Free Cash Flow (FCF), Economic Value Added (EVATM), and Net Present Value (NPV):A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation

1. Abstract
§ The paper assist the user of DCF methods by clearly setting forth the relationship of free-cash-flow (FCF) and economic value added (EVATM) concept to each other and to the more traditional applications of DCF thinking such as NPV
§ The equivalence between EVA and NPV, approaches:
i. Links the problems of security valuation, enterprise valuation, and investment project selection
ii. Relates to more directly use of standard financial accounting information
§ FCF approach → focuses on the periodic total cash flows obtained by deducting total net investment and adding net debt issuance to net operating cash flow
§ EVA(TM) approach → requires defining the periodic total investment in the firm
§ FCF and EVA(TM) are equivalent to NPV

2. Introduction
§ The use of DCF method for investment decision making and valuation is well entrenched in finance theory and practices
§ Modern literature has broadened application of DCF techniques → capital budgeting and security valuation problems
§ Free cash flow → security valuation
§ Economic value added → managerial performance evaluation

3. Cash Flow
a. The cash budget identity
i. Consider the single period cash budget identity
ii. The components are operating revenues and cost, net security issuance, interest payments, dividend payments, taxes paid, and net investment.
iii. Investment maybe divided into working capital and long-term investment
iv. In practice, use of accounting information for economic analysis requires a number of adjustments to bring the accounting numbers into conformity with economic reality
v. Sources = Uses
Rt + ∆Bt = Ot + Intt + Divt + Taxest + ∆It + ∆WCt

b. Dividends
i. Divt = (Net profit after tax + depreciation) – total net investment + net debt issuance

c. Divisions of cash flow among investors
i. Cash flow to equity (CFE is equivalent to our expression for dividend
ii. Proponents of the FCFE method emphasize that FCFE is dividends that could be paid to shareholders
iii. The difference between FCFE and dividends paid in given year maybe characterized as investment in “excess marketable securities” and its omission from consideration is moot so long as such investments have zero NPV
iv. Cash flow to debt holders in period t, CFDt:
CFDt = Intt - ∆Bt = interest paymentst – net debt issuance

d. Taxes
i. Consider the total-taxes-paid component of cash flow to equity
ii. It is being equal to the tax on operating income before interest – the tax-shield benefits provided by interest payments
iii. Taxest = tax with no debt financing – interst-tax-shield benefits

e. Free cash flow to the firm
i. Free cash flow to the firm → cash flow to equity + cash flow to debt holders – interest-tax-shield benefits from the cash flow to debt holders
ii. We can express that
© CFFt = after tax operating profit from equivalent unlevered firm + depreciation – totaol net investment

4. Valuation
i. Three basic business contexts:
© Project valuation (capital budgeting)
© Security valuation
© Firm valuation
ii. Purpose → demonstrate the conceptual consistency in valuation methodology among the various computational techniques employed in the three valuation contexts

a. Equity valuation by the dividend discount approach
i.

b. Equity valuation by the free-cash-flow-to-equity approach
i.

c. Debt valuation
i.

d. Total firm valuation
i. Total firm value:
ii. To express free cash flow to the firm, firm value can be described in terms of NOPAT, depreciation, and total net investment

e. Project valuation
i.

f. Economic profit (EP) and economic value added (EVATM)
i. The concept of EP boils down to a simple restatement of total firm valuation that “reallocates” investment expenditures from the periods in which they are made to periods over which their resulting benefits occur.
ii. In the EVA(TM) approach to EP →the reallocation assigns to each period an “EVA(TM) depreciation” component representing the “usage” of a portion of the cost of the firm, plus a “capital charge” representing the opportunity cost of the remaining net investment in the firm
iii. The computation of EP:
EPt = (NOPATt + difference between tax depreciation and EVA(TM) depreciation – capital charges on EVA(TM) operating assets / economic profitt

5. Measurement Issues
§ Another important use of valuation concepts requiring use of accounting information is determination of managerial compensation
§ Spirit of managerial compensation arrangement → to reward manager to increase shareholders value → measurement of changes in firm value is critical
§ With the free cash flow model, income must be adjusted for the fact that GAAP involve reliance on both the realization and matching principles

a. Derivation of operating cash flow from accounting profit
i. The dividend discount and free cash flow to equity models adjust accounting profits by starting with NPAT, then adding depreciation and net debt issuance, and subtracting total net investment

b. Derivation of economic profit from accounting profit
i. It is not only concerned with reconciliation of accounting profit and cash flow, but also focuses on issues defining the capital investment in the firm

6. Conclusions
a. Free cash flow, economic value added, and net present value approaches to valuation and decision-making are equivalent
b. Linkage among the problems of security valuation, enterprise valuation, and investment project selection, and by doing so in a manner that relates directly to the use of standard financial accounting information
c. Net operating profit after tax (NOPAT) → adding after tax interest payments to net profit after taxes
d. FCF approach → focuses in periodic total cash flow obtained by deducting total net investment and adding net debt issuance to net operating cash flow
e. EVA(TM) approach → requires defining the periodic total investment in the firm

Outperform with Expectations-Based Management: A State-of-the-Art Approach to Creating and Enhancing Shareholder Value

1. Content
§ How to incorporate expectations into the corporation’s decision processes to enhance shareholder value
§ EBM → A revolutionary new performance metric that links performance standards, performance measurement, and the achievement of performance
§ The literature on investment management pays little attention to shareholder value → from the perspective of the relationship between corporate managers' behavior and investors' expectations
§ Corporate finance research → sidesteps the issue of how management actions affect investor expectations and stock price discovery
§ Beating expectations drives shareholder value
§ expectations into fundamental management behavior
i. Difficult → because it requires corporate managers to adopt an unaccustomed mindset and focus
§ The Author:
i. Tom Copeland is a distinguished financial scholar who has moved to consulting
ii. Aaron Dolgoff is an associate principal of consulting firm CRA International
§ Managing based on beating expectations through a systematic decision process is the best way to increase shareholder value

2. Sections
a. Measuring performance with expectations
i. Expectations-based management (EBM) → determining which management approach is most correlated with increases in shareholder value → EBM
ii. EBM's underlying intuition is almost too simple:
© Managers must beat the expectations embedded in stock prices → create value
© Achieving what analysts already predict about the company will not create value
b. Managerial implications of expectations-based performance
i. the authors argue that expectations count
ii. The corporate manager's job is to identify investors' most important expectations and systematically include them in all aspects of company behavior
iii. EBM is not a simple lesson but a way of thinking that must be translated into action throughout the company
iv. Example:
© how a company should evaluate a new investment proposal
o The projected return on investment must exceed not only the cost of capital but also investors' expectations for returns on existing projects
v. Copeland and Dolgoff argue that managers need to reverse-engineer the value of the company to determine what the market thinks returns should be
vi. Market's expected return is the hurdle rate that must be met, not for a given quarter but over multiple periods
vii. Clarifying a company's actions to exceed market expectations is the key role of management
viii. Top management has to be driven to beat expectations, rather than rewarded for rising stock prices that merely reflect a general market increase
c. The expectations-based model from viewpoints other than management's

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