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Why DCF and Not EPS
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Wall Street often focuses on a corporation s quarterly earnings-pershare number. Investment services, such as First Call and Zacks, and
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research analysts from stock brokerage firms estimate quarterly earnings. And pity (or better yet, short) the stock of a company that does not achieve or exceed those estimates. There is no doubt that, all other things being equal, we prefer that a company in which we own stock has more earnings than less. However, all other things are not equal. Often, EPS comes up short in measuring returns. Why With EPS calculations, no consideration is given to dividends or to the time value of money. (Remember Principle 7.) EPS ignores the risk associated with a stock. (Recall Principle 1.) No consideration is given as to when (timing) an investor expects to receive the cash flows. In fact, no discounting process at all is associated with EPS measure. (Remember Principle 10.). EPS implicitly and explicitly ignores the risks and timing of returns that are dealt with in a discounted cash flow analysis. EPS also fails to incorporate expectations of future corporate performance. Analysts prefer to work with discounted cash flows rather than earnings-related ratios for two additional reasons. First, earnings may be calculated in a number of ways, ranging from using various types of inventory control accounting, to the use of different methods for depreciation, to numerous ways to recognize revenue. Management may manipulate these methods to increase reported earnings. Second, EPS does not address the investments in fixed assets and working capital that are necessary to support the growth of the firm. If EPS growth requires too much additional investment, then earnings growth actually may result in a decrease in free cash flow and a decrease in the company s stock value. Prior to the enactment of the Sarbanes-Oxley Act of 2002, many corporations managed their EPS and earnings growth through accounting gimmicks to achieve or exceed the expectations of Wall Street. Gimmicks du jour go in and out of favor as aggressive, but legal, methods to boost an income statement. Telecom companies swapped fiber optic cable capacity and immediately booked income. This was aggressive, but probably not illegal. Andrew Fastow, mimicing the Wizard of Oz, operated behind dark curtains and used smoke and mirrors to push certain Enron activities to off-balance-sheet entities to hide losses and debts. Some of Enron s transactions may have been legal, but many were scams. And WorldCom brought a new level of audacity to corporate accounting by booking over $9 billion in ordinary expenses as capital expenditures. We hope that the SEC, the
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Justice Department, and the various state Attorneys General truly clamp down on scam accounting and sham transactions and prosecute perpetrators to the fullest extent permitted by law. Without reliable accounting numbers, stock valuation is a worthless exercise.
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The discounted FCFF valuation approach uses a four-step process to value the stock of a company. In this section we value the common stock of Microsoft, at a point in time prior to its announcement on January 16, 2003 of a two-for-one stock split to take effect on January 28th. If you follow along with us closely, you ll quickly learn the basics about valuing a stock. Step 1: Forecast Expected Cash Flow. The first order of business is to forecast the expected cash flows for the company. We use the most likely assumptions regarding the company s growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement. It s easier than it sounds. In 5 we describe these cash flow inputs and how to estimate them reasonably. The expected cash flows are separated into two time periods. First, the excess return period in which the corporation generates cash flows from operation; and second, the residual value period the time period after the excess return period, in which the corporation is not able to create additional free cash flow. Step 2: Estimate the WACC. Next, we estimate the company s WACC. Its weighted average cost of capital is the discounting rate that we use in the valuation process. We show how to estimate a company s WACC in 6. Step 3: Calculate the Enterprise Value of the Corporation. We then use the company s WACC to discount the expected cash flows during the excess return period to get the aggregate of the corporation s cash flow from operations. We calculate the company s residual value, which usually represents 60 percent to 90 percent of the corporation s total value, by dividing the company s net operating profit after taxes (NOPAT ) at the end of the excess return period, by its WACC. We then discount that future value back to today, also at a discount rate equal to the company s WACC. We add the cash flow from operations, the
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