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To produce revenue, not only must a corporation incur operating expenses, it also must invest money in real estate, buildings and equipment, and in working capital to support its business activities. A company s new investment, its annual investment in plant, property, and equipment, may be quite substantial and represent a significant cash outflow for the company. For example, during the late 1990s, the McDonald s Corporation invested about 20 percent of its total yearly revenues to expand its number of restaurants and make the improve-
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ments and capital expenditures that the fast food business requires. These were big cash outflows. Partially offsetting capital expenditures is the depreciation deduction that a company receives as it annually expenses its prior capital expenditures for tax purposes. Depreciation is a noncash expense and is not a cash outflow. The net investment that a company makes to support its operations is: Net Investment New Investment Depreciation
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Working capital is the company s investment in its accounts receivable plus its inventories (both being cash outflows), minus its accounts payable (a cash inflow). Working Capital (Accounts Receivable Inventories) Accounts Payable
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The net change in working capital is the yearly change that is required to support the growing revenues and operations of the company. The corporation must pay income tax, another cash outflow, on its earnings. From Exhibit 4-1, we see that Microsoft had a provision for $3684 million in income taxes in 2002, which when divided by its income before income taxes of $11,513 million, is equal to a tax rate of 32.0 percent. Capital expenditures, working capital, and income tax payments represent real cash outflows from the corporation hard-earned dollars flowing out of the firm that are not available to pay the good guys, the shareholders. How do we blend these cash flow measures together to come up with a stock s value We use a discounted free cash flow to the firm approach to calculate the intrinsic value of a company s stock. The number that results from adjusting the earnings measure associated with NOP for the actual cash flows of taxes, net investment in longterm assets, and net change in working capital is known as free cash flow to the firm (FCFF). FCFF is an important measure to stockholders. This is the cash that is left over after the payment of all hard cash expenses and all operating investment required by the firm. FCFF is the actual cash that is available to pay the company s various claim holders, especially the
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STREETSMART GUIDE TO VALUING A STOCK
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stockholders. The following equation is used to calculate the annual FCFF: FCFF NOP Taxes Net Investment Net Change in Working Capital The accounting definition of earnings and profits are fine for accounting purposes, but from a stock valuation standpoint, stockholders should be more concerned about the amount of free cash flow to the firm. How do all of these cash flows and acronyms relate to a stock s value It boils down to this: on any corporate investment, a corporation creates additional value for stockholders if and only if it earns a rate of return, after all net cash flow adjustments, that exceeds the corporation s weighted average cost of capital. This occurs only when the investment generates additional free cash flow to the firm. We have stated that the value (not necessarily the price) of an investment is equal to the present value of its expected cash flows, appropriately discounted for risk and timing. So the value of a firm is not determined by historic performance, or even current performance. The firm s value is determined by investors belief about the company s future performance. Future performance is difficult to predict particularly when you re putting your hard-earned money behind your prediction in the way of a stock purchase. However, there are some tried-and-true methods to estimate growth and other valuation inputs that are used by analysts and savvy investors for valuation purposes. We talk about those later, and we provide some tips on how to make well-informed assumptions ones that we re willing to put our dollars behind!
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