[Pro] 16 - Discounted cash flow models
Key points:
Cash flows can be manipulated and need to be deeply analyzed to confirm that management is not prettying up their statements.
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Lets start this discussion with a little review of cash flow. There are three sources of cash flow, cash flow from operations, cash flow from financing, and cash flow from investing:
Cash flow from operations (CFO) - This is cash that is derived from the core components of the business.
Cash flow from financing (CFF) - This is derived from cash obtained through financing from either debt or equity securities.
Cash flow from investing (CFI) - This is cash flow derived from the return on investments.
Cash flow from investments and cash flow from financing activities come from non-core components of the business and aren’t necessarily recurring which is why we focus on CFO.
The first thing to understand is that CFO begins from net income on the income statement, and then you adjust backwards by adding in non-cash items like depreciation and amortization. This is because the income statement shows you the accrual based perspective of the business. By this we mean that the income statement follows the matching principle of accounting where we recognize expenses at the same time as revenues. The statement of cash flows just focuses on the actual change in cash flows at each period. What this means in practice is that the income statement is something that can be “managed”, meaning that subjective decision making can play a role in what’s presented on it. The statement of cash flows is a bit harder to manipulate, but there are still subjective decisions that analysts need to be aware of.
Now, why the focus on free cash flow? Free cash flow is the cash that’s available to bondholders and equity holders alike, so if someone is considering acquiring a company, the discounted cash flow model is the one to use because they would be acquiring those cash flows. The acquirer could literally issue all of the free cash flow as dividends if they wanted to because they have control of the company.
Since analysts care a lot about free cash flow, companies will manipulate it. Companies can shift inflows and outflows between operating, investing, and financing cash flows. For example, a company could record a sale of inventory to a bank while keeping that inventory as collateral for a loan. This would increase earnings and CFO. A company could also use inventory as a collateral on a loan and then sell that inventory through the normal course of business but they still have the obligation of buying it back later. This is a strategy that allows companies to book this income as cash from operations instead of cash from financing. Keep an eye out for SPVs or subsidiaries where the parent company purchases from the SPV or subsidiary. Enron used this tactic in order to continue to meet shareholder expectations.
Receiveables are commitments from customers to pay for the products later on and they are an asset on the balance sheet. Another example of this would be selling receivables before the due date for those receivables. This is manipulative because from the outside, it may look like increasing cash flow, but on the inside it’s not a regular cash flow and can’t be relied on in the future. You could also focus on operating cash flow if you’re concerned about the actual generating part of the business. Another thing that companies can do to manipulate their operating cash flow is to capitalize expenses. This records those expenses as assets on the balance sheet instead of reducing net profits on the income statement, which then boosts the cash flow from operations.
One of the pros of the discounted cash flow model is that it’s flexible, so you can just subtract those components of the free cash flow that are not derived from the core business, or you can keep them since, in some sense, they generate value to the stakeholders. These difference of opinions between analysts on what financial components should be kept in the model before discounting lead to many different stock prices opinions and therefore many different buy and sell decisions. If you believe in the wisdom of the crowds then this is excellent because the single price that the market coalesces around must be correct. Another way of looking at it though is that there is only one correct answer out of all of those prices and the rest (99.9% of investors) are wrong and you can take advantage of that.
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