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STREETSMART GUIDE TO VALUING A STOCK
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TABLE 5-5
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Projected Taxes and NOPAT (in millions of dollars)
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Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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34.36% 34.36% 34.36% 34.36% 34.36% 34.36% 34.36% 34.36% 34.36% 34.36%
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the telecom companies and fiber optic cable providers. During that period, the new investment-to-revenue-ratios for those companies were so high that there was no possibility for a telecom company to generate positive free cash flow.
Net Investment: Our Recommendation
We ve found that the easiest way to estimate net investment as a valuation input is to do the following: 1. During the excess return period, which assumes revenue growth, project that new investment and depreciation expense continue at the historic average percentages of revenue. 2. After the excess return period, which assumes that the return from new investment equals the company s WACC, set new investment equal to depreciation so that the company adequately maintains property, plant, and equipment.
Forecasting Expected Cash Flow
The estimation procedure described here assures that to maintain its revenue growth, a company s new investment will keep pace on a percentage basis with total revenue. When revenue growth stops, new investment just keeps pace with depreciation expense, and net investment equals zero. That is: 0 New Investment Depreciation Expense
Some analysts believe that it s more accurate to project net investment and new investment in terms of a percentage of incremental revenue growth. We find that adjustment confusing and we prefer to use the percentage of revenue approach. Also, when new investment ratios get exceedingly high and out of control, such as in the telecom industry s binge investment years, for valuation purposes we assume that new investment will return to more sustainable prior levels.
Cisco s Net Investment
Let s now look at Cisco s investment ratios and depreciation ratios to get comfortable with this calculation. In addition to growth of its current operations, Cisco has a history of buying growth through the purchase of companies. The 2002 statement of cash flow (see Exhibit 5-3) shows that Cisco acquisition of property and equipment was $2641 million in 2002, $2271 million in 2001, and $1086 million in 2000. As shown in Table 5-6, over the last three years Cisco has invested approximately 10 percent of revenue in the purchase of property, plant, and equipment and has expensed most of it 8.31 percent in the way of depreciation. If we assume that over the next 10 years it continues to cost Cisco similar investment and depreciation amounts to increase sales, then the schedule of net investment for Cisco is shown in Table 5-7.
Valuation Inputs Relating to Net Investment
The inputs relating to new investment and depreciation expense, used to calculate net investment on the general input screen for the ValuePro 2002, software are: New investment rate (percent of revenue) Depreciation rate (percent of revenue) 9.96 percent 8.31 percent
STREETSMART GUIDE TO VALUING A STOCK
EXHIBIT 5-3
Cisco Systems 2002 Statement of Cash Flow
The FCFF approach allows for individual yearly inputs of new investment and depreciation expense ratios over the excess return period, and it can accommodate numerous capital investment and depreciation assumptions in the valuation process.
Forecasting Expected Cash Flow
TABLE 5-6
Cisco Systems
Investment and Depreciation History (in millions of dollars)
Year 2002 2001 2000
Revenue $18,915 $22,293 $18,928
Investment $2,641 $2,271 $1,086
% Investment 13.96% 10.19% 5.74% 9.96%
Depreciation $1,957 $2,236 $863
% Depreciation 10.35% 10.03% 4.56% 8.31%
Net Investment $684 $35 $223
3-year average
Incremental Working Capital
Working capital is needed to support the sales effort of a company. In the calculation of incremental working capital, we want to find shortterm assets and liabilities, the levels of which depend directly on the
TABLE 5-7
Cisco Systems
Projected Net Investment Schedule (in millions of dollars)
Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Revenue $18,915 $22,698 $27,238 $32,685 $39,222 $47,067 $56,480 $67,776 $81,331 $97,597 $117,117
Investment
Depreciation
Net Investment
$2,261 $2,714 $3,256 $3,907 $4,689 $5,627 $6,752 $8,102 $9,723 $11,668
$1,887 $2,264 $2,717 $3,260 $3,912 $4,695 $5,633 $6,760 $8,112 $9,735
$375 $450 $539 $647 $777 $932 $1,119 $1,342 $1,611 $1,933
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