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STREETSMART GUIDE TO VALUING A STOCK
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amount of revenue. The current assets and current liability categories that most directly relate to sales are: accounts receivable monies owed to the company from customers; inventories monies used by the company to finance its products prior to their sale; and accounts payable monies owed by the company to other entities. We define working capital as accounts receivable plus inventory minus accounts payable: Working Capital [(Accounts Receivable Inventory) Accounts Payable]
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Often a company s change in net working capital, either positive or negative, is approximately proportional to its change in revenue. Some firms, like Intel whose incremental working capital averaged 14.8 percent of revenue, have a very large amount of cash tied up in working capital. Other firms, such as some electric utilities that have an easy-pay plan in which customers deposit monies in the summer based upon a level monthly-pay plan for their peak electricity use in the winter, have a cash inflow due to a surplus of working capital.
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Incremental Working Capital: Our Recommendation
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The components to calculate incremental working capital are listed on the balance sheet of the company. Most often, the company s intrinsic stock value is least sensitive to this cash flow input. Many analysts use the trend in balance sheet data, such as a significant increase in inventories or accounts receivable, as an early warning sign that may indicate problems at a company. Such balance sheet sleuthing is beyond the scope of this book. We use a simple averaging process to calculate the ratio that we use for incremental working capital, and we suggest that you do likewise. This ratio, either positive or negative, is multiplied by the increase or decrease in revenue not the absolute level of revenue. For example, if the company s working capital ratio is 10 percent, and its estimated increase in revenue is $100 million, its incremental working capital requirement is $100 million * (10 percent) $10 million. Likewise, if the company s growth rate is zero, its incremental working capital requirement is zero.
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Forecasting Expected Cash Flow
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Cisco Systems 2002 Balance Sheet
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Cisco s Incremental Working Capital
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Let s take a look at Cisco s working capital (taken from Cisco s balance sheet, see Exhibit 5-4) over the past two years to see the effect that an increase in revenue will produce. Table 5-8 shows that Cisco has a significant amount of cash tied up in net working capital an average of 9.63 percent of revenue.
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STREETSMART GUIDE TO VALUING A STOCK
TABLE 5-8
Cisco Systems
Two-Year Working Capital History (in millions of dollars)
Year 2002 2001
Revenue $18,915 $22,293
Acct. Rec. $1,105 $1,466
Inventory $880 $1,684
Acct. Pay. $470 $644
Working Cap $1,515 $2,506
%Work. Cap. 8.01% 11.24% 9.63%
2-year average
For our estimate of incremental working capital, we make projections that show working capital expanding at a rate of 9.63 percent times the yearly increase in revenue, as shown in Table 5-9.
Valuation Input Relating to Incremental Working Capital
The input relating to incremental working capital for the ValuePro 2002 software on the general input screen is: Working Capital (% of change in revenue)
TABLE 5-9 Cisco Systems
Projected Working Capital (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 $3,783 $4,540 $5,448 $6,537 $7,844 $9,413 $11,296 $13,555 $16,266 $19,519 $364 $437 $525 $630 $755 $907 $1,088 $1,305 $1,566 $1,880 Increase Rev. Inc. Work. Cap
9.63%
Forecasting Expected Cash Flow
The FCFF approach allows for individual yearly inputs of incremental working capital ratios over the excess return period, and it can accommodate numerous working capital investment assumptions in the valuation process.
Free Cash Flow to the Firm
Estimating Free Cash Flow During Excess Return Period
That was painful, but we re home free! We now have all of the estimates that we need for the calculation of free cash flow to the firm. We take the net operating profit after tax and subtract net investment and incremental working capital to get free cash flow to the firm. Remember our FCFF equation from 4: FCFF NOP Taxes Net Investment Net Change in Working Capital Earlier in this chapter we saw that NOPAT doesn t take a mathematician to see that: FCFF NOPAT Net Investment NOP Taxes. And it
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