Cash Flows and the Risk Premium
What do you call an economist who doesn't make assumptions? An accountant.
Lecture 2 is divided in two parts. Part 1 seeks to give you some insight into the kind of issues that you will face when undertaking a valuation exercise. Part 2 provides you with a somewhat detailed analysis of accounting statements and their use in financial valuation analysis.
Beginning with valuation issues, I chose to focus on something that people normally take for granted - the discount rate. Some of the choices we are required to make in formulating a discount rate (measure of risk) include assessing the risk free rate and the risk premium. Risk is a relative measure, and the risk free rate provides us with a reference point to which we can relate risky assets. A discount rate of 5%, 10%, 30% is meaningless unless we know what the risk free rate is delivering. By this very definition, in theory there should only really be a single risk free rate, but due to capital constraints (and other issues that prevent the arbitrage to a single rate) we normally have a range of rates to deal with.When selecting a risk free rate, you should choose a rate where the expected variance around the return is close enough to zero and where the degree of re-investment risk is also in that range (this just means it should be long-term i.e. >10 years). Although this process is not very difficult in terms valuing a company in the Australian, American, European market (or any other developed part of the world), finding a proxy for countries with less developed exchanges is a more difficult problem.For this kind of problem we normally can try and approximate the rate by using the rate of a country with a similar credit rating. There are problems with this approach and this will discussed in a later post.
One final issue I discussed in relation to the risk free rate was the issue of double counting. Given the definition of the risk-free rate, it is always concerning to see a valuation done on a Greek company (let's not discriminate now - there is also the Spanish, Irish, Portuguese, Italian etc..) where analysts will proxy the yield on 10 year Greek bonds as the risk-free rate. They are trading at ~ 12.85% at the moment after Moody's downgraded its debt to B1. With a yield this high at a credit rating in the B's - this is hardly a risk-free asset. It therefore, makes no sense to use this number when trying to work out the return on equity of an asset (through something like the CAPM). The economic risk will and should be reflected in the risk premium and therefore a more appropriate risk free rate can be devised from using the yield on some long term Euro-bond contract.
Enough about the risk free rate and on to the risk premium. We know this number is going to move around a lot depending on market conditions and the collective behaviour of investors. The risk premium is what you demand as an investor to invest in the stock market. In the middle of the GFC when central banks were dropping their rates to get economies moving, the risk premium was moving in the opposite direction. A lack of confidence in the economy and equities markets, compounded by a massive shift in funds to safer securities will drive the risk premium to stratospheric levels. Therefore, when conducting a valuation analysis, if you are tempted to change the risk free rate because it appears too low, think again because chances are this has happened for a reason, and the risk premium will also be affected. The risk premium like the risk free rate should also not be taken for granted. Most practitioners advocate a rate of about 6% - which reflects a historical average of 100 years of data. In settling with this number we should be aware of the measurement problems, and issues regarding survivorship bias in the estimated figure.
Hopefully, the description above will alert you to the fact that valuation analysis won't be easy. Your assumptions will need to be thought out. Fortunately for you there are no wrong answers. While there are "best-practices", we generally divide responses into acceptable and not-so-acceptable solutions. If you have managed to digest at least half of the above message - GREAT! We will be re-visiting this later down the track where hopefully you will pick up the other half.
Now on to the accounting. Financial statements in isolation do not give us the information we need to value a company. We need to understand the nature of the business, the position of the firm within the industry and also understand the macro environment to be able to yield anything meaningful from financial statements. From this point financial statement analysis will be able to tell us about company efficiency, asset utilisation practices, its ability to handle leverage or even pay dividends.
The 3 financial statements that we will concentrate on are the P&L statement, the Balance Sheet and the Cash Flow Statement. The first records a company's performance, the balance sheet records the cumulative position of the firm and a cash flow statement records movements in cash for the firm over the fiscal year. Companies follow an accrual accounting system which just means that costs and benefits are recorded at the time of sale rather than when cash is exchanged. As such, its gives a clearer indication of performance. One should be familiar with definitions of assets, revenues, expenses etc... because while most account descriptions are obvious, when deciding where something belongs (in a valuation exercise) we should not just take an accounting classification as given. I illustrated in class how something like Research and Development costs, or costs related to operating leases can have significant ramifications for how we interpret performance.
According to accounting rules (for most places) if something is developed internally it needs to be expensed even if it is something like a patent or R&D. Doing so from a valuation perspective means that if you take a company in pharmaceuticals like CSL or Pfizer who have a high level of intangible assets, by expensing R&D (a significant proportion of overall expenses) instead of capitalising it then you are significantly overstating the actual return on invested companies. For the purpose of measuring company performance, if the benefit of the expense is expected to prevail and last more than a single period and is also in a sector where R&D is needed to sustain operations (i.e. Biotech, Technology, Pharmaceutical, Mining to an extent) then capitalising what accountants expense should be a consideration. It will give us a better representation of what a company is earning on its investment (artificially boosting the return on invested capital). So in conclusion (although once again don't worry if you haven't digested all of this because we will return to this later) capitalising instead of expensing R&D will generally decrease ROIC because of the increase in invested capital, increase gross profit margins because your expenses decline and there should probably not be a difference in terms of net income (although once again, this will not always be the case).
Finally, we moved onto free-cash flow (I may be moving a little fast here but you can refer back to this later when we explore this in more detail). This is the number we are interested in for valuation analysis. This is ultimately the number that will help us determine firm value which we determine via the accounting framework. From a definitional perspective, FCFs are the cash available to suppliers of capital after operating expenses have been paid and necessary investment in working capital and fixed assets have been made. FCF's can be determined either directly or indirectly - indirectly though will be our focus (be careful as my view of direct and indirect may not be akin to others). The model that i presented in class will be the initial focus. This is the FCF to all stakeholders, otherwise known as the Free cash flow to the firm (FCFF):
Right, no more jokes from me (really!) and that sums up Lecture 2.
Lecture 2 is divided in two parts. Part 1 seeks to give you some insight into the kind of issues that you will face when undertaking a valuation exercise. Part 2 provides you with a somewhat detailed analysis of accounting statements and their use in financial valuation analysis.
Beginning with valuation issues, I chose to focus on something that people normally take for granted - the discount rate. Some of the choices we are required to make in formulating a discount rate (measure of risk) include assessing the risk free rate and the risk premium. Risk is a relative measure, and the risk free rate provides us with a reference point to which we can relate risky assets. A discount rate of 5%, 10%, 30% is meaningless unless we know what the risk free rate is delivering. By this very definition, in theory there should only really be a single risk free rate, but due to capital constraints (and other issues that prevent the arbitrage to a single rate) we normally have a range of rates to deal with.When selecting a risk free rate, you should choose a rate where the expected variance around the return is close enough to zero and where the degree of re-investment risk is also in that range (this just means it should be long-term i.e. >10 years). Although this process is not very difficult in terms valuing a company in the Australian, American, European market (or any other developed part of the world), finding a proxy for countries with less developed exchanges is a more difficult problem.For this kind of problem we normally can try and approximate the rate by using the rate of a country with a similar credit rating. There are problems with this approach and this will discussed in a later post.
One final issue I discussed in relation to the risk free rate was the issue of double counting. Given the definition of the risk-free rate, it is always concerning to see a valuation done on a Greek company (let's not discriminate now - there is also the Spanish, Irish, Portuguese, Italian etc..) where analysts will proxy the yield on 10 year Greek bonds as the risk-free rate. They are trading at ~ 12.85% at the moment after Moody's downgraded its debt to B1. With a yield this high at a credit rating in the B's - this is hardly a risk-free asset. It therefore, makes no sense to use this number when trying to work out the return on equity of an asset (through something like the CAPM). The economic risk will and should be reflected in the risk premium and therefore a more appropriate risk free rate can be devised from using the yield on some long term Euro-bond contract.
Enough about the risk free rate and on to the risk premium. We know this number is going to move around a lot depending on market conditions and the collective behaviour of investors. The risk premium is what you demand as an investor to invest in the stock market. In the middle of the GFC when central banks were dropping their rates to get economies moving, the risk premium was moving in the opposite direction. A lack of confidence in the economy and equities markets, compounded by a massive shift in funds to safer securities will drive the risk premium to stratospheric levels. Therefore, when conducting a valuation analysis, if you are tempted to change the risk free rate because it appears too low, think again because chances are this has happened for a reason, and the risk premium will also be affected. The risk premium like the risk free rate should also not be taken for granted. Most practitioners advocate a rate of about 6% - which reflects a historical average of 100 years of data. In settling with this number we should be aware of the measurement problems, and issues regarding survivorship bias in the estimated figure.
Hopefully, the description above will alert you to the fact that valuation analysis won't be easy. Your assumptions will need to be thought out. Fortunately for you there are no wrong answers. While there are "best-practices", we generally divide responses into acceptable and not-so-acceptable solutions. If you have managed to digest at least half of the above message - GREAT! We will be re-visiting this later down the track where hopefully you will pick up the other half.
Now on to the accounting. Financial statements in isolation do not give us the information we need to value a company. We need to understand the nature of the business, the position of the firm within the industry and also understand the macro environment to be able to yield anything meaningful from financial statements. From this point financial statement analysis will be able to tell us about company efficiency, asset utilisation practices, its ability to handle leverage or even pay dividends.
The 3 financial statements that we will concentrate on are the P&L statement, the Balance Sheet and the Cash Flow Statement. The first records a company's performance, the balance sheet records the cumulative position of the firm and a cash flow statement records movements in cash for the firm over the fiscal year. Companies follow an accrual accounting system which just means that costs and benefits are recorded at the time of sale rather than when cash is exchanged. As such, its gives a clearer indication of performance. One should be familiar with definitions of assets, revenues, expenses etc... because while most account descriptions are obvious, when deciding where something belongs (in a valuation exercise) we should not just take an accounting classification as given. I illustrated in class how something like Research and Development costs, or costs related to operating leases can have significant ramifications for how we interpret performance.
According to accounting rules (for most places) if something is developed internally it needs to be expensed even if it is something like a patent or R&D. Doing so from a valuation perspective means that if you take a company in pharmaceuticals like CSL or Pfizer who have a high level of intangible assets, by expensing R&D (a significant proportion of overall expenses) instead of capitalising it then you are significantly overstating the actual return on invested companies. For the purpose of measuring company performance, if the benefit of the expense is expected to prevail and last more than a single period and is also in a sector where R&D is needed to sustain operations (i.e. Biotech, Technology, Pharmaceutical, Mining to an extent) then capitalising what accountants expense should be a consideration. It will give us a better representation of what a company is earning on its investment (artificially boosting the return on invested capital). So in conclusion (although once again don't worry if you haven't digested all of this because we will return to this later) capitalising instead of expensing R&D will generally decrease ROIC because of the increase in invested capital, increase gross profit margins because your expenses decline and there should probably not be a difference in terms of net income (although once again, this will not always be the case).
Finally, we moved onto free-cash flow (I may be moving a little fast here but you can refer back to this later when we explore this in more detail). This is the number we are interested in for valuation analysis. This is ultimately the number that will help us determine firm value which we determine via the accounting framework. From a definitional perspective, FCFs are the cash available to suppliers of capital after operating expenses have been paid and necessary investment in working capital and fixed assets have been made. FCF's can be determined either directly or indirectly - indirectly though will be our focus (be careful as my view of direct and indirect may not be akin to others). The model that i presented in class will be the initial focus. This is the FCF to all stakeholders, otherwise known as the Free cash flow to the firm (FCFF):
FCFF = NI + I(1-T) - ∆CAPEX – ∆WC + NCC (1)
NI = Net Income after Tax (NPAT)
I(1-T) = after tax interest cash flow
∆CAPEX = The change in fixed capital investments.
∆WC = The change in working capital investments.
NCC = Non-cash charges like depreciation and amortisation charges
By building pro-formas, which are just forecasted accounting statements, we can use these statements to work out future CFs.
Looking at the equation above, we start with net income and add back any non-cash flows. Obvious items as such include depreciation and amortisation charges are such that cash is not leaving your pocket. Depreciation arises out of a matching principle (i.e. matching expenses with revenues, so the more you use a piece of equipment to generate revenue the more you should expense it) and so these need to be added back to net income.
If we are trying to work out how much cash we earned in the actual period and made sales (i.e. made the sale) for which we didn't receive the cash then we should not include that in the current period's cash flow. This is part of working capital which is investment required in cash, inventory etc.. to grow and sustain a company in the short run. If we are an aggressive company it is likely we might offer attractive payment terms and such our working capital will be larger (more in accounts receivable) Therefore, in terms of the change in working capital which is this year's WC - last years WC, an increase in working capital is deducted from cash flows since it reflects an increase in investment.
The same applies for fixed investments (CAPEX). CAPEX can be calculated by looking at Net PPE on the balance sheet in successive years. How much I spend on CAPEX is a function of the net PPE position in the current year - net PPE in the previous year + the depreciation expense in the current year. Why is this the case? A company has to sustain its current operations. If every year for example it is depreciating $100 worth of assets it will need to repurchase this to keep its asset position in the same position. This represents a cash expenditure that needs to be factored into our cash flow analysis.
After-tax interest expense must be added back to net income to arrive at FCF's to the firm (remember this definition includes the claims of debt and equity holders). Recognising the tax savings we get from employing debt in our capital structure we therefore only add back the after tax amount and not the gross amount.
If we are trying to work out how much cash we earned in the actual period and made sales (i.e. made the sale) for which we didn't receive the cash then we should not include that in the current period's cash flow. This is part of working capital which is investment required in cash, inventory etc.. to grow and sustain a company in the short run. If we are an aggressive company it is likely we might offer attractive payment terms and such our working capital will be larger (more in accounts receivable) Therefore, in terms of the change in working capital which is this year's WC - last years WC, an increase in working capital is deducted from cash flows since it reflects an increase in investment.
The same applies for fixed investments (CAPEX). CAPEX can be calculated by looking at Net PPE on the balance sheet in successive years. How much I spend on CAPEX is a function of the net PPE position in the current year - net PPE in the previous year + the depreciation expense in the current year. Why is this the case? A company has to sustain its current operations. If every year for example it is depreciating $100 worth of assets it will need to repurchase this to keep its asset position in the same position. This represents a cash expenditure that needs to be factored into our cash flow analysis.
After-tax interest expense must be added back to net income to arrive at FCF's to the firm (remember this definition includes the claims of debt and equity holders). Recognising the tax savings we get from employing debt in our capital structure we therefore only add back the after tax amount and not the gross amount.
Right, no more jokes from me (really!) and that sums up Lecture 2.
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