367 million
Cost of capital = 8.20%(7350/13717) + 4%
(6367/13717) = 6.25%

Return on capital = 1362 (1-.35)/(3130+6367)

= 9.30%

11

TheMagnitudeofR&DExpenses
R&D as % of Operating Income
60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Market

Aswath Damodaran

Petroleum

Computers

12

R&DExpenses:OperatingorCapitalExpenses

AccountingstandardsrequireustoconsiderR&Dasanoperatingexpense
eventhoughitisdesignedtogeneratefuturegrowth.Itismorelogicaltotreat
itascapitalexpenditures.
TocapitalizeR&D,

Aswath Damodaran

SpecifyanamortizablelifeforR&D(210years)
CollectpastR&Dexpensesforaslongastheamortizablelife
SumuptheunamortizedR&Dovertheperiod.(Thus,iftheamortizablelifeis5
years,theresearchassetcanbeobtainedbyaddingup1/5thoftheR&Dexpense
fromfiveyearsago,2/5thoftheR&Dexpensefromfouryearsago...:

13

CapitalizingR&DExpenses:SAPin2004

R&Dwasassumedtohavea5yearlife.

Year

R&DExpense

Unamortizedportion

Amortizationthisyear

Current
1020.02
1.00
1020.02
1
993.99
0.80
795.19
198.80
2
909.39
0.60
545.63
181.88
3
898.25
0.40
359.30
179.65
4
969.38
0.20
193.88
193.88
5
744.67
0.00
0.00
148.93
Valueofresearchasset=
2,914million
Amortizationofresearchassetin2004
=
903million
IncreaseinOperatingIncome=1020903=117million

Aswath Damodaran

14

TheEffectofCapitalizingR&D:SAP
Conventional Accounting
Income Statement
EBIT& R&D = 3045
- R&D
= 1020
EBIT
= 2025
EBIT (1-t)
= 1285 m

Balance Sheet
Off balance sheet asset. Book value of equity at
3,768 million Euros is understated because
biggest asset is off the books.
Capital Expenditures
Conventional net cap ex of 2 million Euros
Cash Flows
EBIT (1-t)
= 1285
- Net Cap Ex
=
2
FCFF
= 1283
Return on capital = 1285/(3768+530)
= 29.90%

Aswath Damodaran

R&D treated as capital expenditure

Income Statement
EBIT& R&D = 3045
- Amort: R&D = 903
EBIT
= 2142 (Increase of 117 m)
EBIT (1-t)
= 1359 m
Ignored tax benefit = (1020-903)(.3654) = 43
Adjusted EBIT (1-t) = 1359+43 = 1402 m
(Increase of 117 million)
Net Income will also increase by 117 million
Balance Sheet
Asset
Liability
R&D Asset 2914 Book Equity +2914
Total Book Equity = 3768+2914= 6782 mil
Capital Expenditures
Net Cap ex = 2+ 1020 903 = 119 mil
Cash Flows
EBIT (1-t)
= 1402
- Net Cap Ex
=
119
FCFF
= 1283 m
Return on capital = 1402/(6782+530)
= 19.93%

15

III.OneTimeandNonrecurringCharges
Assumethatyouarevaluingafirmthatisreportingalossof$500million,
duetoaonetimechargeof$1billion.Whatistheearningsyouwouldusein
yourvaluation?
Alossof$500million
Aprofitof$500million
Wouldyouranswerbeanydifferentifthefirmhadreportedonetimelosseslike
theseonceeveryfiveyears?
Yes
No

Aswath Damodaran

16

IV.AccountingMalfeasance.

Thoughallfirmsmaybegovernedbythesameaccountingstandards,the
fidelitythattheyshowtothesestandardscanvary.Moreaggressivefirmswill
showhigherearningsthanmoreconservativefirms.
Whileyouwillnotbeabletocatchoutrightfraud,youshouldlookfor
warningsignalsinfinancialstatementsandcorrectforthem:

Aswath Damodaran

Incomefromunspecifiedsourcesholdingsinotherbusinessesthatarenot
revealedorfromspecialpurposeentities.
Incomefromassetsalesorfinancialtransactions(foranonfinancialfirm)
SuddenchangesinstandardexpenseitemsabigdropinS,G&AorR&D
expensesasapercentofrevenues,forinstance.
Frequentaccountingrestatements

17

V.DealingwithNegativeorAbnormallyLowEarnings
Use
Why
Temporary
Cyclicality:
Life
Leverage
Long-term
Normalize
Value
Average
If
firms
Cycle
firms
are
the
size
Dollar
the
firm
related
average
Earnings
has
earnings
by changed
not
doing
ROE
negative
detailed
(if
orcash
abnormally
low? with Negative or Abnormally Low Earnings
A
Framework
for
Analyzing
Companies
Problems
Eg.
reasons:
Problems:
Operating
flow
changed
Earnings
over
valuing
Auto
forecasts
time
equity)
firm
Young
significantly
(Net
Eg. starting
Income
or average
with revenues and
inEquity
firms
An
Problems:
reduce
over
if
ROC
recession
otherwise
time
and
(ifor
valuing
and
firms
eliminate
Eg.EBIT
Awith
firm)
firm
ifthe
onproblem
current over
infrastructure
healthy
with
time.:
Firm
BV
ofsignificant
made
equity
firmby
with
(if ROE) or current
problems
too
production
(a)
the
BV
Ifof
much
firm
problem
capital
over
debt.
ortime
(if
cost
is ROC)
structural: Target for
problems. margins of stable firms in the
operating
sector.
(b) If problem is leverage : Target for a
debt ratio that the firm will be comfortable
with by end of period, which could be its
own optimal or the industry average.
(c) If problem is operating: Target for an
industry-average operating margin.

Aswath Damodaran

18

Whattaxrate?

Thetaxratethatyoushoulduseincomputingtheaftertaxoperatingincome
shouldbe
Theeffectivetaxrateinthefinancialstatements(taxespaid/Taxableincome)
ThetaxratebasedupontaxespaidandEBIT(taxespaid/EBIT)
Themarginaltaxrateforthecountryinwhichthecompanyoperates
Theweightedaveragemarginaltaxrateacrossthecountriesinwhichthe
companyoperates
Noneoftheabove
Anyoftheabove,aslongasyoucomputeyouraftertaxcostofdebtusingthe
sametaxrate

Aswath Damodaran

19

TheRightTaxRatetoUse

Thechoicereallyisbetweentheeffectiveandthemarginaltaxrate.Indoing
projections,itisfarsafertousethemarginaltaxratesincetheeffectivetax
rateisreallyareflectionofthedifferencebetweentheaccountingandthetax
books.
Byusingthemarginaltaxrate,wetendtounderstatetheaftertaxoperating
incomeintheearlieryears,buttheaftertaxtaxoperatingincomeismore
accurateinlateryears
Ifyouchoosetousetheeffectivetaxrate,adjustthetaxratetowardsthe
marginaltaxrateovertime.

Aswath Damodaran

Whileanargumentcanbemadeforusingaweightedaveragemarginaltaxrate,it
issafesttousethemarginaltaxrateofthecountry

20

ATaxRateforaMoneyLosingFirm
Assumethatyouaretryingtoestimatetheaftertaxoperatingincomefora
firmwith$1billioninnetoperatinglossescarriedforward.Thisfirmis
expectedtohaveoperatingincomeof$500millioneachyearforthenext3
years,andthemarginaltaxrateonincomeforallfirmsthatmakemoneyis
40%.Estimatetheaftertaxoperatingincomeeachyearforthenext3years.
Year1
Year2
Year3
EBIT
500
500
500
Taxes
EBIT(1t)
Taxrate

Aswath Damodaran

21

NetCapitalExpenditures

Netcapitalexpendituresrepresentthedifferencebetweencapitalexpenditures
anddepreciation.Depreciationisacashinflowthatpaysforsomeoralot(or
sometimesallof)thecapitalexpenditures.
Ingeneral,thenetcapitalexpenditureswillbeafunctionofhowfastafirmis
growingorexpectingtogrow.Highgrowthfirmswillhavemuchhighernet
capitalexpendituresthanlowgrowthfirms.
Assumptionsaboutnetcapitalexpenditurescanthereforeneverbemade
independentlyofassumptionsaboutgrowthinthefuture.

Aswath Damodaran

22

Capitalexpendituresshouldinclude

Researchanddevelopmentexpenses,oncetheyhavebeenrecategorizedas
capitalexpenses.Theadjustednetcapexwillbe
AdjustedNetCapitalExpenditures=NetCapitalExpenditures+CurrentyearsR&D
expensesAmortizationofResearchAsset

Acquisitionsofotherfirms,sincethesearelikecapitalexpenditures.The
adjustednetcapexwillbe
AdjustedNetCapEx=NetCapitalExpenditures+Acquisitionsofotherfirms
Amortizationofsuchacquisitions
Twocaveats:
1.Mostfirmsdonotdoacquisitionseveryyear.Hence,anormalizedmeasureof
acquisitions(lookingatanaverageovertime)shouldbeused
2.Thebestplacetofindacquisitionsisinthestatementofcashflows,usually
categorizedunderotherinvestmentactivities

Aswath Damodaran

23

CiscosAcquisitions:1999
Acquired
GeoTel
Fibex
Sentient
American Internent
Summa Four
Clarity Wireless
Selsius Systems
PipeLinks
Amteva Tech

Aswath Damodaran

Method of Acquisition
Pooling
Pooling
Pooling
Purchase
Purchase
Purchase
Purchase
Purchase
Purchase

Price Paid
$1,344
$318
$103
$58
$129
$153
$134
$118
$159
$2,516

24

CiscosNetCapitalExpendituresin1999
CapExpenditures(fromstatementofCF)
Depreciation(fromstatementofCF)
NetCapEx(fromstatementofCF)
+R&Dexpense (capitalized)
AmortizationofR&D
+Acquisitions
AdjustedNetCapitalExpenditures

=$584mil
=$486mil
=$98mil
=$1,594mil
=$485mil
=$2,516mil
=$3,723mil

(Amortizationwasincludedinthedepreciationnumber)

Aswath Damodaran

25

WorkingCapitalInvestments

Inaccountingterms,theworkingcapitalisthedifferencebetweencurrent
assets(inventory,cashandaccountsreceivable)andcurrentliabilities
(accountspayables,shorttermdebtanddebtduewithinthenextyear)
Acleanerdefinitionofworkingcapitalfromacashflowperspectiveisthe
differencebetweennoncashcurrentassets(inventoryandaccounts
receivable)andnondebtcurrentliabilities(accountspayable)
Anyinvestmentinthismeasureofworkingcapitaltiesupcash.Therefore,
anyincreases(decreases)inworkingcapitalwillreduce(increase)cashflows
inthatperiod.
Whenforecastingfuturegrowth,itisimportanttoforecasttheeffectsofsuch
growthonworkingcapitalneeds,andbuildingtheseeffectsintothecash
flows.

Aswath Damodaran

26

WorkingCapital:GeneralPropositions

Changesinnoncashworkingcapitalfromyeartoyeartendtobevolatile.A
farbetterestimateofnoncashworkingcapitalneeds,lookingforward,canbe
estimatedbylookingatnoncashworkingcapitalasaproportionofrevenues
Somefirmshavenegativenoncashworkingcapital.Assumingthatthiswill
continueintothefuturewillgeneratepositivecashflowsforthefirm.While
thisisindeedfeasibleforaperiodoftime,itisnotforever.Thus,itisbetter
thatnoncashworkingcapitalneedsbesettozero,whenitisnegative.

Aswath Damodaran

27

VolatileWorkingCapital?
Amazon
$1,640
419 404
25.53%
$(309)
15.16%
8.71%

Revenues
NoncashWC
%ofRevenues
Changefromlastyear
Average:last3years
Average:industry
AssumptioninValuation
WCas%ofRevenue 3.00%

Aswath Damodaran

Cisco
$12,154

Motorola
$30,931
2547

3.32%
($700)
3.16%
2.71%

8.23%
($829)
8.91%
7.04%

0.00%

8.23%

28

DividendsandCashFlowstoEquity

Inthestrictestsense,theonlycashflowthataninvestorwillreceivefroman
equityinvestmentinapubliclytradedfirmisthedividendthatwillbepaidon
thestock.
Actualdividends,however,aresetbythemanagersofthefirmandmaybe
muchlowerthanthepotentialdividends(thatcouldhavebeenpaidout)

managersareconservativeandtrytosmoothoutdividends
managersliketoholdontocashtomeetunforeseenfuturecontingenciesand
investmentopportunities

Whenactualdividendsarelessthanpotentialdividends,usingamodelthat
focusesonlyondividendswillunderstatethetruevalueoftheequityina
firm.

Aswath Damodaran

29

MeasuringPotentialDividends

Someanalystsassumethattheearningsofafirmrepresentitspotential
dividends.Thiscannotbetrueforseveralreasons:

Earningsarenotcashflows,sincetherearebothnoncashrevenuesandexpensesin
theearningscalculation
Evenifearningswerecashflows,afirmthatpaiditsearningsoutasdividends
wouldnotbeinvestinginnewassetsandthuscouldnotgrow
Valuationmodels,whereearningsarediscountedbacktothepresent,willover
estimatethevalueoftheequityinthefirm

Thepotentialdividendsofafirmarethecashflowsleftoverafterthefirmhas
madeanyinvestmentsitneedstomaketocreatefuturegrowthandnetdebt
repayments(debtrepaymentsnewdebtissues)

Aswath Damodaran

Thecommoncategorizationofcapitalexpendituresintodiscretionaryandnon
discretionarylosesitsbasiswhenthereisfuturegrowthbuiltintothevaluation.

30

EstimatingCashFlows:FCFE

CashflowstoEquityforaLeveredFirm
NetIncome
(CapitalExpendituresDepreciation)
ChangesinnoncashWorkingCapital
(PrincipalRepaymentsNewDebtIssues)
=FreeCashflowtoEquity

Aswath Damodaran

Ihaveignoredpreferreddividends.Ifpreferredstockexist,preferreddividendswill
alsoneedtobenettedout

31

EstimatingFCFEwhenLeverageisStable

NetIncome
(1)(CapitalExpendituresDepreciation)
(1)WorkingCapitalNeeds
=FreeCashflowtoEquity
=Debt/CapitalRatio
Forthisfirm,

Proceedsfromnewdebtissues=PrincipalRepayments+(CapitalExpenditures
Depreciation+WorkingCapitalNeeds)

IncomputingFCFE,thebookvaluedebttocapitalratioshouldbeusedwhen
lookingbackintimebutcanbereplacedwiththemarketvaluedebttocapital
ratio,lookingforward.

Aswath Damodaran

32

EstimatingFCFE:Disney

NetIncome=$1533Million
Capitalspending=$1,746Million
DepreciationperShare=$1,134Million
Increaseinnoncashworkingcapital=$477Million
DebttoCapitalRatio=23.83%
EstimatingFCFE(1997):
NetIncome
(Cap.ExpDepr)*(1DR)
Chg.WorkingCapital*(1DR)
=FreeCFtoEquity

$1,533Mil
$465.90
[(17461134)(1.2383)]
$363.33
[477(1.2383)]
$704Million

DividendsPaid

$345Million

Aswath Damodaran

33

FCFEandLeverage:Isthisafreelunch?

1600

1400

1200

1000

800

600

400

200

0
0%

Aswath Damodaran

10%

20%

30%

40%

50%

60%

70%

80%

90%

34

FCFEandLeverage:TheOtherShoeDrops

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

0.00
0%

Aswath Damodaran

10%

20%

30%

40%

50%

60%

70%

80%

90%

35

Leverage,FCFEandValue

Inadiscountedcashflowmodel,increasingthedebt/equityratiowill
generallyincreasetheexpectedfreecashflowstoequityinvestorsoverfuture
timeperiodsandalsothecostofequityappliedindiscountingthesecash
flows.Whichofthefollowingstatementsrelatingleveragetovaluewouldyou
subscribeto?
Increasingleveragewillincreasevaluebecausethecashfloweffectswill
dominatethediscountrateeffects
Increasingleveragewilldecreasevaluebecausetheriskeffectwillbegreater
thanthecashfloweffects
Increasingleveragewillnotaffectvaluebecausetheriskeffectwillexactly
offsetthecashfloweffect
Anyoftheabove,dependinguponwhatcompanyyouarelookingatand
whereitisintermsofcurrentleverage

Aswath Damodaran

36