ACCT3013 Financial Statement Analysis WorkshopCash-based valuation

Exercise W6E1: Discounted cash flow (DCF) valuation

Additional information & assumptions

Nikes applicable tax rate is 35%.

Nikes interest income figures for fiscal years 2015, 2014 and 2013 are $5, $6 and $12

million, respectively.

Nikes cost of capital is 10%.

Nikes free cash flow is expected to grow at 6% per annum from the fiscal year 2016 to

2020 and at 4% per annum from the fiscal year 2021 onwards.

Nikes net interest payment (interest paid interest received) before tax is assumed to be

$28 million for all three years

Required

1. Calculate the free cash flows for fiscal years 2013, 2014 and 2015 and perform a

discounted cash flow valuation as of the fiscal year end of 2015. Show all your workings

and all item used in your calculations.

ACCT3013 Financial Statement Analysis Workshop Cash-based valuation [For enquiries please contact Zihang.peng@sydney.edu.au] Note: As explained during lectures and in a Blackboard announcement, to successfully complete these material we assume knowledge of FINC2011. See also the last page of the updated UoS outline. Tutorial assignment Exercise W6E1: Discounted cash flow (DCF) valuation The statement of cash flows extracted from Nike Inc. 2015 annual report is provided below Consolidated Statements of Cash Flows - USD ($) [$ in Millions] Cash provided by operations: Net income Income charges (credits) not affecting cash: Depreciation Deferred income taxes Stock-based compensation (Note 11) Amortization and other Net foreign currency adjustments Net gain on divestitures Changes in certain working capital components and other assets and liabilities: (Increase) decrease in accounts receivable (Increase) in inventories (Increase) in prepaid expenses and other current assets Increase in accounts payable, accrued liabilities and income taxes payable Cash provided by operations Cash used by investing activities: Purchases of short-term investments Maturities of short-term investments Sales of short-term investments Investments in reverse repurchase agreements Additions to property, plant and equipment Disposals of property, plant and equipment Proceeds from divestitures (Increase) in other assets, net of other liabilities Cash used by investing activities Cash used by financing activities: 12 Months Ended May. 31, May. 31, May. 31, 2015 2014 2013 $ 3,273 $ 2,693 $ 2,472 606 (113) 191 43 424 0 518 (11) 177 68 56 0 438 20 174 64 66 (124) (216) (621) (144) 1,237 (298) (505) (210) 525 142 (219) (28) 27 4,680 3,013 3,032 (4,936) 3,655 2,216 (150) (963) 3 0 0 (175) (5,386) 3,932 1,126 0 (880) 3 0 (2) (1,207) (4,133) 1,663 1,330 0 (598) 14 786 (2) (940) Net proceeds from long-term debt issuance Long-term debt payments, including current portion (Decrease) increase in notes payable Payments on capital lease obligations Proceeds from exercise of stock options and other stock issuances Excess tax benefits from share-based payment arrangements Repurchase of common stock Dividends common and preferred Cash used by financing activities Effect of exchange rate changes on cash and equivalents Net increase (decrease) in cash and equivalents Cash and equivalents, beginning of year CASH AND EQUIVALENTS, END OF YEAR Cash paid during the year for: Interest, net of capitalized interest Income taxes Non-cash additions to property, plant and equipment Dividends declared and not paid 0 (7) (63) (19) 514 218 (2,534) (899) (2,790) (83) 1,632 2,220 3,852 0 (60) 75 (17) 383 132 (2,628) (799) (2,914) (9) (1,117) 3,337 2,220 986 (49) 10 0 313 72 (1,674) (703) (1,045) 36 1,083 2,254 3,337 53 1,262 206 $ 240 53 856 167 $ 209 20 702 137 $ 188 Additional information & assumptions Nike's applicable tax rate is 35%. Nike's interest income figures for fiscal years 2015, 2014 and 2013 are $5, $6 and $12 million, respectively. Nike's cost of capital is 10%. Nike's free cash flow is expected to grow at 6% per annum from the fiscal year 2016 to 2020 and at 4% per annum from the fiscal year 2021 onwards. Nike's net interest payment (interest paid - interest received) before tax is assumed to be $28 million for all three years Required 1. Calculate the free cash flows for fiscal years 2013, 2014 and 2015 and perform a discounted cash flow valuation as of the fiscal year end of 2015. Show all your workings and all item used in your calculations. Notes on DDM & DCF valuation [Much of the note is based on Prof. Stephen Penman's book Accounting for Value.] To appreciate the material in the chapter - and difficulties faced with DCF valuations -- you must appreciate the difference between a terminal investment and a going concern investment. Cash valuation works well for a terminal investment, but may not work well for a going-concern investment. The difficulty with a going-concern investment is due to the need to anticipate payoffs for the far distant feature - the firm goes on \"forever.\" Long-term forecasts are very speculative -- we are more unsure the further ahead we have to forecast. We have more confidence in short-term forecasts - for the next few years, for example. The fundamental analyst obeys the creed: Distinguish what you know from speculation. So she wants to use a valuation method that puts a lot of weight on the near-term forecasts in which she is relatively confident. In the long run we are all dead. But the near-term forecasts must be of attributes that inform about value. And here lies the problem with cash flows. We saw with the dividend discount model that dividends in the short term - the cash flows to shareholders - are often unrelated to value, and for many firms they are zero. The same problem applies to discounted cash flow valuation. The two points can be illustrated with the valuation of a savings account. Back to the Valuation of a Savings Account There is a basic rule in valuation: what works for equities and other securities must work for a savings account. If someone proposes an equity valuation model that does not work for a savings account, you know that there is something wrong with it. So we can illustrate misguided valuation techniques by showing that they don't work for a savings account, or that they only work in special circumstances. Consider a $100 account earning at a rate of 10% per annum, terminating after five years. To value the account at date 0, the analyst produces the following pro forma for the five years into the future: A Terminal Savings Account with Full Payout Year Book value Earnings Dividends Free cash flow 0 1 2 3 4 5 100 10 100 10 100 10 100 10 100 10 0 10 10 10 10 10 10 10 10 10 110 110 You notice two things about this pro forma. First, it's for a terminal investment: the balance of the account is paid out at the end of year 5. Second, the earnings of $10 each year are withdrawn from the account, leaving $100 in the account to earn at 10%: this is a case of \"full payout.\" Withdrawals are the dividends from the account. Free cash flow is the amount of cash remaining after reinvesting the cash generated each year back into the account. In this case, none of the $10 generated by the account is reinvested, so free cash flow is $10, with a final cash flow of $110 in year 5, and that free cash flow is paid out in dividends. (Without leverage, free cash flow always equals dividends.) As this is a terminal investment, we can value it by taking the present value of dividends, which in this case in also the present value of cash flows. The required return is 10%, so Value = 10/1.10 + 10/1.21 + 10/1.331 + 10/1.4641 + 110/1.6105 = 100 The rule always holds: for terminal investments, one can always discount cash flows or dividends. This is because, with a terminal investment, we always capture the final liquidating payoff. Note that the book value method and capitalized forward earnings method, laid out in the Chapter 1 web page, also work here: Value = Book Value = 100 Value = Capitalized Forward Earnings = 10/0.10 = 100. With going concern investments, the problem is that there is no expected liquidating payoff. Suppose, now, that this savings account is expected to continue for a very long time. Your grandparents set it up for you when you were born under the condition that you pass it on to your grandchildren. They permit you to withdraw the earnings, however, leaving the principal intact. The pro forma for this account for the first five years is as follows: Going-concern Savings Account with Full Payout Year Book value Earnings Dividends Free cash flow 0 1 2 3 4 5 100 10 100 10 100 10 100 10 100 10 100 10 10 10 10 10 10 10 10 10 10 10 There is no terminal payment in year 5 as the account continues indefinitely. There is full payout every year, as before. We can value the account by discounting the dividends or cash flows. The continuing value at year 5 (or 10/0.10 = 100) is calculated as a $10 perpetuity. Value = 10/1.10 + 10/1.21 + 10/1.331 + 10/1.4641 + 10/1.6105 + (10/0.10)/1.6105 = 100 The dividend discount model and the discounted cash flow model work. Of course, we need not forecast dividends for five years. Just capitalizing dividends for year 1 will capture the perpetuity: Value = 10/0.10 = 100 Note again the book value method and the capitalized earnings method still work for the going concern: Value = Book Value = 100 Value = Capitalized Forward Earnings = 10/0.10 = 100 Now suppose your grandparents said that you could not withdraw anything from the account, but had to let the earnings accumulate in the account for the benefit of your grandchildren. The pro forma in this case is as follows: Going-concern Savings Account with No Payout Year Book value Earnings Dividends Free cash flow 0 1 2 3 100 110 10 121 11 133.1 12.1 0 0 0 0 0 0 4 0 0 5 146.41 13.31 161.05 14.64 0 0 0 0 Here earnings each year are reinvested in the account, so free cash flows and dividends are expected to be zero. We now get to one of the main points: forecasting dividends or cash flows over five years (or ten, or twenty years) won't work. Value = Book Value = 100 Value = Capitalized Forward Earnings = 10/0.10 = 100 You could, of course, get a value based on forecasted dividends or cash flows if you forecasted your grandchildren's ultimate withdrawals and discounted them back to the present. But, to be as practical as possible, we want to work with relatively short forecast. Forecasting the ultimate liquidation of the account two generations on requires a very long forecasting horizon and considerably more computations. But there is another important point to appreciate. Even if you decided to forecast dividends (and cash flows) 50 years hence, book value and earnings are need for the calculation. How would you proceed if you do not know what is the book value of the account or the earnings in the account? That is, if you only have the pro forma lines for dividends and free cash flow? The forecast of future dividends depends on the book value of the account and the earnings on the book value. In fact, the future liquidating dividend will always be equal to the expected future book value at that date, and, with no payout, that value is equal to the current book value (of $100) plus the expected earnings up to that date. Book value and earnings are accrual accounting numbers rather than cash flows. They are very important for valuation. The example illustrates further points. Dividends over the near future are not necessarily related to the value of the investment. This is the Miller and Modigliani (M&M) concept. Dividends involve the distribution of value to the owner, not the generation of value for the owner. Suppose the withdrawals were $1 per year, rather than zero. Would this tell you anything about the value of the account? No, the account would still be worth $100. But the book value and earnings, in the case of the savings account, tell you everything. Similarly, the free cash flow in this case tells you nothing about value. The value of the account is $100 for both the case of $10 free cash flow and the case of zero cash flow. The case of zero free cash flow arises from investing $10 each year back into the asset. Investing reduces free cash flow (in this case to zero), but it does not reduce value. Moving from the Savings Account to Equities With an appreciation of the difficulties of valuing a savings account with only forecasts of dividends or cash flows, there is little to be added as insight when moving to business firms and equities. But there are some points to be made. Focusing on Dividends Dividends are the payoffs to holding shares, so it would seem to make sense that we should forecast dividends to value shares. The dividend paradox says that value is based on expected dividend payoffs, but the investor should not forecast dividends to value equities. To appreciate that we should not focus on expected dividends, one has only to appreciate that many firms do not pay dividends. If a firm pays no dividends, tt is ridiculous to think of forecasting dividends for the next 5, 10 or 20 years, hoping to get some indication of what to pay for a share. U.S. firms, while typically creating value for shareholders over the past 20 years, have been lowering their payouts. The dividend yield (dividends/price) for the S&P 500 has declined form about 4% in the late 1970s to 1.2% in 2001. The payout ratio (dividends/earnings) has declined from about 45% to 31%. And the percentage of firms paying dividends has declined from 80% in the 1950s to 20% by 2000. (It should be pointed out that stock repurchases - another way of distributing cash - has increased, however.). The decline in dividends would seem to have little to do with value creation: over that period, U.S. firms have generated considerable value for shareholders (if share prices are any indication). Focusing on Cash Flows It may be a little more difficult to see that the arguments about cash flows for the savings account apply also to equities. In the savings account, free cash flows equal dividends, but this need not be the case in a firm; the firm might pay out only part of the free cash flow to shareholders. And free cash flows are generated within the firm from the operations that add value