Tying Free Cash Flows to Market Valuations

Introduction
Fixing Financial Statement → Financial Statement Overhaul
Traditional Financial Statement → redesign → useful for meaningful financial analysis, decision making, and value creation
Fundamental objective → increase shareholder value → increasing NPV of the future cash flows

Relating Free Cash Flows to Market Values
Firm market value → collective judgments of the shareholders
Constant expected cash flows → market value → constant
Expected cash flow increase → market value → increase
Recasting → more explicit & clear → Reach clearer calculation
Assume Free cash flow $100m → continue to perpetuity
i. Perpetuity valuation → capitalize annuity stream → using cost of capital → assume 10% as discount rate
ii. FCF of $100m → divided by 10% yield → NPV → $1Bill
iii. NPV = “entity value” → represents → $$$ should be paid today → to access that future stream of cash flow
$$$ Debt → Subtracted firm entity value → determine → $$$ value accrues to entity
i. If Market value exceed equity value → expect FCF improve
ii. If Market value less equity value → market expect eroding CF
Perpetuity negative value → result negative value → Negative starting cash flow → impossible to generate positive market value
Firm market value x estimated Cost of Capital → FCF in perpetuity
The amount → compared with current cash flow → how much improvement
Dot-com company → $ 10bill market value + 15% estimated cost of capital → can generate $1.5Bill FCF + zero debt
i. Negative CF → see how much improvement need → and decide
Free Cash Flows
i. Management → regularly undertake process
ii. Invertors → should do the same for each investment

Managing for Free Cash Flows and Shareholder Value Creation
It’s a management’s fundamental responsibility → increase shareholder value
Require → NPV increase
Three ways to do:
i. Increase cash earnings
1. Growth → in and of itself
2. Won’t do it → No Profitable growth
3. Cost management → Differ from cost reduction
a. Spending more → increase cash earnings and FCF
4. Good Cost Management:
a. Spending to develop new products or support customers
b. Find ways to take out cost from product → no affect to perceived value
c. Reducing administrative cost

ii. Reduce investment
1. Managing working capital & other assets → tightly → means
a. collecting receivable quickly
b. turning inventories faster
c. focusing more on intangible assets performance

iii. Financial Management
1. Managing mix of capital → minimize weighted average cost of capital
a. Increasing the proportion of debt capital that less expensive than equity capital → why? → fixed assets are frequently undervalued → and intangible assets not recognize
b. Company actually has additional debt capacity → before cost of capital rise → increase risk

2. Using FCF → increase company’s future value
a. More mature company → positive CF → able to pay their dividend
b. This not represent real condition → company could leverage up cash by not pay dividend
Most business have variety of products and product groups
Product stage → Life Cycle, positioning, competitive strength, and investment requirement → influence cash flow pattern
Ultimate financial management challenge → use FCF → to invest → new business opportunity → build shareholders value

Xerox Corp. – Profits vs. Cash Flows
Best condition:
i. Xerox Corp. → provide example hoe potentially misleading accounting profits can be.
ii. Early 1999 → excellent year → EPS ↑ 16% → income 17% → best condition
iii. After annual report released → Xerox stocks ↑ → market capitalization → $42bill
Bad News:
i. 3rd and 4th quarter 1999 → large earning shortfall
ii. Stock dropped from $64 → $ 20/share
iii. Xerox might bankrupt → Stock fell $5/ share → loss 90% value
Before Restructuring
i. Things going right → Profits going up → market expected more

d. Three year period → Xerox burned close to $2 billion in cash → before interest payments and dividend distributions → reported earnings aggregated more than $3 billion → cash flows were more than negative $5 billion
e. April → agreed to restate earnings for four year period and pay a $10 million fine to the security and the exchange commission

Metrics to Monitor Free Cash Flows and Value Creation
Traditional → just focused on → measure of Profitability and Risk
i. Profitability → focused on → return on assets & return on equity
ii. Risk → focused on → liquidity & solvency
ROA suffers on two counts → Net Operating Profit After Tax & Assets denominator that stated in book value
i. NOPAT suspect → many deficiencies of accrual earnings
ii. Assets denominator → makes ROA overvalued
ROE fail the same → Net income divided by average book equity → in most cases → resulting overstated calc.
To create shareholders value → Return on Invested Capital → must exceed WACC
By ROE → if ROE > estimated shareholder cost of capital → the firm creating the shareholders value

Summary
FCF → Has to be Focus on major financial statement overhaul
Also → may be directly related to current market valuations → determine Current FCF support / not support market values