Trying Free Cash Flows to Market Valuations

1. Introduction
§ In a companion piece to his article in the last issue*, Robert Howell turns his attention to the importance of free cash flow in determining valuations
§ Fixing Financial Statements:
i. Traditional format → must be redesign → useful for:
Meaningful financial analysis
Decision making
Value creation
§ Objective of business → increase real shareholders value → increase NPV
§ Financial statement → put more emphasis on the free cash flows

2. Relating Free Cash Flows to Market Values
§ A firm market value → reflects the collective judgment of the shareholders’ expectation of its future cash flow
i. If the expected cash flow:
Constant → market value constant
Better → market value rise
Worse → market value erode
§ Assume a firm has positive cash flow $100 million → assume it is perpetuity
i. A perpetuity valuation model → capitalize → annuity stream using the firm’s cost of capital as discount rate
ii. Free cash flow $100 million divided by yields 0.1 → NPV $1 billion
iii. This $1 billion is equal to entity value → represent the NPV for a stream of $100 million
iv. Debt s have to be subtracted from firm’s entity value → determine how much value accrues to the equity shareholders / equity value
v. If:
Market value > equity value → market expect free cash flow to improve
Market value < equity value → market expect free cash flow to erode § Perpetuating negative cash flow → negative value § We may start with the firm’s market value → multiply by firm’s cost of capital → to calculate free cash flow would be required to justify market price i. Dot-com company with $10 billion and estimated cost of capital → $1.5 billion in free cash flow § Management should regularly undertake those process to their own firm § Invertors should do the same to each infestation

3. Managing for Free Cash Flows and Shareholder Value Creation
§ Management’s fundamental responsibility → increase shareholders value
i. Requires increasing the NPV of the future stream of cash flow
§ Three ways to do it:
i. Increase cash earnings by growing the business
Growth improve free cash flows → has to take into account additional investment in working capital and capital expenditures required to support the growth
Cost management → spending more to increase cash earnings and free cash flows
Good cost management may means:
o Spending to develop new products or support customers
o Finding ways to take costs out of products without effecting their perceived value
o Reducing administrative cost

ii. Reduce investments
Means managing working capital and fixed and other assets more tightly
That might mean:
o Collecting receivables more quickly → Dell
o Turning inventories faster → Toyota
o Getting out under fixed assets via outsourcing → Nike
o Focusing more attention on intangible asset performance

iii. Financial management
It has two primary elements:
o Managing the mix of capital to minimize the firm’s weighted average cost of capital
a. Means increasing the proportion of debt capital that is less expensive than equity capital
o Using free cash flow → increase the company’s future value
a. Many mature company pays dividend
b. Shareholders must pay taxes of the dividend
§ Most business have variety of products and products group
§ Each product’s life cycle, positioning, competitive strength, and investments requirements influences its cash flow pattern and value-creating contribution
§ The ultimate financial management challenge is to use free cash flows to invest in new business opportunities that build shareholder value

4. Xerox Corp. Profits vs. Cash Flows
§ Xerox Corp. provides a classic example of how potentially misleading accounting profits can be
i. Year 1998 is excellent year → EPS were up to 16 %, income were up to 17 %
ii. After annual report was released, Xerox stocks climbed to nearly $64 per share
§ Bad news in 1999:
i. Softness in its significant Brazilian market
ii. A profit warning for the third quarter that stunned Wall Street
iii. Another warning and large earning shortfall for the fourth quarter
§ Speculation emerge → Xerox might file for bankruptcy
i. Stock fell to $5 per share
ii. Lost more than 90 % of its value
§ Revenues were up in 1998; margins before restructuring were better and profits would have been up slightly.
i. Revenues dropped in 1999, but profit held up
ii. The market expected more → the market valuation slid
§ In three year period, Xerox burned close to $2 billion in cash before interest payments and dividend distributions
§ In three year period, reported earnings aggregated more than $3 billion, cash flows were more than negative $5 billion
§ In early April, it agreed to restate earnings for four year period and pay a $10 million fine to the security and the exchange commission
§ What Xerox did was attribute more of its leasing transactions to current revenues and profits than it should have

5. Metrics to Monitor Free Cash Flows and Value Creation
§ Traditional financial statement analysis has focused on measure:
i. Profitability focused on “return on assets” and “return on equity”
ii. Risk measures focused on “liquidity” and “solvency”
§ ROA suffers on two counts
i. The return numerator of net operating profit after taxes (NOPAT) is suspect because of the many deficiencies of accrual-based earnings
§ ROE measures fail for same reasons
§ Return on invested capital (ROIC) → NOPAT divided by the investments in the business-working capital property, plant and equipment and intangible assets
§ To create shareholders value → ROIC must exceed the firm’s WACC.
§ To use ROE, the equity base must be the market value
i. Market based ROE > estimated shareholder cost of capital → the firm is creating value for shareholders
§ The classic liquidity measures focused on the relationship of current assets to current liabilities
i. More is better is deficient on the last two counts:
It fails to recognize the flow characteristics of working capital
Having fewer resources tied up in working capital is better in that it reduces the amount of cash required to support growth and improves ROIC
§ Solvency measures are the times-interest earned ratio and various debt-to-capital ratios

6. Summary
§ Free cash flow have to be the focus of major financial statement overhaul
§ Free cash flow may be directly related to current market valuations to determine if the current free cash flows support current market values