Financial Analysis: Capital Expenditures & Free Cash Flow

Estimating Cash Flows

• The slides provide a guide to estimating cash flows for valuation purposes, focusing on Free Cash Flow to Equity (FCFE) and Free Cash Flow to Firm (FCFF).

Free Cash Flow: FCFE and FCFF

• FCFE represents the cash flow available to equity holders.
• FCFF represents the cash flow available to all claim holders (both debt and equity).

Free Cash Flow to Equity Calculation:

• Start with net income.
• Add back non-cash expenses like depreciation and amortization.
• Subtract capital expenditures and acquisitions.
• Subtract changes in non-cash working capital.
• Add new borrowings less debt repaid.
• Result: Free Cash Flow to Equity, which is available as a potential divided.

Free Cash Flow to Firm Calculation:

• Start with operating income (EBIT).
• Subtract taxes.
• Add back non-cash expenses like depreciation and amortization.
• Subtract capital expenditures and acquisitions.
• Subtract changes in non-cash working capital.
• Result: Free Cash Flow to Firm, which is available to all claim holders.

Steps in Cash Flow Estimation

• Estimate current earnings, using net income for equity cash flows and operating earnings after taxes for firm cash flows.
• Account for investments needed for future growth (capital expenditures).
• Consider cash flows from net debt issues when looking at cash flows to equity (debt issued - debt repaid).

Measuring Free Cash Flow to the Firm: Three Pathways

• Method 1: EBIT(1-tax rate) - (Capital Expenditures - Depreciation + Changes in noncash Working Capital) = FCFF
• Method 2: EBIT(1-tax rate) - Reinvestment = FCFF
• Method 3: EBIT(1-tax rate) * (1 - Reinvestment Rate) = FCFF

Measuring Free Cash Flow to Equity: Alternative Pathways

• Method 1: Net Income - (Capital Expenditures - Depreciation + Changes in noncash Working Capital) + (New Debt Issued - Debt Repaid) = FCFE
• Method 2: Net Income - Reinvestment + Net Debt Cashflow = FCFE
• Method 3: Net Income * (1 – Equity Reinvestment Rate) = FCFE
• The Equity Reinvestment Rate is defined as (Reinvestment - Net Debt Cashflow) / Net Income.

Microsoft in 2021: FCFE and FCFF

• FCFE was $61.271B in FY 2021
• FCFF was $40.879B in FY 2021

Accounting Earnings: From Reported to Actual

• The process involves normalizing earnings.
• Cleanse operating items such as financial expenses, capital expenses, and non-recurring expenses.
• Update earnings using trailing earnings and unofficial unofficial numbers

Updating Earnings

• Use financial statements for inputs on earnings and assets, but update outdated annual reports.
• Annual reports can be updated using trailing 12-month data from quarterly earnings reports.
• Use unofficial news reports if quarterly reports are unavailable.
• Updating is most impactful for smaller, more volatile firms, and those undergoing significant restructuring.
• To get a trailing 12-month number, use one 10K and one 10Q (ex: third quarter): Trailing 12-month Revenue = Revenues (in last 10K) - Revenues from first 3 quarters of last year + Revenues from first 3 quarters of this year.

Correcting Accounting Earnings

• Ensure that there are no financial expenses mixed in with operating expenses.
• Financial expense covers tax-deductible commitments that, if unmet, would result in a loss of business control.
• Before 2019, operating leases skew income statements and balance sheets because of the way accounting conventions treated them.
• Ensure that there aren't any capital expenses mixed in with the operating expenses.
• Capital expenses expect to generate benefits over multiple periods.

Operating Leases: Magnitude and Adjustments

• Operating leases should be treated as financing expenses because they give rise to contractual commitments.
• Debt Value of Operating Leases = Present value of Operating Lease Commitments at the pre-tax cost of debt
• When operating leases are converted into debt create counterpart asset to counter it of exactly the same value.
• Adjusted Operating Earnings = Operating Earnings + Operating Lease Expenses - Depreciation on Leased Asset
• Approximation: Adjusted Operating Earnings = Operating Earnings + Pre-tax cost of Debt * PV of Operating Leases.

Operating Leases at The Gap in 2003

• The Gap had conventional debt of around $1.97 billion at 6% and operating lease payments in 2003 of $978 million, with future commitments as indicated in the slide.
• Debt Value of leases = $4,396.85 (Also value of leased asset)
• Debt outstanding at The Gap = $1,970m + $4,397m = $6,367m
• Adjusted Operating Income = Stated OI + OL exp this year - Deprec' n = $1,012m + $978m - $4397m / 7 , or $1.362 Million
• Approximate OI = $1,012m + $4397m (.06) = $1,276m

The Collateral Effects of Treating Operating Leases as Debt

• The sheet shows how accounting treatments affect the income statement and the balance sheet of earnings.

Correcting for Accounting Mistakes

• Accountants sometimes treat financing expenses as operating expenses.
• In that event, operating income will be understated.
• Book debt and assets will be understated
• Financial experts should be aware of the effects this may cause

Accounting Comes to its senses on Operating Leases: IFRS and GAAP

• In 2019, IFRS and GAAP made a change on operating leases: They now require companies to capitalize leases and list them on the balance sheets.
• Accounting rules are more complex because accounting must balance the desire to "do the right thing" while adhering to legacy rules
• Companies have lobbied to modify rules.

Checking on Accountants:

• Accountants accounting as % of estimate can dramatically vary.

Magnitude of R&D Expenses:

• R&D expenses can increase revenue but depending on the market vary greatly

R&D Expenses: Operating or Capital Expenses

• While accounting standards require R&D to be treated as an operating expense, it should otherwise be considered capital expenditures.
• You can specify an amortizable life for R&D (2 to 10 years).
• Collect past R&D expenses for as long as the amortizable life.
• Sum the unamortized R&D over the period.

Capitalizing R&D Expenses: SAP Illustration

• The illustration shows what capitalizing R&D in 2004 would look like for SAP.

One Time and Nor-Recurring Charges

• Valuation may vary depending on whether there are one-time charges when assuming a firm.

Accounting Malfeasance

• The fidelity of standards for firms may vary.
• Aggressive firms indicate higher earnings when this occurs.
• Warning signals can denote fraudulent or problematic finances

Dealing with Negative or Abnormally Low Earnings

• Quick fixes include adding back one-time expenses to fix corrected earnings.
• Long term involves estimating the profit margin that mature companies in the business earn.

Taxes and Reinvestment

What Tax Rate?

• Consider the effective tax rate in financial statements (taxes paid/Taxable income).
• Think about the marginal tax rate for the country in which the company operates.
• Take all metrics into consideration and compute your after-tax cost of debt using the same tax rate.

The Right Tax Rate to Use

• Free cash flow to the firm starts with after-tax operating income: After-tax Operating Income = Operating Income (1 - tax rate).
• When computing free cash flow to the firm, consider the effective & the marginal tax rate.
• Using the marginal rate, can understate after-tax operating income in previous years and is more accurate over time.
• Start with the effective tax rate and adjust towards the marginal tax rate over time.

A Tax Rate for Money Losing Firm

• Important concept so it could be explained in more detail

Net Capital Expenditures

• Net capital expenditures represent the difference between capital expenditures and depreciation.
• Net Cap Ex = Capital Expenditures - Depreciation
• Depreciation is a cash inflow that compensates for capital expenditures.
• Net capital expenditures depend on growth expectations.

Capital Expenditures Should Include

• Research and development (R&D) expenses, after being recategorized as capital expenses.
• Acquisitions of other firms.
• Some firms do not perform acquisitions every year this should influence the normalization of acquired firms

Cisco's Acquisitions: 1999

• The sheet shows what the acquiring company did with the acquired company.

Cisco's Net Capital Expenditures in 1999

• The sheet highlights the formula and function of net capital expenditures.

Working Capital Investments

• Accounting definition: Working capital is the difference between current assets (ex: inventory, cash, accounts receivable) and current liabilities.
• Valuation definition: Working capital looks at the difference between non-cash current assets and non-debt current liabilities

Working Capital: General Propositions

• Experts view specific information being brought as pointless unless it lets you forecast the details.
• Due to volatility year to year in changes in non-cash, it is better to estimate the change as the percentage of sales while keeping an eye on industry averages.
• Firms with negative non-cash working capital can have increasing cashflow.

From the Firm to Equity

Dividends and Cash Flows to Equity

• The only cash flow from an equity investment in a public firm is the divided paid on the stock.
• Dividend are much lower than the potential dividends (based on what could have been paid out)

Measuring Potential Dividends

• Earnings are not cash flows, because of non-cash revenues and expenses.
• The cash flows left over after the firm has made investments and new debt repayments is related to future growth of net debt.
• Future growth makes non-discretionary loses is what is built into valuation

Estimating Cash Flows: FCFE

• Cash Flows To Equity for a Levered Firm is calculated with this formula: Net Income - (Capital Expednitures - Depreciation) - Change in non-cash Working Capital + (New Debt Issues + Debt Repaid)
• Cash flows is left over after every investment

FCFE from the Statement of Cash Flows

• Review of cash flows may be necessary and needed, experts shouldn't blindly trust the statement.

FCFE Across the Life Cycle

Lifecycle stages and how they relate to earnings, cash flow, debt cash flow.

FCFE Over Time: Tesla

• Tesla demonstrated volatile net incomes and FCFE from 2006-2021, but closed on strong numbers.

Dividends versus FCFE: Across the Globe

• Breakdown of firms numbers and the difference between them

Estimating FCFE When Leverage is Stable

• Leverage should be viewed as a debt/capital ratio when estimating cash flows.

Estimating FCFE: Disney

• Real world example of calculating the earnings between cap ex and depreciation given a certain debt to capital raio.

FCFE and Leverage: Is this a Free Lunch?

• Chart diagram of Disney's earnings during their debt rations.

FCFE and Leverage: The Other Shoe Drops

• Chart diagram of Disney's beta.

Leverage, FCFE, and Value:

• Increasing the debt/equity ratio affects cashflow and equity numbers, however the effect is influenced by what company the numbers are coming from.

Explore after-tax income calculation, net capital expenditures in high-growth firms, and free cash flow estimation, plus adjustments for accurate financial valuation. Understand the relationship between growth and capital expenditure assumptions. Examine the components of adjusted net capital expenditures.