8/14/2019 Tying Free Cash Flows to Market Valuation - Robert Howell - Financial Executive

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Article 21

Tying Free Cash FlowsTo Market Valuations

In a companion piece to his article in the last issue*, Robert Howell turns his attentionto the importance of free cash flows in determining valuations.

By Robert A. Howell

Last month, in this magazine, this author argued in Fix-ing Financial Statements: Financial Statement Overhaul thatthe traditional formats of the primary financial state-mentsincome statement, balance sheet, and cash flowstatementneed major redesign to again be useful formeaningful financial analysis, decision-making andvalue creation.

Since the fundamental objective of a business is to in-crease real shareholder value, this means increasing thenet present value (NPV) of the future stream of cashflows. Financial statements must, therefore, put muchmore emphasis on the free cash flows that a business gen-erates. A vivid example of the different impressions onecan get from focusing on profits and cash flows is XeroxCorp. (see page 18). Focusing on profits could suggest Xe-rox is doing well; free cash flows tell another story.

Relating Free Cash Flows To Market Values

A firms market value reflects the collective judgment of the shareholders expectations of its future cash flows. If the company produces expected cash flows or expecta-

tions remain constant, the market value should remainconstant. If cash flows, or the expectations, turn out bet-ter, market value should rise; if cash flows or the expecta-tions for them turn down, as with Xerox, value shoulderode. Recasting financial statements into a much moreexplicit and clear free cash flow format permits one to atleast relate the current periods free cash flows to the cur-rent market valuation and reach some conclusions re-garding those valuations.

As a starting point, assume that a firm has positive freecash flows of $100 million, and that it will continue to pro-duce that amount in perpetuity. A perpetuity valuation

model would capitalize that annuity stream using thefirms cost of capital (assume 10 percent) as the discountrate. Free cash flow of $100 million divided by 0.10 yieldsan NPV of $1 billion. This $1.0 billion is equal to the en-tity value of the company, and represents the NPV for astream of $100 million in perpetuity; in essence, it repre-sents the most that should be paid today, to access that fu-ture stream of cash flows.

Any debt has to be subtracted from the firms entityvalue to determine how much value accrues to the equityshareholders or the equity value. If debt is $200 million,the equity value is $800 million. If the market value ex-ceeds the equity value, the market is saying that it ex-pects the free cash flows of the business to improve; if themarket value is less, the market expects eroding cashflows.

It is also possible to work in the opposite direction,starting with the companys current market value, adding back any debt; then calculating the rate at which currentfree cash flows must grow, in perpetuity, to support thecurrent market value. If that required rate of growth ishigh, say in excess of 10 percent, one has to question howlikely that is.

In mid-2001, even after the securities markets hadfallen considerably from their early March 2000 highs,companies such as Oracle Corp., EMC Corp., Cisco Sys-tems and Siebel Systems free cash flows would have hadto grow at 14, 18, 18 and 21 percent, respectivelyveryunlikely. Since then, all of these companies market val-ues have dropped further, as could be expected.

Startup and high-growth may be particularly difficultto analyze. Perpetuating negative cash flows would resultin a negative value, and calculating a growth rate from anegative starting cash flow to generate a positive market

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value is mathematically impossible. However, one maystart with the firms market value, then multiply by thefirms estimated cost of capital, to calculate how muchfree cash flow, in perpetuity, would be required to justifythe market price. This amount may be compared to thefirms current (negative) free cash flows to determinehow much improvement is required.

So, a dot-com with a market value of $10 billion and anestimated cost of capital of 15 percent would need to gen-erate $1.5 billion in free cash flows, assuming no debt(which would have had to be added to the market valuehave had to be added to the market value to establish thefirms entity value), in perpetuity, to justify its marketvalue. If the dot-com had negative cash flow, one couldsee how much improvement was needed, and decide if that was even likely. In most cases, it was very unlikely,as eventually became clear.

These examples make simple assumptions regardingfree cash flows. In the first case, it is assumed that the cashflows remain constant in perpetuity; in the second case, itis assumed that they grow constantly in perpetuity. Onemay also develop a set of free cash flow projections for aspecific firm, over a period of 5 to 10 years, put a terminalvalue on the firm at the end of the period and discount theprojected cash flows at the firms cost of capital to deter-mine its value. This is the process management should gothrough when considering acquisition candidates to de-termine how much it can pay and still add value forshareholders. Management should regularly undertakethe same process for its own firm; and investors shoulddo the same for each investment(s).

Indeed, it is possible to directly relate a business free

cash flows to its market value. Financial statementsshould make this connection easy. Today, they do not.

Managing for Free Cash FlowsAnd Shareholder Value Creation

It is managements fundamental responsibilitysomewould say obligationto increase shareholder value.This requires increasing the NPV of the future stream of cash flows. There are only three ways to do it: increasecash earnings, reduce investments and employ financial

management.1. Increase cash earnings by growing the business valu-ably. Growth, in and of itself, wont do it, nor will prof-itable growth, if the impact on free cash flows is actuallynegative. Its important that growth improve free cashflows, which has to take into account additional invest-ments in working capital and capital expenditures re-quired to support the growth.

A second approach, cost management, differs fromcost reduction; it may mean spending more to increasecash earnings and free cash flows, not less. Depending onthe categories of costs across a companys value chain,

good cost management may mean a) spending to developnew products or support customers, rather than drasti-cally cutting those costs; b) finding ways to take costs outof products without affecting their perceived value; or c)reducing administrative costs.

2. Reduce investments means managing working capitaland fixed and other assets more tightly. That might meancollecting receivables more quicklysuch as Dell Com-puter Corp.; turning inventories faster; such as ToyotaMotor Corp.; and getting out from under fixed assets viaoutsourcing, such as Nike Inc. has doneand focusingmore attention on intangible asset performance, whichplacing them on the balance sheet would have a tendencyto do.

3. Financial management has two primary elements.First, managing the mix of capital to minimize the firmsweighted average cost of capital. Generally, this meansincreasing the proportion of debt capital that is less ex-pensive than equity capital. Because fixed assets are fre-quently undervalued and intangible assets are not evenrecognized, many companies understate their book eq-uity, and overstate their debt to capital. They actuallyhave additional debt capacity before their cost of capital begins to rise, due to increased risk.

Second, using free cash flows, or free cash flows afterinterest payments and debt service, to increase the com-panys future value. Historically, more mature compa-nies with positive cash flows have paid dividendsineffect, giving cash back to shareholders, assuming thatshareholders can invest elsewhere to achieve higher re-turns. Thats not saying much for the firmthe share-holder must pay taxes on the dividends, and the companyitself could leverage up the cash it held by not paying div-idends.

Unless a firm has run out of good investment opportu-nities, it should think long and hard about the economicsof cash dividends. Thats also true for stock buybacks.Only if reducing the number of shares outstanding in-creases the per-share value of the remaining shareholdersis this appropriate. For many companies, buying backstock has proven dilutive for continuing shareholders.

Most businesses have a variety of products and prod-uct groups. Each products stage of life cycle, positioning,

competitive strength and investment requirements influ-ences its cash flow pattern and value-creating contribu-tion. Disaggregating firm-wide cash flows will, in alllikelihood, identify groups and individual products thatare actually destroying, rather than creating valuesomeof which may come as a real surprise to management.

The ultimate financial management challenge is to usefree cash flows to invest in new business opportunitiesthat build shareholder value. Every investment a firmmakes, be it a standalone piece of equipment, a new plant,an acquisition or the business itself, should be evaluatedaccordingly.

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Article 21. Tying Free Cash Flows To Market Valuations

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Xerox Corp. Profits vs. Cash Flows

A 1999 1998 1997 G. Richard Thoman, who had been appointed CEO only13 months before, was ousted, attributed in part to afailed sales force reorganization that he had spear-headed. By that autumn, speculation emerged thatXerox might file for bankruptcy. The stock fell to $5per share, having lost more than 90 percent of itsvalue.

Looking at Xeroxs reported profits (before restruc-turing, as management would want the reader to do)provides one impression (See exhibit A).

Revenues were up in 1998; margins before restructur-ing were better and, without restructuring, profitswould have been up slightly. Revenues droppedslightly in 1999, but profits held up, at least relative to1997 and 1998, before restructuring. The market ex-pected more, however, and the market valuation slid.

Looking at the consolidated statements of cash flows,it would be difficult to discern a cash flow problem.however, by rearranging the cash flow data to present iton a free cash flow basis, the picture changes dramat-ically. (See exhibit B).

This says that for the three-year period 19971999including 1998, which was described in such glowingtermsXerox burned close to $2 billion in cash beforeinterest payments and dividend distributions. Yet, be-fore the problems came to light, the companys marketcapitalization soared. That would imply the unsuspect-

ing shareholders were willing to pay $42 billion, plusany outstanding debt, for the opportunity to acquirethis stream of negative cash flows! When one takes intoaccount the interest and dividends, the story gets grim-mer. (See exhibit C).

During this three-year period, reported earnings ag-gregated more than $3 billion, yet cash flows were morethan negative $5 billion. Where were its bankers?

It has recently come to light that Xerox had pursuedaggressive accounting during this period. In early April,it agreed to restate earnings for a four-year period andpay a $10 million fine to the Securities and ExchangeCommission. Separately, the SEC announced that it waswidening its probe of Xerox to include ex-executivesand its external audit firm.

What Xerox did was attribute more of its leasingtransactions to current (e.g., 98 and 99) revenues andprofits than it shoudl have. Looking at the cash flowseliminates these overstatements, because the added rev-enues booked only increased its receivables and had no beneficial effect on cash flows.

Revenues $19,228 $19,447 $18,144

Total Costs and Expenses(Before Restructuring) 17,192 17,153 16,003Restructuring Charge and InventoryWritedown 1,644Net Income 1,424 395 1,452

(all figures in millions of dollars)

B 1999 1998 1997Net Income $1,424 $395 $1,452+Interest (1-tax rate) 543 627 528Net Operating Profit A.T. 1,967 1,212 1,980+\- Non Cash Adjustments 1,316 2,817 1,037Cash Earnings 3,283 4,029 3,017Changes in Working Capital (2,547) (4,235) (2,017)Investments in Capex, etc. (627) (867) (1,251)Cash Charges-'98 Restructure (437) (332)FREE CASH FLOWS (335) (1,405) (251)

C Interest Payments (A.T.) (543) (627) (528)Dividends (586) (531) (475)CASH FLOWS AFTERINTEREST and DIVIDENDS (1,464) (2,563) (1,254)

Xerox Corp. provides a classic example of how poten-tially misleading accounting profits can be, especially inthe context of a troubled company. In early 1999, Xeroxmanagement stated in the companys annual report that1998 was "an excellent year" in which "earnings per share(EPS) from continuing operations were up 16 percent be-fore the restructuring. Income was up 17 percent." Man-agement went on to say, "Our company has never beenstronger in the marketplace nor our opportunitygreater." And so it might seem from the markets reac-tion. Shortly after the annual report was released, Xeroxstock climbed to nearly $64 per share, resulting in a mar-ket capitalization of more than $42 billion.

Throughout 1999, Xerox reported a spate of bad news:softness in its significant Brazilian market, a profit warn-ing for the third quarter that stunned Wall Street, thenanother warning and large earnings shortfall for thefourth quarter. By year-end 1999, its stock had droppedto $20. But the problems didnt end there. By May 2000,

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Metrics to Monitor Free Cash FlowsAnd Value Creation

Traditional financial statement analysis has focused onmeasures of profitability and risk. Profitability hastypically focused on return on assets and return on eq-uity; risk measures have focused on liquidity andsolvency. For many of the reasons that financial state-

ments need drastic overhaul, so, too, do performancemeasures.Return on assets (ROA) suffers on two counts. The re-

turn numerator of net operating profit after taxes (NO-PAT), based on managed earnings, is suspect because of the many deficiencies of accrual-based earnings. Becausethe assets denominator is stated at book value, which isfrequently understated, ROA is often overstated. Returnon equity (ROE) measures fail for the same reasons. Here,the return numerator, net income, is divided by average book equity. Again, in most cases, the resulting calcula-tion is overstated.

The ultimate financial managementchallenge is to use free cash flows toinvest in new business opportunitiesthat build shareholder value.

If one wants to use accounting-based return measures,instead of ROA, one should measure return on investedcapital (ROIC), NOPAT divided by the investments inthe businessworking capital, property, plant andequipment and intangible assets. Excess cash and other fi-nancial assets should be netted against any debt. To cre-ate shareholder value, ROIC must exceed the firmsweighted average cost of capital (WACC). To use ROE,the equity base must be the market value. If the market- based ROE exceeds the estimated shareholder cost of cap-ital, then the firm is creating value for shareholders.

The classic liquidity measures, such as the currentand quick ratios, focus on the relationship of current as-sets to current liabilities. The implication for years thatmore is betterthat a firm is more liquid if its assets ex-

ceed its liabilitiesis deficient on at least two counts:First, it fails to recognize the flow characteristics of working capital. Typically, when a firm grows, so do itsworking capital requirements. Next, having fewer re-sources tied up in working capital is better in that it re-duces the amount of cash required to support growth andimproves ROIC by lowering the investment base.

The most frequently utilized solvency measures arethe times-interest earned ratio and various debt-to-capitalratios. Ratios, however, really say little about absolutecash flows. If a firm lacks adequate free cash flows tocover its debt service, it is insolvent, regardless of whatthe ratios say. Important measures tracked in a cash andvalue orientation are such things as: cash earnings tosales; the relationship of cash earnings to the changes inworking capital (a measure of liquidity, in that it reflectswhether enough cash is being earned to support the re-quired changes in working capital); cash earnings to rein-vestments (both in working capital and fixed andintangible assets); free cash flows to sales (the single most

important measure); and free cash flows to interest and tototal debt service, two measures of solvency.

In summary, free cash flows have to be the focus of ma- jor financial statement overhaul, and may be directly re-lated to current market valuations to determine if thecurrent free cash flows support current market values.Focusing on free cash flows also necessitates establishinga new set of metrics that have a cash and value orienta-tion. Management teams and investors who embrace thenew cash and value-oriented statements and associatedmetrics will find that they have new insights into their businesses and investments, and the opportunity to cre-ate real value for their shareholdersand themselves.

[*See Financial Executive, April 2002.]

Robert A. Howell is a Visiting Professor of Business Administration atthe Tuck School of Business at Dartmouth. He can be reached at Robert. A. Howell@Dartmouth.edu

Reprinted with permission from Financial Executive , May 2002, pp. 17-20. 2002 by Financial Executives International, 10 Madison Avenue,Morristown, NJ 07962.