Cash Flow Valuation

Welcome to Cash Flow Valuation. In this site we wish to discuss on cash flow valuation issues.

Tuesday, March 28, 2006

Cash Flow to Equity

Should we consider funds kept by the firm in cash or in market securities as part of the cash flow to equity and as if those funds were distributed to the equity holders?

42 Comments:

Blogger Ricardo Botero said...

"No. Such funds represent a short-term investment by the firm (in cash, cash substitutes and marketable securiities). This is one of the reasons that Microsoft shareholders, and analysts, argued for a dividiend rather than Microsoft's retaining such funds in the firm."
Lawrence Schall

6:06 PM  
Blogger Ignacio Vélez-Pareja said...

Agree. Many textbooks consider cash, cash substitutes ans marketable securities as part of the cash flow to equity. This is a violation of the concept of cash flow. Something in an account in the Balance Sheet cannot be considered at the same time, a cash flow.
Ignacio Velez-Pareja

6:16 PM  
Blogger Ricardo Botero said...

"The short answer is yes, but I suggest a computation which avoids this question: In my book "Corporate Finance: A Valuation Approach" (McGraw-Hill, 1996), we [co-authored with Oded Sarig] have a chapter on computing the equity cash flow."
Simon Benninga

5:21 AM  
Blogger Ricardo Botero said...

"The fundamental assumption is that any cash held by the firm is "productive" and therefore worth its face value. Assuming that it is invested in securities is a convenience".

Charles Haley

4:08 PM  
Blogger Ricardo Botero said...

"Yo opino que sí. Si suponemos que la deuda ha sido satisfecha (se han pagado los intereses del periodo y se ha amortizado la parte que contractualmente debiera hacerse) ese dinero sobrante sólo puede pertenecer a los accionistas. El motivo de por qué no se les ha entregado es lo que debe explicar la dirección de la empresa. Por tanto figura como flujo de caja libre de los accionistas (aunque no lo hayan recibido) para que la suma del flujo de caja libre de los accionistas y de los acreedores coincida con la del flujo de caja libre operativo."

12:11 PM  
Blogger Ignacio Vélez-Pareja said...

The problem of matching the cash flows depends on what you include in the working capital. If you include in the working capital cash in hand and market securities, then the Modigliani & Miller cash flow conservation equation holds. This equation is FCF + TS = CFD + CFE where FCF is free cash flow, TS is tax savings, CFD is cash flow to debt and CFE is cash flow to equity.
If the firm invest at a rate lower than Ke, the cost of equity, then this should affect the value of equity. And if that happens and the CFE includes the cash and cash like items, it is equivalent to assume that those funds are invested at Ke and yet they are invested at a different rate.

1:42 PM  
Blogger Ricardo Botero said...

"Investing at the riskfree rate is equivalent to investing at the cost of equity adjusting for risk."

Charles Haley

7:42 PM  
Blogger Ricardo Botero said...

"Primero: el excedente de tesorería que suele figurar en la cuenta Inversiones Financieras Temporales (IFT) no se puede incluir en el valor de la empresa (Enterprise Value), no lo hace nadie. Es un activo "no operativo" es decir, que no genera valor al negocio de la empresa y el valor actual neto del mismo es cero. Por tanto, tampoco se puede incluir en el "working capital"; si alguien lo incluye es que no entiende qué es el "working capital" y para que sirve. Es un dinero que debería haberse repartido a los accionistas y no se ha hecho, por lo que muchas compañías tienen problemas con sus accionistas por dicho motivo. Los tiburones financieros se aprovechan precisamente de que dicha liquidez no está incluida en el valor de mercado de las empresas que compran.
Segundo: el FCF = CFD + CFE (véase Copeland, Koller y Murrin o mi propio libro de Fusiones y Adquisiciones de Empresas). En CFD ya va incluido el escudo fiscal. El lado izquierdo de la ecuación es el FCF "operativo" y el de la derecha el "financiero" y precisamente para que la igualdad se mantenga dentro del CFE es dónde figura la variación en el saldo de las IFT.
Tercero: Tanto si el rendimiento financiero de las acciones de la empresa es superior o inferior al Ke, ello no afecta al valor de las IFT porque su VAN es cero por definición (repito son activos no operativos, no invertidos en el negocio de la empresa sino en el mercado de valores y por tanto, su tasa de descuento es la que le asigne el mercado según su riesgo ¡no Ke!)"

2:09 AM  
Blogger Ignacio Vélez-Pareja said...

Las afirmaciones contenidas en este sitio sobre el valor de los excedentes de liquidez están basadas en un modelo teórico ideal de Miller y Modigliani sobre la irrelevancia de los dividendos en el valor de la firma. Eso es cierto en condiciones ideales. En la realidad esos supuestos casi nunca se cumplen y los modelos financieros deben reflejar lo que en realidad sucede y no necesariamente lo que debería suceder en condiciones ideales.

Aunque en varios sitios está mi posición sobre este tema veamos lo que se dice respecto a qué hacer con los excedentes de liquidez mantenidos en caja y/o en inversiones de corto plazo:
1. Unos dicen que equivale a una deuda negativa y entonces lo que aparece en el balance se lo restan al saldo de la deuda. (ver Jennergren, L. Peter, A Tutorial on the McKinsey Model for Valuation of Companies en http://swoba.hhs.se/hastba/papers/hastba0001.pdf)
2. Otros dicen, como varios en estos comentarios, que el valor es el valor en libros, o puesto en otras palabras, que su VPN es cero, que no crea valor para la firma.

En el primer caso estamos creando un “flujo” de caja de la deuda ficticio. Eventualmente se modificaría la estructura de capital de manera ficticia. Estaríamos negando el concepto básico de flujo de caja: no hay un movimiento de dinero.

Miremos las implicaciones de lo que dicen en el segundo caso:
1. Si el VPN es siempre cero significa nada más ni nada menos que al no crear valor para la firma, cualquier decisión que el tesorero o gerente financiero tome respecto de esos excesos de liquidez es completamente irrelevante en términos de creación de valor. ¿No gastamos esfuerzos para enseñar cómo crear valor y sacarle lo máximo a los recursos disponibles en la empresa? Según ese planteamiento de VPN = 0 para la empresa dará lo mismo mantener los excedentes de liquidez en una cuenta corriente sin ningún retorno o mantenerlo a una tasa no negativa en papeles del mercado.
2. Si esos fondos son de los accionistas, entonces en cualquier modelo financiero deben aparecer como repartidos (recompra de acciones o de participaciones). Es fácil demostrar que si así se hace, podríamos fácilmente aparecer con un patrimonio cero o negativo.
3. Cuando se estima la beta de una acción (se estima, no se calcula) ¿cómo lo hacemos? ¿Consideramos los dividendos pagados o los dividendos potenciales? El término dividendos potenciales lo usan Copeland y Damodaran. No he visto la primera propuesta de calcular las betas usando dividendos potenciales en lugar de dividendos pagados.
4. ¿Cómo va a descontar un accionista un flujo que no va a recibir sino que va a estar depositados en una cuenta corriente o unos depósitos a término o en un fondo de pensiones? Para el accionista lo que vale es lo que le entra al bolsillo… ¿Las bolsas de valores qué descuentan? ¿Dividendos pagados (o por pagar en el futuro, por supuesto) o dividendos potenciales? Se niega otra vez el concepto básico de lo que es un flujo de caja.
5. Los supuestos de M&M pueden ser válidos en un mundo ideal, por ejemplo, en perpetuidades, donde se supone distribución total de los excedentes de efectivo.

4:04 PM  
Blogger Ignacio Vélez-Pareja said...

This next comment is the same previous comment but translated into English.
The assertions contained in this site on the value of the excess of cash are based on an ideal theoretical model of Miller and Modigliani on the irrelevance of dividends in the value of the company/firm. That is true in ideal conditions. In reality those assumptions almost never are fulfilled and the financial models must reflect what in fact it happens and it is not necessarily what would have to happen in ideal conditions.

Although in several papers and books I have written about this subject let us see what it is said with respect to what to do with the excess of cash either maintained as cash on hand and/or in marketable securities:

1. They say that the excess cash is equivalent to a negative debt and then what is listed in the balance sheet is subtracted from the debt balance. (ver Jennergren, L. Peter, A Tutorial on the McKinsey Model for Valuation of Companies en http://swoba.hhs.se/hastba/papers/hastba0001.pdf)
2. Others say, like in several of these comments, that the value of the cash excess is the book value, or in other words, that its NPV is zero, that it does not create value for the company/firm.

In the first case we are creating a fictitious "cash flow" for debt. When this is the case, possibly the structure of capital would be modified in a fictitious. We would be denying the basic concept of cash flow because there is not a cash movement.

Let us see which the implications of what they say are:
1. If the VPN is always zero it means nothing else nor nothing less than if that cash excess does not create value for the company/firm, any decision that the treasurer or financial manager takes respect to those excesses of liquidity is completely irrelevant in terms of value creation. Don’t we spend time and effort to teach how to create value and obtaining the maximum from the resources available in the company? According to that idea of NPV = 0 for the company it will be the same to maintain the excess of cash in a current account with no return or to maintain it at a nonnegative rate in market securities.
2. If those funds belong to the shareholders, then in any financial model they must appear as distributed (repurchase of stocks or participation in the firm). It is easy to demonstrate that if this is the case, we could easily end up with a zero or negative equity book value.
3. When we estimate the beta of a stock (it is estimated, not calculated) how we do it? We consider the paid dividends or potential dividends? The term potential dividends is used by Copeland and Damodaran. I haven’t seen any proposal to estimate betas using potential dividends instead of paid dividends.
4. How a shareholder is going to discount a cash flow that is not receiving, but is deposited in a current account or in a pension fund? For the shareholder what is worth is what she gets into her pocket… What is discounted by the stock market? Paid dividends (or to be paid in the future, of course) or expected potential dividends? Again, in this case, they are denying the basic concept of cash flow as a movement of cash.
5. M&M assumptions might be valid in an ideal world, say, in perpetuities, where you assume full distribution of available funds.

4:12 PM  
Blogger Ricardo Botero said...

"That is precisely what we do when we compute FCFE. Just make sure that you don't double count the cash by counting the income that would have been earned if that cash had been held in the firm."

Damodaran

11:03 AM  
Blogger Roberto Mosquera said...

Disculpen mi comentario, pero quería saber si Ricardo Botero ha estudiado en Purdue en los años 1981-1983

5:19 AM  
Blogger Sergei Cheremushkin said...

The textbooks and commercial software often use the net cash flows to determine the NPV of an investment project (business plan). However the net cash flow may diverge from the free equity cash flow (in fact it may no correspond to either the cash flow to equity, nor the cash flow to firm). For expample, the firm may establish reserves to repay debt or to reinvest retained earnings in a lump-sum assets. If we assume the repayment of free cash in every period, the cash flow pattern will change and the following cash flows on investment and financial activities will be different (then the new debt or new equty would be required), since there are no reserves under such an assumption. Also the minimum cash required to finance operations should be excluded from the free cash flow to equity as well as any other reserves that are designated to be used in future periods. The net cash flow approach generally lead to overevaluation of the project net present value. What do you think about this point.

1:34 AM  
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11:06 AM  
Blogger SSPractice said...

I am trying to read and understand what you put in two papers
(forecasting financial statements with no plugs and no circularity + a
step-by-step guide to construct a financial model….) in these two
days, including looking at the excel spreadsheet.
This is what I see…the paper is like, pushing us to track the cash
implications of [each] major [groups of] transactions [of operating
activities, investing activities and financing activities] and reflect
that into the Cash Budget. The driving force is the application of
double entry equation. It is a good approach…..however, I have just
one point to say:

Focusing on cash flow account (instead of profit account) will be
quite problematic. This will surely be impacted by our assumptions as
to when the major accounts in the working capital will be collected
and paid. In other words, the movement and balance of cash flow
account really depends on the window period that you see, though in
terms of Profit account, it is the same. What I manage to say, when we
put our window period one month or two months, this will impact the
cash deficit or cash plus that we will see in the cash account, even
though the profit stays the same.

Why I know this, I worked almost 5 years as a finance head and my main
job is to put so much focus on the working capital, as it is the blood
line of the business. I could give you many examples, but if you could
find the book in your library, titled “Short-term Financial
Management” by Terry S. Maness and John T. Zietlow, chapter 1, there
is one example, showing that if we take one month period (June 1-30),
the cash profit is minus $75, June 1- July 15 : cash profit minus
$575, and June 1- July 30 (two months), cash profit plus $125, though
for all those periods (either June 1-30 (one month), June 1-July 15 (6
weeks) and June 1- July 31 (two months), the net profit stays the same
plus $25. The implication is big to our financial model. If we assume
to forecast for two months, then we will have $125 in our cash, which
means we don’t need any 60%:40% financing (assumption in your paper),
and this money could be put as a short-term investment, generating
interest income as a result. But if we use 6 weeks, we will definitely
need financing to fill the hole in the cash ($575), thus we will see
the financing accounts coming to view (long-term debt and equity),
resulting to interest expense, blah.blah..(tax as well). So what I am
trying to say, by focusing on cash flow and not balance sheet account,
this is like managing [daily, monthly, whatever periods we want to
use] transactions…they all will be different in giving us the balance
of the balance sheet accounts. Which one is correct? Hard to say….The
business lives day by day…and not month by month…So if we are really
loyal to “double entry principle” we need to use this (daily period) )
in the forecasting…Do we need really to do that?

Your spreadsheet will be 100% balance..no doubt for that…but the
balance is doubtful.. I could come up with a very totally different
balance in the balance sheet and income statement if I use two months,
instead of one month forecasting in constructing the financial model.

8:49 PM  
Blogger SSPractice said...

I am trying to read and understand what you put in two papers
(forecasting financial statements with no plugs and no circularity + a
step-by-step guide to construct a financial model….) in these two
days, including looking at the excel spreadsheet.
This is what I see…the paper is like, pushing us to track the cash
implications of [each] major [groups of] transactions [of operating
activities, investing activities and financing activities] and reflect
that into the Cash Budget. The driving force is the application of
double entry equation. It is a good approach…..however, I have just
one point to say:

Focusing on cash flow account (instead of profit account) will be
quite problematic. This will surely be impacted by our assumptions as
to when the major accounts in the working capital will be collected
and paid. In other words, the movement and balance of cash flow
account really depends on the window period that you see, though in
terms of Profit account, it is the same. What I manage to say, when we
put our window period one month or two months, this will impact the
cash deficit or cash plus that we will see in the cash account, even
though the profit stays the same.

Why I know this, I worked almost 5 years as a finance head and my main
job is to put so much focus on the working capital, as it is the blood
line of the business. I could give you many examples, but if you could
find the book in your library, titled “Short-term Financial
Management” by Terry S. Maness and John T. Zietlow, chapter 1, there
is one example, showing that if we take one month period (June 1-30),
the cash profit is minus $75, June 1- July 15 : cash profit minus
$575, and June 1- July 30 (two months), cash profit plus $125, though
for all those periods (either June 1-30 (one month), June 1-July 15 (6
weeks) and June 1- July 31 (two months), the net profit stays the same
plus $25. The implication is big to our financial model. If we assume
to forecast for two months, then we will have $125 in our cash, which
means we don’t need any 60%:40% financing (assumption in your paper),
and this money could be put as a short-term investment, generating
interest income as a result. But if we use 6 weeks, we will definitely
need financing to fill the hole in the cash ($575), thus we will see
the financing accounts coming to view (long-term debt and equity),
resulting to interest expense, blah.blah..(tax as well). So what I am
trying to say, by focusing on cash flow and not balance sheet account,
this is like managing [daily, monthly, whatever periods we want to
use] transactions…they all will be different in giving us the balance
of the balance sheet accounts. Which one is correct? Hard to say….The
business lives day by day…and not month by month…So if we are really
loyal to “double entry principle” we need to use this (daily period) )
in the forecasting…Do we need really to do that?

Your spreadsheet will be 100% balance..no doubt for that…but the
balance is doubtful.. I could come up with a very totally different
balance in the balance sheet and income statement if I use two months,
instead of one month forecasting in constructing the financial model.

8:49 PM  
Blogger SSPractice said...

The whole point of forecasting is on
forecasting the earnings and cash flows quality of the business.
That’s all…..

I don't even care where we are going to put the plugs...you could plug
it wherever you want. I learn this from my personal experience. One of
the main tasks of the company (finance head) is to “sell” the cash
flows of the business (in my case, to HQ). I am always intrigued by
the fact that most of corporate finance textbooks will always put
“capital budgeting” topics in the first part of the book (usually
after the finance role, time value of money). I keep asking that as to
why we (finance) need to learn capital budgeting in the first place. I
thought before probably that because they are the investing analysis
stuffs….Yet the older I am and was sitting as a finance head, I just
realized that this capital budgeting is not about NPV, etc….etc…It is
about having a clear idea about the business’ cash flows quality in
the future. Once we have that…the rest (excluding the discount rate,
which is a very complicated topic, since we lump into one rate, the
time value of money and the risk premium, two stuffs that are totally
different) is relatively easy to handle…meaning that if we can have a
positive net cash inflows (and we are ready to put our head to
“guarantee” it to happen – kidding), then someone out there somehow
will be willing to finance it…we could call it equity, long-term debt,
short-term, medium note, mezzanine, hybrid…whatever…I don’t even care
(or want to ask) from where the money is coming, when the HQ sent the
money down to us to execute the project. Meaning I don’t ask where
they put the plugs….

If we look at the formula that finance people are usually using for
Free Cash Flows…we don’t even have the “plugs” in that formula. All we
need, are stuffs like the ebit, the marginal tax rate, the net working
capital movement, and the capex. To be honest, when doing the
forecasting, I put more time to look at the company’s profit margin
and asset’s turnover. Of course, we could make it a bit complicated
(to impress the client), by linking it to the retention ratio and
financial leverage to see how far the company’s sustainable growth
rate will be. (As a note: I found it quite surprised to know that my
most favourite corporate finance textbook: Corporate Finance by
Jonathan Berk and Peter DeMarzo does not have any definition for Free
Cash Flows. The book just gave me the formula. I sent an email to the
authors, and they came with a short answer, they intentionally did
that! No definition for Free Cash Flows. …Peter DeMarzo’s point made
me realized that at the end of the day, we probably don’t need balance
sheet and income statements and cash flows statements and all those
stuffs…all that matters, is, how much money we could put on the table
at the end of the day of each period. The rest maybe just a
definition, and plugs probably is one of them.)

8:52 PM  
Blogger SSPractice said...

My approach to forecasting the balance sheets and income statements
are pretty much the same with all the “old school” in the finance
textbooks, which will use “plugging” account. Which account will be
used will depend on assumption that we will use in the financial
modeling. This assumption is not taken out of the blue air, but based
on discussions with the management and understanding the past. There
will be many options to go:

If the asset balance is lower than the total of liability and equity accounts:
We could use cash in excess of operating cash (Apple and Microsoft is
a good example, as they keep building up their cash balance. Or, if we
could see this pattern in the past, any “excess” cash will
automatically be used to pay down any short-term or long-term
liability, or we could use any sequential assumptions, for example,
certain loan will be paid first before going to next tranche of loan.
Or dividends be increased.

If total liability and equity accounts are lower than total assets,
then this will depend again what the company has done in the past. I
prefer using short-term working capital loan assumed to be rolled over
automatically. Some books I see, they go to equity account, though I
don’t see that this is always feasible, as the shareholder might
decline to keep injecting cash to the company.

The above options will not be the same from one company to another
company. And this is the beauty of doing the financial modeling.
Understanding the past and the business and what are the industry or
sector players were doing in the past and how the industry operates.
Some businesses’ profitability are more sensitive to the movements in
the business cycle in the industry, or a function of industry
profitability. No assumptions should be assumed to fall from the sky!

8:53 PM  
Blogger SSPractice said...

I believe that in doing the valuation, whatever assumptions we built
into the balance sheet, income statement and cash flows, it should go
down to one thing: distributions to equity holders….And this is always
a challenge, since we know that in practice, distributions to equity
holders are made at the discretion of management, based on a variety
of factors. However, we do know that we could roughly get the idea
about the amount (and hopefully the timing) of this distribution by
analyzing:

How much cash the business’s operating activities had generated in the
past and how much it could generate in the near future? In line with
this, is how much cash have been invested in the investing activities
in the past to maintain or expand the scale and scope of the
business’s operating activities? And all this will lead us or push us
to answer how much cash should be retained in the business in the form
of financial assets, or the financial flexibility options that the
company should have, to provide for future cash flow needs.

Answering the question of how much cash the business’s operating
activities could generate, then short-term financial management and
near-term performance and long-term performance should be put under
our through analysis.
Short-term financial management, especially how the company manages
its working capital. We could learn much from this process. For
example, if the company’s current assets are bigger than current
liabilities…we need to dig deeper, how the company has financed the
difference between current assets over current liabilities. They could
come from liability or equity account. This pattern could be
recurring. Or, if the current liabilities are higher than current
assets, we need to ask where the money is going to? It might be that
the current liabilities are being used to finance long-term assets.

Near-term performance might be driven by firm-specific activities but
in the long-term performance, industrywide and countrywide forces will
become the drivers.

8:54 PM  
Blogger SSPractice said...

I believe that in doing the valuation, whatever assumptions we built
into the balance sheet, income statement and cash flows, it should go
down to one thing: distributions to equity holders….And this is always
a challenge, since we know that in practice, distributions to equity
holders are made at the discretion of management, based on a variety
of factors. However, we do know that we could roughly get the idea
about the amount (and hopefully the timing) of this distribution by
analyzing:

How much cash the business’s operating activities had generated in the
past and how much it could generate in the near future? In line with
this, is how much cash have been invested in the investing activities
in the past to maintain or expand the scale and scope of the
business’s operating activities? And all this will lead us or push us
to answer how much cash should be retained in the business in the form
of financial assets, or the financial flexibility options that the
company should have, to provide for future cash flow needs.

Answering the question of how much cash the business’s operating
activities could generate, then short-term financial management and
near-term performance and long-term performance should be put under
our through analysis.
Short-term financial management, especially how the company manages
its working capital. We could learn much from this process. For
example, if the company’s current assets are bigger than current
liabilities…we need to dig deeper, how the company has financed the
difference between current assets over current liabilities. They could
come from liability or equity account. This pattern could be
recurring. Or, if the current liabilities are higher than current
assets, we need to ask where the money is going to? It might be that
the current liabilities are being used to finance long-term assets.

Near-term performance might be driven by firm-specific activities but
in the long-term performance, industrywide and countrywide forces will
become the drivers.

8:54 PM  
Blogger SSPractice said...

inancial ratios play also a significant role in my financial modeling
since I believe it is really important that we could evaluate the
changes in ratios in the context of changes in the underlying business
operating drivers and strategies of the firm.

Back to your “good” approach without plugs, etc. I don’t think that we
need to be so worried about using plug(s). For many businesses, over
long periods of time, the cash inflows and outflows from that
business’s operating and investing activities, especially its trend,
become known, while over short periods of time, the short-run cash
flows can have little relation to the long-run economic consequences.

So what I am suggesting, instead of putting so much effort and time to
“improve” the financial modeling (without plugs)…it is worth spent
time better on looking at the accounting, financial ratio and cash
flow analysis of the company and conduct sensitivity and scenario
analysis. At the end, I believe in a simple model. Forecasting is
forecasting! And don’t forget, though we could come with a very
accurate model, there will be still some much flaws in the
assumptions, including when we assume that all future net cash
distributions will accrue to current shareholders, or, if the current
shareholders sell their share to other party(-ies), this transaction
will be made at the share’s intrinsic value. This is not always the
case in reality or in the future.

Keep things simple though we know they are not perfect..Using plugs
doesn't always mean it is not right. The business model will be only
limited to our understanding of the business. So better to start
understanding the business first...model could come later, and
probably we don't need that model at all....as far as you know the
business. I remember one book that I read "Barbarians at the gate",
this is a story about KKR managed to acquire Nabisco...Though KKR was
full with very bright persons knowing very well about financial
models...they still worked very hard to get somebody that really have
a full knowledge of how Nabisco's businesses were run and where the
cash flows were generated (from which department, which product lines,
etc) and which areas that the money were overspent....In other words,
without this information, no even a single financial model that could
help us. The value is at the end, if someone is willing to pay.

8:55 PM  
Blogger SSPractice said...

Industry and sector matters in forecasting the sales and all research
papers show that the growth and return will revert to the mean...this
doesn't mean that everything will be exactly the same, there will be
always a difference between all those companies though they revert to
the mean (in that portfolio of companies). The historical data of the
company is interesting since they are all we have as a starting point,
but looking at what is going on the industry both in the short-term or
medium term, will surely make us wiser. So, usually I use historical
data and external research as a check and balance. Again, I put more
eyes on how much money the company's business could generate. Sales
growth (in terms of quantity and price) and profit margin and asset's
turnover will all go down to the amount of the cash that the business
will bring up. We need to really consider whether we are comfortable
with that amount. Instead of focusing on %, I choose "buck". If the
"buck" doesn't make sense, then I will go back to see where is the
"bugs" in the forecasting.

8:56 PM  
Blogger SSPractice said...

Industry and sector matters in forecasting the sales and all research
papers show that the growth and return will revert to the mean...this
doesn't mean that everything will be exactly the same, there will be
always a difference between all those companies though they revert to
the mean (in that portfolio of companies). The historical data of the
company is interesting since they are all we have as a starting point,
but looking at what is going on the industry both in the short-term or
medium term, will surely make us wiser. So, usually I use historical
data and external research as a check and balance. Again, I put more
eyes on how much money the company's business could generate. Sales
growth (in terms of quantity and price) and profit margin and asset's
turnover will all go down to the amount of the cash that the business
will bring up. We need to really consider whether we are comfortable
with that amount. Instead of focusing on %, I choose "buck". If the
"buck" doesn't make sense, then I will go back to see where is the
"bugs" in the forecasting.

8:56 PM  
Blogger Raj Solanki said...

Thanks for the latest news about stock and commodity market.
Stock Cash Tips

1:35 AM  
Blogger SSPractice said...

for the short-term investment, then you suggest where to put that in the valuation process?

As part of NWC - I don't think this is correct
As negative debt - I don't think this is correct
Treated as non-productive assets, which will then be added to the enterprise value - this is also no correct since they might earn interest more than its cost, so its value is above its book value, or in other case, it could earn lower than its cost, then we have negative assets instead of productive assets.

5:18 AM  
Blogger Ignacio Vélez said...

Remember this: using my approach of defining the CFE as the ammounts that are planned to be paid to shareholders (the negative of Net Cash Balance in Module 4 in the Cash Budget) the debate on "where I put excess cash" is irrelevant. CFE is what I plan to pay to owners. No more, ni less.

However, the only way to match that CFE with the indirect method is including cash in the NWC!

10:35 AM  
Blogger SSPractice said...

Just because we "only" want to see CFE and CFD as the expected cash flowing to the shareholders and creditors, yet, we can't ignore the existence of that excess debt, and we still have to address it.

4:36 PM  
Blogger Ignacio Vélez said...

Well,we don't ignore that cash. It is there coming in and out and yielding little or zero return. When you value the cash flows, you will take care of it in the Terminal Value as the liquidation of what I call "trapped" cash: AR, AP, market securities and cash in hand. This trapped cash is added to the calculated Terminal value and become part of the value of equity/firm.

6:13 PM  
Blogger SSPractice said...

Seems to me by pushing it to terminal value, we try to avoid addressing this issue on hand. Terminal value is what I like to call a period that anything can happen. We just don't know. Let's say forecast period is 20 years. What we can say after 20 years? Like British economist Keynes said, in the long run, we are all dead.

We better halve the tv for its price.

4:49 PM  
Blogger Ignacio Vélez said...

Then, you prefer to consider that you are paying something only in paper. It is a make believe cash flow. That doesn't make sense. Reality is that the cash is there, in the firm's vault and not paid. Hence, it is a fictitious value. As bad or worse, than the TV in 20 yrs.

7:23 PM  
Blogger Ignacio Vélez said...

I have a question: which is the proper way to calculate the return of a stock (just as needed to run a regression with market return to find beta). I think it is

Rs_t = [(P_t + Div_t)/P_t-1] - 1

where P is price and Div is dividends.

Am I missing something? What do you think?

9:32 AM  
Blogger Ignacio Vélez said...

Do you see any cash distribution, real or virtual? I don't. Hence, to model the NWC assuming implicitly that any increase/decrease in cash is distributed to shareholders is not correct and is not consistent with CAPM and the like!!!

What you do wrongly assuming that full distribution is called by some people (Damodaran among them) as Potential Dividends. Why? Because they are not distributed in reality. They are a fiction. And yet, Damodaran uses the formula to calculate the return of any stock to estimate betas without assuming that fictitious distribution of cash.

Cash available is a headache to many people. This headache is crystal clear solved with my approach: consider CFs the funds you expect to pay to debt and equity holders. No headache, no confusion, no interpretation. No room for discussion. What else can you expect?

When I forecast the financial statements and from there the cashflows, those cashflows are the ones I need to comply with in the future. Those CFs don't include fake CFs, but yes, the ilussions created by N assumptions on what will happen in the future. If you can arrive to those CFs, why the interest in including what is not distributed?

On the other hand, I am not against distributing all cash available. Great to do that and it will increase value. BUT if you suggest to distribute ALL that cash, DO IT! Reflect that decision in the financial statements. That is all I ask the analyst. No more, no less.

9:36 AM  
Blogger Ignacio Vélez said...

Whatever you decide to do with excess cash, include it into de the CB and IS and BS. If you plan to buy another firm, or buy inventory, do it and include that in the CB. The problem is eliminating it ‎from the WC and still keeping it in the BS as mkt securities, because when you do that the result is to increase artificially the CF to equity. I insist. Whatever you plan to do with excess cash, include it into the financial statements: CB, IS and BS. No more, no less.

What you shouldn't do is to assume happily that it is distributed to shareholders WITHOUT listing that decision in the Financial statements.
That's all.

7:16 AM  
Blogger Ignacio Vélez said...

Management has many alternatives for using excess: you can repay or prepay debt, distribute extraordinary dividends, invest in a firm, leave it invested in market securities, whatever...

No matter which decision you make (and include in the forecast) it is valid to examine within the framework of the forecasting. What you shouldn't do is to include it implicitly in the way you calculate cashflows and not reflect that in the financial statements (Cash Budget, Income Statement and Balance Sheet. You have to know what is the impact of those decisions (using 100% excess cash).

For instance, what is the effect of thse decisions on the total leverage of the firm. This is an index that banks and lenders in general, look and make lending decisions on that. For instance, many banks would not accept to extend loans to a new firm/project with a total leverage of 50% or more. When you don't list all these decisions in the financial statements, the effect, say, on total leverage is hidden.

Again, do with the excess cash whatever you wish, BUT list that decision on the financial statements. I am not asking too much.

7:28 AM  
Blogger SSPractice said...

I copied here what I exchanged emails with Ignacio, some may got repeated from what Ignacio had put in his Blog:

Sukarnen:

Using cash flows always creates many interpretations. I will send you tomorrow one articles listing various ways in defining cash flows.

This is why stern&co use FCFF. Free cash flows To the Firm. It is distributABLE cash flows either to debtholders or equityholders.

Ok forget that....

Use earnings as Stephen Penman suggested. Started with book value then plus value added along the way.

This will reduce the headache with that potential or real.

Ignacio:

Dear Karnen

I look forward to the papers you offered. Thanks!

The headache you mention is crystal clear solved with my approach: consider CFs the funds you expect to pay to debt and equity holders. No headache, no confusion, no interpretation. No room for discussion. What else can you expect?

When I forecast the financial statements and from there the cashflows, those cashflows are the ones I need to comply with in the future. Those CFs don't include fake CFs, but yes, the ilussions created by N assumptions on what will happen in the future. If you can arrive to those CFs, why the interest in including what is not distributed?

On the other hand, I am not against distributing all cash available, Great to do that and it ir will increase value. BUT if you suggest to distribute ALL that cash, DO IT! Reflect that decision in the financial statements. That is all I ask the analyst. No more, no less.

Sukarnen:

Pls find enclosed the paper published in the CPA Journal about so many ways in defining Free Cash Flows.

I don't say, I don't agree with your approach. Yet, just claiming that's "cash flows to the shareholders" and "cash flows to the debtholders" by tracking thru the cash budget, doesn't mean that it is always correct for valuation purposes. That cash flow is the product, so we need to look at the process behind that product. It is clear to me that to get that CFE and CFD, you put the changes of excess cash in the NWC. This is not always correct. In reality, that excess cash can go to anywhere, and for 100%, it is not for NWC. We learnt from Microsoft, Apple, etc, they used that excess cash for acquisition (cash deal makes the acquisition decision faster!), and later stock buybacks, bonus and dividends.

Ignacio:

Whatever you decide to do with excess cash, include it into de the CB and IS and BS. If you plan to buy another firm, or buy inventory, do it and include that in the CB. The problem is eliminating it ‎from the WC and still keeping it in the BS as mkt securities, because when you do that the result is to increase artificially the CF to equity. I insist. Whatever you plan to do with excess cash, include it into the financial statements: CB, IS and BS. No more, no less.

What you shouldn't do is to assume happily that it is distributed to shareholders WITHOUT listing that decision in the Financial statements.
That's all.

7:04 PM  
Blogger SSPractice said...

Sukarnen:

Sure Ignacio.

Excess cash should be defined for what purposes. We can't just net it off against debt as many books (including Berk and Peter DeMarzo's corporate finance textbook) to get what they call "net debt". I have seen analysts doing this, but at the same time, they don't make necessary adjustment for this excess cash (that in reality, earning marginally low interest rate) to the WACC.

Theoretically, WACC should be kd(after tax) + ke + k_excess cash (after tax).

Your basic message didn't shoot into my head, since it seems to me you keep saying about CFE and CFD. However, your email above dawned on me that you are more concerned about detailing the plan of excess cash and reflect that plan into CB, IS and BS ultimately.
Sure Ignacio, I learnt much from this "heavy-charged" discussions. At least this made me think hard.


Ignacio:
Yes, I am concerned on that but it is not something inocous. See my comment in the blog. When you don't do that, some indexes could fall down, as I say there, for instance, total leverage that is what many lenders look to make the decision to lend money. If you make decisions on excess cash without looking the possible positive or negative effect of that, you assume the risk of doing something that impairs the firm/project to receive fresh money from banks or lenders in general.
In our model we use for consulting we keep track of D% (total liabilities/Total assets). Hence, if I decide to distribute 100% of excess cash (that in the right side is shown in retained earnings that clearly affects equity book value and D%) it may result on a D% too high and the project will risk the possibility of receiving new loans.

7:06 PM  
Blogger Arsh Bharti said...

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12:06 AM  
Blogger Ignacio Vélez said...

Thanks for your interest. Try to work with the model. I just updated it for a minor detail.
If you decide to use it, please let me know how was your experience.
Best regards

6:59 AM  
Blogger Ignacio Vélez said...

This is a reply to Sergei Cheremushkin (https://www.blogger.com/profile/04336059821525524844)

Remember, my dear Sergei.

Equity is worth what you effectively distribute to equity holders. No more, no less. That should be the main purpose of our forecasting excercise. This is, to estimate the amounts and time when they will receive back their money.

This means that CFE should be one and only one. When you have the Cash Budget Statement (also known as Cash Flow Statement) there is no ambiguity on what you have there (as a forecast). That is very simple (and at the same time, complicated) statement. Which are the amounts to be paid and when, to equity holders. No more, no less.

7:12 AM  
Blogger Ignacio Vélez said...

This is a reply to Liz (https://www.blogger.com/profile/02443595474867404061)

Thanks so much for your comment. Call again. Give us your ideas, doubts, criticisms and comments
Best

7:14 AM  
Blogger cap vision said...

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Base Metal Tips

3:12 AM  
Blogger Ignacio Velez-Pareja said...

Hi, Cap vision
Thank you for your interest.

In this place http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=145648#reg you will find all the ideas and papers (published and unpublished) I have worked on.

Best regards

4:45 AM  

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