Slides 9

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007

Estimating Investmentand Corporate Cash Flows

April 9, 2007 (LA) and March 29, 2007 (OCC)


Assumptions for Cash Flows Sources of Data Computer sources of data Financial models for valuation How and why to use ratio analysis Library Resources


Projecting Corporate Cash Flows

Familiarity with financial analytical techniques in practice

Understand structure of PVFIRM05 and be prepared to use for Part 2 of Group Project

Download Compustat data from Wharton Identify relevant library materials on

companies, industries, and the economy Team organized and functioning


Know where data comes from

S ource of C om pustat D ata

C om pustatD enver

100 analys ts

S tandard and P oor'sInform ation and R atings

B us iness W eek+ others (D odge)

D R IE conom etrics

M cG raw H illH old ing C o.


Source of Compustat Data

Source documents and data entry– Annual reports– 10-Ks and 10-Qs– Manual formatting and input– Cross-checking

Wharton School– wrdsx.wharton.upenn.edu– See “Data Sources” sheet on website


Investment Analysis Project cash flows

– Requires sales projections and assumptions concerning operations and assets

Fundamental analysis versus technical analysis

Graham and Dodd, Warren Buffett, and Copeland et al

Used in securities analysis, investment banking, and lending


Financial Models Pro formas are a useful framework No-one knows the future, analysts must

deal with uncertainty in model assumptions Models must be internally consistent, for

example balance sheets must balance Models focused on valuation are most

concerned with cash flows We will use PVFIRM05, an Excel

spreadsheet


Structure of PVFIRM05 Four “sheets” in Excel “workbook”

– Sheet 1 - Market value of debt and equity– Sheet 2 - Input assumptions needed to calculate

cash flows and pro formas– Sheet 3 - Choosing a discount rate, discussed

nest– Sheet 4 - Present value calculations and

interpretations, discussed at end of semester You have completed Sheet 1


Market Value of the Firm

Value of the entire firm = entity value Sheet 1 calculates market value of the entity

= market value of D + E Entity value is present value of all cash

flows available for investors, whether in form of debt or equity

Cash flows to entire firm discounted at weighted average cost of capital


Advantages of Entity Approach

Focuses on operations and not financing, avoiding problem of changing capital structure through time

Focuses on free cash flow and pinpoints impact of alternative strategies

Free cash flow is net operating profit less an allowance for taxes (NOPLAT) minus necessary investments in working capital and fixed assets

Can focus on explicit forecast period and continuing values after explicit forecast period


Free Cash Flow Free cash flow is same as Baldwin example Net Operating Profit less Adjustment for

Taxes (NOPLAT) - Net Investments Free cash flow does not include interest

expenses (or other financing costs) Net investments are from working capital

and capital expenditures Need sales, operating costs, cash, accounts

receivable, accounts payable, and inventory assumptions


Financial Analysis Required for assumptions concerning future

performance Require historical and comparable firm data but

future may not be like the past We will follow handout Financial Statement

Analysis and Assumptions for Valuation Always apply plausibility check to both ratios,

assumptions, and projections Ratio analysis of projections useful in assessing

plausibility of assumptions


Dupont Analysis of Performance

Dupont Analysis focuses on return on equity (pp. 53f ):

Closest to goal of management Ratios can be calculated in different ways

– Year-ending number balance sheet number or averages of two years

– Before tax or after tax

BVEEACROE


Abbreviations used in Ratios

Abbreviations for accounting values used:

ROE = return on equityEAC = earnings available to commonBVE = book value of equityEBT = earnings before taxEBIT = earnings before tax and interestSLS = salesASSTS = total operating assets


Basic Ratio Approach

ROE can be decomposed into elements:

Focus first on gross return on assets (p. 38)

ROA = “Earning Power” determined by gross profit margin and asset turnover

TurnoverinargMROA

ROE EACBVE

EAC

EBT

EBIT

SLS

SLS

ASSTS

EBT

EBIT

ASSTS

BVE

ROE T M in Turnover LeverageFactors ( ) arg1


Gross Profit Margin (p. 46)

Sales Components of Costs

– Materials– Labor– SG&A– Other

Common size income statement valuable Need assumptions for future on these


Asset Turnover (pp. 50ff) Working Capital

– Inventories

– Accounts Receivable

Look at liquidity and activity ratios– Turnover, days

Current liabilities: trade and bank debt Fixed Assets

– Net vs. Gross

– Turnover, average age

Need assumptions to project these


Valuation in Two Parts Forecast horizon

– Approach stable patterns– Impact of major changes complete

Continuing value (CV) after forecast– Cannot be ignored– Present value of impact depends on when

forecast horizon ends PVFIRM05 uses five year forecast horizon


Approaches to CV Capitalize cash flows or earnings after

explicit forecast period Use multipliers to capitalize which are

based on discount rates and growth rates Multipliers rely on projections of return on

equity (pp. 53-4), sustainable growth rate (p. 74), price-earnings ratio (p. 53), and market-to-book ratio (p. 54)

We discuss CV in detail later


Team Tasks

Computer data downloading Spreadsheet analysis Sales projections and business analysis Financial analysis and formulation of a

range of relevant assumptions Structuring tables, discussion, and reports

for persuasive analysis Plausibility checking and trouble shooting


Part 2 of Group Project

Individual part change assumptions and note effects as in questions

Obtain and analyze data from Wharton data base

Analyze sources, trends, etc., to project sales and ratios to make operating assumptions

Project 5 years cash flows using Sheet 2 of PVFIRM05


Next Week Read Chapter 8 and do (at a minimum)

the assigned problems Prepare Part 2 of the group project and

related individual parts Relate discussion this week to viewing

the acquisition of a firm as an investment of either shares, debt, or a complete corporate acquisition

Slides 9

Economy & Finance