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We can derive cash flow from net income in an alternate format, ie, as a percentage adjustment to net income Usually this will be a much easier calculation than forecasting all the elements of cash flow, ie, depreciation, capital expenditures, and net working capital changes For valuation purposes, the Payout Ratio (POR) is the portion of net income that can be distributed to owners ideally without impairing operations10 The portion of net income required for operating and growing the business is called the Retention Ratio (RR), which equals one minus the Payout Ratio In algebraic form, we can calculate cash flow through the Payout Ratio, as shown in the following equations:
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In calculating the Payout Ratio historically, it is simply dividends paid divided by net income Even if the owner did impair operations by paying out too much in dividends, one does not distinguish whether or not operations were impaired However, for valuation purposes, in forecasting ahead, we consider only the dividends that can be paid without impairing operations
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CHAPTER 4 Defining and Measuring Economic Cash Flow
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CF Where CF Ratio Cash Flow, NI CF
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Net Income, and POR (1 RR)
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Where 1 RR POR Since both of these equations calculate cash flow, they are both equivalent to the shortcut equation I will assume you understand net income, so we need to understand the Payout Ratio and the Retention Ratio The Retention Ratio is the percentage you withhold from net income for the maintenance and growth of the business Let s consider the investment needs of a stagnant business Suppose Connie s boomerang business has no real growth It sells the same number of boomerangs year after year, has the same number of employees, etc Sales and probably wages will show only inflationary growth, which has been approximately 3 percent per year in the United States Such a business will not need much new equipment It can probably do with just replacing existing equipment when it wears out Thus, in our shortcut equation, capital expenditures will only exceed depreciation expense by growth in the costs of boomerang carving equipment If we forecast the business to decline, then if it declines by just the inflationary difference, capital expenditures will equal depreciation expense in dollars If it declines by more than that, capital expenditures will be less than depreciation expense On the other hand, an expanding business will require capital expenditures in excess of depreciation expense for two factors: the inflationary increase in prices, and the real increase in the amount and quality of machinery in the business
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Payout Ratios of Publicly Held Firms
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There is a logical connection between the Retention Ratio and the growth of the business The faster you expect your business to grow, the larger the percentage of net income you ll need to retain in order to fuel that growth As a benchmark, the Dividend Payout Ratio (1 RR) for publicly held firms was 47 percent at the beginning of 1926 and decreased to 32 percent by
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PART ONE Business Valuation
the end of 200011 However, a new working paper by Boudoukh, et al12 suggests that stock repurchases have taken up the slack for the drop in the Payout Ratio This means that publicly traded firms retain on average 1 47% 53% of their income for cash flow and growth Publicly held firms experienced an average growth of approximately 6 to 8 percent, which is much faster than private firms certainly due to their much larger Retention Ratio and greater business opportunities13 Growth in cash flows is not the same as sales growth Often during periods of high sales growth, the firm s profit margin declines Thus, it is not only possible but common to find high sales growth coupled with stagnant profits and cash flows The cash flows of most healthy privately held firms grow from 1 to 6 percent per year The 1 percent nominal growth is really a 2 percent decline, after subtracting 3 percent for inflation, while the 6 percent growth represents 3 percent for inflation and 3 percent real growth It is a rare privately held firm that can reasonably be expected to grow forever at an average rate of 8 percent per year That rate is more typical of a young firm, especially one with a very exciting or unusual product It s important to note that it is growth in cash flows not growth in sales that count in valuation If sales grow by 15 percent per year but the business is losing its profit margins and cash flows decline, it is the decline in cash flow that we use in our valuation formula, not the increase in sales
Roger G Ibbotson and Peng Chen, The Supply of Stock Market Returns, Yale ICF Working Paper No 00-44, page 7 and Figure 4 12 Boudoukh, Jacob, Roni Michaely, Matthew Richardson, and Michael R Roberts, On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing, available on the Social Science Research Network, 12/16/03 13 According to Ibbotson and Chen (cited above), page 5, equation 6, geometric average capital gains in the public equity markets from 1926 to 2000 were 302 percent in real terms and approximately 62 percent in nominal terms Arithmetic returns are always higher than geometric returns, and the former is the correct measure for valuation purposes This suggests nominal capital gains of approximately 7 to 8 percent The author wishes to thank Dr Shannon Pratt for pointing out new research by Roger Grabowski using two-year instead of the traditional one-year arithmetic average returns that suggests that the arithmetic averages may be even slightly lower, perhaps 6 to 8 percent (see Dr Pratt s editorial in Business Valuation Update, November 2003) Income returns in the Ibbotson and Chen article were 428 percent
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