Session 7: Estimating Cash Flows

TL;DR

This content provides a step-by-step process to estimate cash flows, including determining the type of cash flows (equity or entire business) and adjusting for factors such as leases and R&D expenses.

Transcript

these last few sessions have been about establishing a cost of financing a cost for a business and most analysts spend the substantial amount of the evaluation time estimating a cost to capital or discount rates but here is a harsh reality when you're going to mess up an evaluation I'm not suggesting that's a good objective it's because you get the... Read More

Key Insights

• 💰 Estimating cash flows accurately is crucial in valuation. It involves accounting earnings, taxes, reinvestment needs, and debt service. Cash flows can be estimated for equity investors or for the entire business.
• 💵 When estimating cash flows to equity investors, dividends, stock buybacks, and potential dividends are commonly used. Potential dividends estimate what a company could have paid out instead of what it actually paid.
• 💼 To estimate pre-debt cash flows for the entire business, start with operating income and account for taxes and reinvestment needs.
• 📊 When valuing a company, it is important to use up-to-date earnings instead of relying on outdated financial reports. Trailing 12-month earnings are often used for this purpose.
• 🔄 Normalizing earnings is essential, especially for commodity or cyclical companies. Look at what the company can earn in a normal year, taking into account industry fluctuations.
• 📉 Retail and other businesses that lease assets should reclassify lease commitments as financial expenses rather than operating expenses. Discounting these lease commitments to present value gives a more accurate representation of the company's debt.
• 💡 R&D expenses should be treated as capital expenses since they generate benefits over multiple periods. By capitalizing R&D, you can adjust operating income, return on capital, and ultimately the company's valuation.
• 🔢 When computing taxes, it is best to use a combination of the effective tax rate and the marginal tax rate. Use the effective tax rate for the near future and gradually transition to the marginal tax rate for the distant future.
• ⚙️ When estimating cash flows, expand the definition of capital expenditures to include R&D and acquisitions. Consider non-debt current liabilities for working capital and exclude cash, as it is not a wasting asset.
• 💸 Free cash flow to equity is a measure of potential dividends. It starts with net income and subtracts net capex, change in working capital, and net cash flow from new debt issues, then adjusts for debt repayments.

Questions & Answers

Q: Why is estimating cash flows important in business valuation?

Estimating cash flows is crucial for accurate business valuation because an incorrect estimation of cash flows can significantly impact the valuation results. It is often the cause of evaluation errors rather than errors in discount rates or cost of capital.

Summary & Key Takeaways

• Estimating cash flows is crucial for accurate business valuation, and it involves four steps: starting with accounting earnings, considering tax payments, factoring in reinvestment needs, and accounting for debt service.

• Cash flows can be estimated either for equity investors (dividends, stock buybacks, or potential dividends) or for the entire business (starting with operating income and adjusting for taxes and reinvestment needs).

• Adjustments may need to be made for lease expenses (treating them as operating leases or financial expenses) and R&D expenses (capitalizing and amortizing them over their useful life).