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Valuation > Earnings and Cash Flows > Flashcards

Earnings and Cash Flows Flashcards

1
Q

What do financial statements provide ?

A

Fundamental information that we use to analyze and answer valuation question.

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2
Q

What is the difference between finance and accounting ?

A

— Accounting: Measures the current standing and immediate past performance of a firm.
— Finance: Much more forward-looking. How much cash flow are the assets going to generate in the future?

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3
Q

What are the main financial statments ?

A 
1. Cash flow statement
       – True cash movements
2. Income statement
       – Meaningful cash movements
3. Balance sheet
       – Cumulated investments and their financing (through retained earnings or security issuance)
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4
Q

What is a balance sheet ?

A

Snapshotof the firm’s assets, liabilities, and equity
— Sources of capital (Liabilities and equity)
— Uses of capital (Assets)

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5
Q

What is the basic structure of the balance sheet?

A 
— Current assets
— Non current assets
— Operating liabilities
— Financial liabilities
— Equity
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6
Q

What are current assets ?

A

All assets that are reasonably expected to be converted into cash within 1 year.

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7
Q

What are non-current assets ?

A

Assets which are expected to be in use for more than 1 year.

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8
Q

What are operating liabilities ?

A

Money that is owed to business partners from transactions related to the actual production and sale of the firm’s goods and services.

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9
Q

What are Financial liabilities ?

A

Money that is owed to the providers of debt.

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10
Q

What is Equity ?

A

Capital contributed by the owners of the company.

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11
Q

What are the two categories of assets ?

A

— All assets that are depreciated, amortized, or impaired are the result of investment activities.
Mostly non-current assets: Property, plant & equipment; Investments & advances; Intangible assets.
— All other assets are operating assets.Mostly current assets: A/R; Inventories; Other current assets
Mostly current assets: A/R; Inventories; Other current assets

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12
Q

What are the two categories of liabilities ?

A

— All interest-bearing liabilities are financing liabilities.Mostly financial liabilities: Short-term debt; Long-term debt
— All liabilities that are not interest bearing are part of the firm’s operating liabilitiesMostly: A/P; Taxes payable

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13
Q

What composes equity ?

A

All equity items refer to the firm’s financing activity.

— Everything listed under equity

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14
Q

What are operating assets constituted of ?

A
  • Accounts receivable
  • Inventory
  • Prepaid expenses
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15
Q

What are operating liabilities constituted of ?

A
  • Account payable

* Taxes payable

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16
Q

What are financial liabilities constituted of ?

A
  • Short term debt

* Long term debt

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17
Q

What is related to operating activities ?

A

Everything that leads up to EBIT

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18
Q

What are the consequences of interest expenses being part of the financing activities ?

A

— Income taxes are a mixture of operating and financing activities
— Net income is a mixture of operating and financing activities

→ We have to disentangle the two types of activities.

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19
Q

What are the adjustments for NOPLAT ?

A

> We first compute the taxes the firm would have to pay without debt financing. These are the so-called Adjusted taxes.

> Thenwederivethe net income the firm would have without debt financing. That’s the so-called Net Operating Profit Less Adjusted Taxes (NOPLAT).

> NOPLAT = EBIT –Adjusted taxes

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20
Q

What is retained earnings’ formula ?

A

Retained earnings(t)= Retained earnings(t-1)+Net income(t)–Dividend(t)

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21
Q

What do we need to do because of EBIT and net income’s little resemblance with the true earnings ?

A
  1. Obtain updated earnings estimates
  2. Correct for earnings misclassifications
    — R&D expenses
    — Operating Leases
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22
Q

What are capital expenses ?

A

Any expense that is expected to generate benefits over multiple periods.

E.g., the firm invests in a new machine that will produce a product in the future.

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23
Q

What are R&D adjustments ?

A

Since R&D is a capital expenditure (rather than an operating expense), the operating income has to be adjusted to reflect its treatment.

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24
Q

How to capitalize R&D ?

A

— Specify an amortizable life for R&D (2-10 years)
— Collect past R&D expenses for as long as the amortizable life
— Sum up the unamortized R&D over the period
— Thus, if the amortizable life is 5 years, the research asset can be obtained by adding up 1/5thof the R&D expense from five years ago, 2/5thof the R&D expense from fours years ago…

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25
Q

How is adjusted operating income computed ?

A

Adjusted operating income = operating income + R&D expenses - amortization of research asset

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26
Q

How is adjusted net income computed ?

A

Adjusted net income = Net income + R&D expenses - amortization of research asset

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27
Q

How should operating leases be treated ?

A

As Financing expense

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28
Q

What are the adjustments to earnings and capital ?

A

— Debt value of operating lease = Present value of operating lease commitments at the pre-tax cost of debt.

— When you convert operating leases into debt, you also create an asset to counter it of exactly the same value.

29
Q

How are adjusted operating earnings computed ?

A

Adjusted operating earnings = operating earnings + operating lease expenses - depreciation on leased assets

30
Q

Why do managers manage earnings ?

A

— Avoid being fired for missing earnings targets

— Compensation may be based on profit targets such as EPS

31
Q

Why do firms generally manage earnings ?

A

Because they believe that they will be rewarded by markets for delivering earnings that are smoother and come in consistently above analysts estimates.

32
Q

What should cash flow be when valuing a firm ?

A

After taxes, prior to debt payments, and after reinvestment needs.

33
Q

What are the different tax rates we face ?

A

— Effective tax rate
— Marginal tax rate

Marginal tax rates for most firms within a
country/region should be similar, effective tax rates may vary widely.

34
Q

What is the effective tax rate ?

A

It is computed as the taxes due divided by the taxable income.

35
Q

What is the marginal tax rate ?

A

It is the tax rate which a firm faces on its last dollar of income.
– This rate depends on the tax code and reflects what firms have to pay as taxes on their marginal income

36
Q

Why are there differences between marginal and effective tax rates?

A

— Firms may use different accounting standards for tax and for accounting purposes (straight line depreciation for reporting, and accelerated depreciation for tax purposes).
— Firms may use tax credits to reduce the taxes they pay.
— Firms may defer taxes on income to future periods.
— Firms may generate substantial income for foreign domiciles with lower tax rates.

37
Q

What are the two components to reinvestment ?

A
  1. Net capital expenditures

2. Investments in non-cash working capital

38
Q

What is net capital expenditure ?

A

Differences between capital expenditures and depreciation.

39
Q

What is Depreciation ?

A

Cash outflow that pays for some or a lot of the capital expenditures.

40
Q

How is adjusted net capital expenditures computed ?

A

Adjusted net capital expenditures = Net capital expenditures + Current year’s R&D expenses - amortization of research asset

41
Q

What is working capital in accounting terms ?

A

Difference between current assets (inventory, cash, and accounts receivable) and current liabilities (accounts payables, short-term debt and debt due within the next year)

42
Q

What is a cleaner definition of working capital ?

A

Difference between non-cash current assets (inventory
and receivables) and non-debt current liabilities (
payables)

43
Q

What should net income be adjusted to ?

A

— Find the cash flows related to the firm’s operating activities
— Find the cash flows related to the firm’s investment activities
— Find the cash flows related to the firm’s financing activities

44
Q

How is the increase in net working capital defined ?

A

ΔNWC(t) = NWC(t) – NWC(t-1)

45
Q

What is Trade credit ?

A

Difference between receivables and payables

46
Q

How are Free Cash flow computed ? (2 ways)

A 
•	Free cash flow =
(Renevues – Costs – Depreciation) × (1–τ)
\+ Depreciation
– Capital Expenditures
– Changes in non-cash Working Capital
•	Free cash flow =
(Revenues – Costs) × (1 –τ)
– Capital Expenditures
– Changes in non-cash Working Capital
\+ τ×Depreciation
47
Q

How are FCFE computed ?

A 
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity
48
Q

What are the three adjustments needed to get from NOPLAT to operating cash flow ?

A

— Add back depreciation
— Subtract increases in operating assets
— Add increases in operating liabilities

49
Q

How do we get the FCF ?

A

Subtracting the net investments (capital expenditures) from operating cash flow

50
Q

What is FCF ?

A

— Amount of money the firm generates that is not tied up in the operating or the investment activities
— Amount of money that, in principle, can be distributed to the providers of capital (debt and equity)

51
Q

What dows residual CF show ?

A

How much money is available for distribution to the firm’s shareholders

52
Q

What is change in excess cash ?

A

— Cash that remains “unused” on the BS
— Amount of cash firm generated in excess of cash required to run operating activities, maintain assets, satisfy claims of debt and equity holder
— Cash not tied up in any of three sets of activities

53
Q

Why is growth a double-edged sword ?

A

— The good side of growth is that it pushes up revenues and operating income, perhaps at different rates (depending on how margins evolve over time).
— The bad side of growth is that you have to set aside money to reinvest to create that growth.
— The net effect of growth is whether the good outweighs the bad.

54
Q

What are the ways to estimate growth in earnings ?

A

> Look at thepast
— The historical growth in earnings per share is usually a good starting point for growth estimation.

> Look at what others are estimating
— Analysts estimate growth in earnings per share for many firms. It is useful to know what their estimates are.

> Look at fundamentals
— Ultimately, all growth in earnings can be traced to two fundamentals -how much the firm is investing in new projects, and what returns these projects are making for the firm.

55
Q

What do we have to wrestle with when using historical growth rates ?

A

— How to deal with negative earnings

— Deal with the effects of scaling

56
Q

What is historical growth rates sensitive to ?

A

Period used in the estimation

57
Q

How can the historical growth rate be estimated ?

A

Arithmetic or geometric average

58
Q

Why do analysts often make significant errors in forecasting earnings ?

A

— Partly because they depend on the same data sources

— Partly because they sometimes overlook significant shifts in the fundamental characteristics of the firm.

59
Q

What are the two fundamentals growth in earnings can be traced to ?

A

How much the firm is investing and what returns these projects are making for the firm.

60
Q

What are the definitions of the growth in operating income ?

A

Reinvestment rate = (Net CAPEX + ΔWC) / EBIT (1-t)

Return on capital = ROC = EBIT (1-t) / BV Assets

61
Q

What is the growth in EBIT ?

A

gEBIT= Reinvestment rate ×ROC

62
Q

What are the various way to compute the terminal value ?

A
  • Liquidation value
  • Multiple approach
  • Stable growth model
63
Q

When is liquidation value the most useful ?

A

When assets are separable and marketable

64
Q

What is the problem with multiple approach

A

Makes the valuation a relative valuation.

65
Q

What is the problem with the stable growth model ?

A

Requires that you make judgments about when the firm will grow at a stable rate which it can sustain forever, and the excess returns (if any) that it will earn during that period.

66
Q

How can the liquidation value be computed ?

A

— Based on book value of assets: adjust book value of assets by expected inflation
— Based on earnings power: estimate PV of after-tax cash flows until liquidation

67
Q

What is one proxy for the nominal growth rate ?

A

Risk-free rate or the nominal GDP growth rate

68
Q

What are the various characteristics concerning stable growth rate ?

A

— If you assume that the economy is composed of high growth and stable growth firms, the growth rate of the latter will probably be lower than the growth rate of the economy.
— The stable growth rate can be negative. The terminal value will be lower and you are assuming that your firm will disappear over time.
— If you use nominal cash flows and discount rates, the growth rate should be nominal in the currency in which the valuation is denominated.

Valuation (3 decks)

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