Whither cash flow? Whence value? Chapter I

Abstract

Recent changes in the structure, character and behavior of business organizations, as well as capital, product, and service markets, have been turning traditional cash flow and "multiple" valuation methods on their respective heads. How is it that afirm like amazon. com (as of March 2000) can be selling at $62 per share while having losses of $2.18 per share? What economic measure is being valued? Exactly how do we price such an investment? In another instance, think about what happened to Proctor & Gamble in March of this year. Announcement of a relatively moderate earnings decline created a huge loss in share value ($40 MMM), with the price/earnings multiple falling from 37 to 19! It has been claimed that this was actually a complete revaluation using a different model of pricing.1

Closer to home, suppose you as a credit executive, ergo finance expert, have been invited (coerced, impressed, etc. ?) to participate in the process of valuing an acquisition target? You find out that your company's goals are to add to market share, and that the "target" has no earnings, and therefore, little or no cash flow on which to base an analysis of value. You might be able to project cash flows on your own and discount them in the traditional fashion. The result, however, may lead to a price that is substantially above or below market value. If it is above, then you overpay; if below, you don't secure a deal. So how do we determine this price?

These and other valuation issues will be discussed in a two part series beginning with this article. This first article will examine two approaches to valuation using a discounted cash flow methodology. The critical lesson to be learned here relates to the value of having continuous access to financial capital. What will be shown is that in cases where debt financing used to fund an investment can be rolled over, the value of that investment can be substantially greater than in cases where the debt is paid off. Further, these examples will illustrate the importance of understanding and properly measuring the cost of capital While most traditional valuation

modeling examples assume capital costs to be constant, the analysis here shows that a changing cost of capital over time will have a significant effect on the value of a corporate investment. This implies that the investor's access to capital markets will influence the price to be paid The second article will outline different methods of comparison valuation using economic multiples. These models will then be viewed in the context current activity in the high growth end of the public equity markets, where many of the traditional valuation models no longer seem to apply.

Discounted Cash Flow Methods of Valuation The Traditional Approach

The traditional approach to valuation has always been to estimate a series of net cash flows and discount them using a return factor that provides adequate compensation for risk. These risks include both business and financial risks. Business risk is based on the real asset structure (including consideration of products, services, market opportunities, organization and efficiency of the firm, etc). Financial risk is based on the choice of financing mix (debt versus equity in the capital structure). More will be said about the discount factor further below.

The above estimation of net cash flows is based on the principle that the operating and financial cash flows are separated in the valuation process. As a result, the analysis of net cash flows begins with an operating income (earnings before interest and taxes). To convert the income to a cash flow, depreciation and amortization expenses are first added back. This is done because they are non-cash flow expenditures that have resulted in a reduction of EBIT. Capital expenditures that may be needed to maintain the economic viability and operating efficiency of the fixed assets are then deducted. The final two items, changes in current assets and liabilities are commonly combined to create the "change in working capital." Working capital investments may create a negative cash flow (when investment is increasing) or a positive cash flow (when investment is decreasing). In most cases, the simple thing to do is estimate the net working capital as a percentage of sales. If you do this, then each year's working capital investment is simply the working capital percentage multiplied by the change in sales. It is important to note that when separating the operating from financial cash flows that current liabilities should not include interest-bearing debt. Such debt is more properly considered as capital.2

In order to properly value a transaction, it is also important to account for a "terminal" cash flow to be included in the final period of the cash flow analysis. For example, if you were to invest in a piece of capital equipment to be used for ten years, what would it be worth at the end of that time? Such a value should be included in your cash flow analysis, especially if you are valuing a going concern.

In some cases, the terminal value is accounted for under the hypothesis of "liquidation." In this case, it is assumed the asset (or business entity) will be disposed of and/or not operated (by anyone) beyond the final year of the cash flow analysis. Liquidation values may include, salvage revenues, recovery of working capital assets and/or recovery of the book value of any other assets liquidated. These values should be adjusted to reflect any taxes paid or credits received as a result of capital gains or losses.

Determination of the Discount Factor

Choosing an appropriate discount factor is often challenging because of the elusive nature of the cost of capital. Several factors need to be considered, including, 1) the structure of the capital that enables the transaction; 2) whether that capital structure will be stable over time; 3) whether the cost of the different components of the capital structure will be constant over time. In the simple case where the capital structure and its component costs are constant, use of a single weighted-average cost of capital is appropriate. This is especially true when valuing an investment that represents a relatively small portion of a larger company-wide investment portfolio.

Individual component costs of capital are generally determined as a result of market transactions. For debt, the interest rate on a loan or yield to maturity (at issue) generally becomes the cost of capital to the borrowing firm. The cost of equity, however, is more difficult to determine. The cost of equity includes three components: 1) a risk free rate; 2) a business risk premium; 3) a financial risk premium. With private sources of equity capital this information can be communicated directly between the provider and user of the capital. In public market transactions, the cost of equity needs to be imputed by observation of market trading activity. Measuring the cost of equity capital has been the subject of a fierce debate in the finance field for quite some time, and can not be resolved in the space that we have here.

Discounting to Determine Value

A simple example of estimating the value of an asset, in this case the purchase of a self standing business unit is provided in Exhibit A. The pro forma income statement items are displayed in lines 4-13. The operating net income values are converted into net cash flows in lines 18-24. The terminal value (Column N, Line 22) is driven by a growth assumption of 4%. The proposed purchase price is $200MM (line 27), with capital consisting of $120MM in debt and the remainder in equity financing. The debt is split evenly between a two-year note at 7%, a fiveyear note at 9% and a ten-year note at 11%. The equity cost is estimated to be 20%. This yields a weighted average cost of capital (WACC) of 11.24% (see lines 32-38 for this calculation). Cash flows are forecasted for a period of 12 years.3 In this example, the capital structure and component costs are assumed to be constant over the twelve-year period of the analysis.

To determine value, each annual net cash flow is discounted by the WACC of 11.24% (see line 26). The total present value of the net cash flows is $246MM (Col. B, Line 26), which would indicate that the purchase price of $200MM creates an advantage to the buyer. Of course it is imperative to keep in mind that the cash flows are nothing more than estimates, and that realization of the $246NM in value depends upon the materialization of the cash flows, as well as a constant, renewable capital structure at a cost of 11.24%. Changes in the cash flows, capital structure, component costs and/or renewability of the capital will result in a different value realized from the transaction. A good analysis will include a variety of scenarios to establish the degree of risk exposure to the buyer. In many highly levered transactions such as the one in our example, chances are that the debt will be paid down or paid off. Should this affect the value of the transaction? The buyer is still paying for the same assets, and therefore, the operating cash flows are the same. Paying off the debt, however, creates a situation similar to that requiring an additional infusion of capital to sustain the investment. This should have an impact on the price paid for the investment, leading us to the discussion of another method of cash flow analysis and valuation.

Variations in the Traditional Model: Free Cash Flows and Specific Discount Factors

In 1986, inside investors paid $71 per share for the stock of R.H. Macy. The $3.3MMM purchase was financed with $3.OMMM in debt, half of which were loans that required repayment within two years. As we all know the firm sought bankruptcy protection rather than pay much of that debt in 1988. One study showed that the only way to justify a price of $71 per share was to discount a ten year cash flow using a weighted average cost of capital based upon the initial buyout capital structure. This is the same as was done in our example above. What the analysis at the time apparently failed to account for was the impact of the immediate need to pay back the debt. Payback of debt has a substantial impact on the cash flows and needs to be considered explicitly in valuing a highly leveraged transaction. One way to properly account this is to measure and value an equity free cash flow.

As can be seen by comparison to the formula for operating net cash flows, the equity free cash flow will generally be lower. The equity free cash flows represent the residual available to equity investors after all operating and financial payment obligations for the year have been met. Operating cash flows, on the other hand, represent cash available for distribution to all capital providers, both debt and equity.

When discounting equity free cash flows it is important to recognize that the appropriate cost of capital is one that reflects only the risk-adjusted cost of equity. It is further important to note that the cost of equity itself will change as the debt is paid off due to the reduction in the financial risk premium assigned by investors.

Applying the discounted equity free cash flow method to the earlier example of valuing a highly leveraged buyout transaction leads to an entirely different valuation if we assume that the debt needs to be repaid rather than rolled over. It is important to keep in mind here that the operating assets are the same in each variation of the transaction. What differs is the structure and component costs of capital.

Turning to Exhibit B, it can be seen in line 23 that the equity free cash flows for the transaction are negative in the first three years, and also substantially negative in each of the years in which a debt principle payment is made. The cost of equity capital is assumed (for the example) to be 14% in the zero debt case, and 20% in the case where DIE is 1.5. Given these two values, it is possible to generate an equation that will re-compute the cost of equity for each year. In line 26, the equity invested is computed by adding the net income to equity from the prior period. The debt/equity ratio is calculated in line 27, and the cost of equity capital (line 28) is then calculated using formula [4]. The cumulative cost of equity capital is the computed in line 29, using formula [5j. This is then used to discount the free cash flows, with the result showing in line 31. The total present value of the equity free net cash flows is $54.39MM. It is important to recall that this value reflects only the equity position. To value the entire transaction, it is necessary to add the debt to the equity value, arriving at a total transaction value of $174.39NM. This falls well below the proposed buyout price of $200.OOMM and signals to the buyer that the price and/or structure of the deal should be renegotiated.

Explaining the Differences in Results

There is, in economics, a principle known as the law of one price. This law holds that any two identical assets should have the same price in an open market. We all know that price reflects value. What this example shows is that the value of ownership of this set of operating assets depends upon how purchase of those assets is financially structured. In the first case, where the buyer is presumed to have permanent access to debt capital by rolling over issues that are due, the value of the cash flows generated by those operating assets is $246.58MM. Where access to such permanent debt is not available, the value of the same operating cash flow stream is reduced to $174.39MM. If two firms were competing to purchase the operating entity in this case, that with greater access to permanent debt capital will win the battle. This shouldn't surprise us. Maintaining access to the capital markets is a primary goal of almost any company's financial management strategy.

What this example should alert us to is the importance of paying attention to financial structure and changes in the cost of capital in a valuation procedure. A procedure that does not properly account for debt servicing and payoff as well as potentially changing capital costs may end up causing a buyer to pay too much for a business entity, as the buyers of Macy's did in 1986. Properly accounting for the impact of these changes will make for a more astute and wellprepared investor.

While this article has addressed the question of how to measure the cost of capital only to a limited degree, the examples here should provide the reader with a good context and model in which to frame a valuation analysis. This should also help the reader develop an awareness of some of the trickier issues to be resolved in cash flow analysis. The next article in this series will address the application of comparison multiplier methods of valuation in today's markets.

Working copies of the spreadsheets (Exhibits A & B) are available on the Credit Research Foundation website at www. cn`online. org

1 Traditional P/e and other "multiple" models could not account for the high price of P&G prior to the announcement. Following the announcement, the more traditional models seemed to account for the lower price. See Floyd Norris, "When the News Turns Bad, Valuation Suddenly Matters," The New York Times March 10, 2000, pg. CI.

2 This may be subject to debate. If a firm maintains a stable level of interest bearing short-term debt, this can be considered as permanent capital and included with the capital structure. Under those circumstances, the impact on valuation will be picked up in the cost of capital, or discount factor, which is discussed further below. If the level of short-term debt is more volatile from year to year, it may be appropriate to include it as a cash flow rather than as capital, but then ideally the interest payments should be included in the cash flow calculation as well.

3 The twelve-year period was chosen for expositional reasons. Typically a period of ten years or less in used in most cash flow analyses.

4 T-bill returns are devoid of a risk premium for time, but the yields on longer term T-bonds are considered to be less volatile, and therefore> many prefer their use as a risk free rate. The difference between the two is usually about one percent.

5 Stocks, Bonds, Bills & Inflation Annual Yearbook, (Chicago, Ibbotson Associates, updated annually)

6 While the financial risk premium is more likely a non-linear function of the DIE ratio, a linear function is easier to work with for expositional purposes.

7 For example, see Shannon Pratt, et.al "Valuing a Business" 3"d Edition, McGraw-Hill, New York 1996.

Steven G Isberg, Ph.D. is currently serving as Credit Research Fellow at the Credit Research Foundation. He is also Associate Professor of Finance at the Robert G. Merrick School of Business, University of Baltimore He has developed a professional expertise in the area of valuation, where his experiences include teaching both university and professional development courses, consulting and serving as an expert witness in a number of litigation proceedings.

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