BIBLIOGRAPHY AND REFERENCES
2. Simpler valuation models work much better than complex ones
5.3 REWRITING FINANCIAL STATEMENTS – CALCULATION OF FREE CASH FLOWS
In this section we will derive the free cash flows of a company by rewriting its income state-ment and balance sheet. There are 2 approaches that we can use to derive the free cash flow of a company. The bottom-up approach and the top-down approach. Let us examine them in turn.
The bottom-up approach starts from the net income of the company. Net income comes right off the income statement and includes any tax or interest expense that must be paid for the period. Since we are talking about cash flows we should add back any non-cash items such as amortization and depreciation that have been taken into consideration in the income statement. Moreover since we want to derive the free cash flows, that is, free to be distributed to all security holders including debt holders, we should add back interest expense which is directed to them. The company will be valued as a going concern, as we mention above, that
is, on the basis that it will operate in the foreseeable future. Due to this fact it needs to make the necessary investments in CAPital EXpenditure (CAPEX) and working capital in order to attain revenue growth forecasts. Thus any necessary capital expenditure as well as investments in working capital will be subtracted. The resulting figure is the so-called Free Cash Flow to the Firm (FCFF).
The other approach, the top-down, starts with the estimation of future revenues and oper-ating expenses (including depreciation) to find Earnings Before Interest and Taxes (EBIT) for each year. Then we subtract taxes to find the so-called Net Operating Profit After Tax (NOPAT) for each year. NOPAT is a crucial measure in a variety of financial analyses because it gives a clearer view of the operating efficiency of a company, a view that is not clouded by how leveraged the company is or how big a bank loan it was able to obtain. After the deri-vation of NOPAT we have to add back any non-cash costs (e.g. depreciation) that have already been subtracted in estimating EBIT. Remember in Chapter 3 we mentioned that, for practical reasons, it is better to gather all depreciation expense categories (cost of goods sold; selling, general, and administrative) in one place (after EBITDA) in the income statement. Had we done so we would not have needed to make any adjustments for depreciation. Finally we subtract capital expenditures and increases in working capital or add back any decreases in working capital.
You will recall that in Chapter 2 we showed that an increase in an asset is a cash outflow whereas a decrease in an asset is a cash inflow. Similarly, we showed that an increase in a liability is a cash inflow whereas a decrease in a liability is a cash outflow. Therefore, since capital expenditure increases the assets of the company, they cause cash outflows and thus have to be subtracted from the operating cash of the company. Moreover, as we mentioned in Chapter 2, the working capital of a company is derived by subtracting its current liabilities from its current assets. So any increase in working capital comes either from an increase in current assets or a decrease in current liabilities or a combination of both. In any case all of the above constitute cash outflows and thus have to be subtracted from the operating cash of the company. Similarly, decreases in working capital come either from decreases in current assets or increases in current liabilities or a combination of both and as such represent cash inflows and have to be added to the company’s operating cash. Exhibit 5.3 shows graphically the top-down approach of the derivation of free cash flows to the firm.
Now we have finished with the theoretical part of the derivation of free cash flows let us apply the top-down approach to SteelCo’s figures as described in Chapter 3. Since the explicit forecast period is 5 years and the FP&A manager has prepared the proforma financial state-ments up to 2017 we need to forecast an extra year. To do so we could follow the same meth-odology as that described in Chapter 3 and forecast a complete income statement and balance sheet for 2018 or follow a more quick and dirty approach. We could forecast directly both the EBITDA and the working capital figures as a percentage of sales. We could keep CAPEX constant as that of 2017. Taxes will be assumed to be zero for 2018. The company has so many accumulated losses from 2013 to 2017 that even if 2018 is an extraordinarily good year and presents profits, their taxable amount will be eliminated by the losses carried forward.
So let us start building a new worksheet with all the relevant information that we will need in order to structure a simple DCF model. The first piece of information will be the figures from the financial statements of SteelCo that make up the free cash flow. So the first part of the worksheet will look like the one shown in Exhibit 5.4.
EBIT is derived by subtracting depreciation from EBITDA. Depreciation and EBITDA figures read directly from the forecast income statement of SteelCo as described in Chapter 3.
EXHIBIT 5.3 Top-down approach to derive free cash flows Operating Profit (EBIT)
Debt Service Dividends CAPEX Investments
−
=
+ +/−
−
=
CAPEX
Debt Service Dividends Investments Change in Working Capital
Depreciation & Amortization Taxes
Net Operating Profit after Tax (NOPAT)
Free Cash Flow ΔWorking Capital
EXHIBIT 5.4 Forecasting the free cash flow for SteelCo for years 2014 to 2018
Depreciation for 2018 was set equal to that of 2017 (instead of the figure of € 2,305k estimated in section 4.5.1). The EBITDA for 2018 was calculated using the formula below:
EBITA EBITDA
Sales Sales
2018 2017
2017
= × 2018
That is, we used the EBITDA margin of 2017 as a proxy for the EBITDA margin of 2018.
The sales for 2018 were estimated using the polynomial regression methodology we described in Chapter 4:
Sales2018= 2,406.8 * x2− 34,206*x + 215,424
where x equals the period under forecast and the range is from 1 to 8 (3 years’ actual sales figures plus another 4 years of estimates plus an extra year we want to forecast). So the sales for 2018 equal:
Sales 2018= 2,406.8 * 82− 34,206*8 + 215,424 = €95,811k and the EBITDA2018
2018
€2,262k
€95,811k €2,348k.
€93,915k
EBITDA = × =
Moreover the working capital (WC) for 2018 is derived by the following equation:
WC2018= WC2018 as a % of Sales × Sales2018
The WC as a percentage of sales, as we calculated it in Chapter 4, for the fiscal years 2011 to 2013 was 49%, 50%, and 52% respectively. We can see that it followed an increas-ing trend. Nevertheless this trend seems to have been reversed in the forecastincreas-ing period 2014 to 2017. The WC as a percentage of sales for this period is 36%, 33%, 30%, and 30%
respectively. We discussed in Chapter 4 whether this is a plausible assumption or not. More-over we discussed how we could forecast this ratio for 1 more year. The ratio was found to be 27% (see Section 4.6). Suffice it to say for the time being that this ratio for 2018 will be 26%. We will discuss the consequences of the ratio being 27% further towards the end of this chapter. So:
WC2018 = 26% × €95,811k = €24,911k
Since we are interested not in the working capital per se but in working capital increases or decreases across the years the ΔWC2018 is:
ΔWC2018-2017= WC2018 − WC2017= €24,911k − €25,570k = − €2,659k
The negative number declares a decrease in working capital and thus cash inflow. That is why we add it to the operating cash of the company.
Finally, the CAPEX for 2018 has been chosen as equal to that of 2017, which is €300k (instead of the figure of €997k estimated in section 4.5.1).
The free cash flow for 2018, then, is:
FCF2018= EBITDA2018− ΔWC2018-2017− CAPEX2018 =
€2,348k − (− €2,659k) − €300k = €2,348k + €2,659k − €300k = €4,707k.
Having finished with the derivation of the free cash flows for the explicit forecast period, next we proceed to the estimation of the weighted average cost of capital.