Valuation of Securities

Future Cash Flows

Cash Flow Defined

Cash flow provides an account of the financial health of a company.

Cash flow is one of the most important concepts of finance because a company's cash flows provide an account of the financial health of the firm. Cash flow is the total volume of money that moves into and out of a company for a given period. The company's capability of producing a positive cash flow is directly linked to its ability to generate wealth and value for investors. Thus, a company's cash flows provide insight into the liquid assets a company has and whether the liquid assets are increasing or decreasing. A company's cash flows move with operating, investing, and financing activities.

Positive cash flow is a sign that the company is able to pay debt obligations and make investments for the future of the company. The various types of cash flows are calculated by examining the statement of cash flows. The statement of cash flows is one of the four major financial statements, representing an organization's cash receipts and payments by operating, investing, and financing activity. The cash flow from operating activity, also known as operating cash flows, is all cash transactions relating to transactions and events that relate to functions of a business directly connected to providing its goods and/or services to the market. More specifically, it indicates the amount of money a company brings in from the ongoing regular business activities, such as manufacturing and selling goods or providing a service. Cash flow from operating activities does not include long-term capital expenditures or investment costs, as they may be one-time activities. For Larry's Flower Company, cash generated from flower sales minus the salary expenses of cashiers and delivery drivers, expenses related directly to the creation and sale of arrangements, and any overhead equals the company's cash flow from operating activities. These cash flows are directly related to the normal operations of running Larry's Flower Company.

Cash flow from investing activity, otherwise known as investing cash flows, are the cash transactions relating to transactions and events that relate to acquiring and disposing of investments and productive long-lived assets. Cash flow from investing activities is an item on the cash flow statement that reports the aggregate change in a company’s cash position resulting from investment gains or losses and changes resulting from amounts spent on investments in capital assets, such as plant and equipment. For example, if Larry’s Flower Company decides to buy a competitor, the cash flows associated with the purchase of the competitor's building, vehicles, and other physical assets are classified as cash flows from investing activities.

Cash flow from financing activity, also referred to as financing cash flows, are cash transactions relating to liability and shareholders' equity items that relate to obtaining and repaying borrowed amounts from creditors, as well as obtaining capital from shareholders. Cash flow from financing activity is a section of a company’s cash flow statement, which shows the net flows of cash that are used to fund the company. Financing activities include transactions involving debt, equity, and dividends. Cash flow from financing activities provides investors with insight into a company’s financial strength and to how well a company’s capital structure is managed. For example, if Larry's Flower Company acquires a competitor, to gain the capital necessary for the acquisition, Larry's must raise capital. Larry's raises capital from two sources: by issuing additional shares of Larry's Flower Company and by obtaining a loan. The cash flows associated with each of these sources are cash flows from financing activities.

Future Value versus Present Value of Cash

The comparison between future cash flow and present cash flow is a driver for investment analysis, as investors will compare these options and choose the one that yields a larger return.
The comparison between future cash flows and present cash flows is a driver for investment analysis, the examination of how an investment is likely to perform and whether it is appropriate for a given investor. The time value of money theory shows that the present value of an asset is greater than the value of an identical asset in the future because the present asset can earn returns. Time value of money is a concept that states that the value of money is sensitive to the passage of time, whereby the purchasing power of money can increase or decrease by the mere passage of time. Thus, the time value of money is the idea that a dollar given today has earning potential that makes it worth more than a dollar received in the future.
The time value of money theory suggests that the present value of money is greater than an equal amount in the future because of the present amount's earning potential.
Time value of money is best demonstrated by the concepts of present value and future value. Future value is a measure of what an investment made today will be worth in the future, given number of periods, interest rate, and amount invested. In contrast, present value is the value in current dollars of a future payment discounted to the present. The rate of return is the return on investment over a given amount of time, conveyed as a percentage of the investment's original investment value. Investors have an expected level of return, known as the discount rate, that they wish to receive for an investment. The discount rate is the minimum allowable rate of return required for investment.

When considering two potential investments, investors calculate and compare the present and future values of both options.

The option that yields the larger return is the superior option.
PV=FV(1+r)nFV=PV(1+r)n\begin{aligned}{\rm{PV}}&=\frac{\rm{FV}}{\left(1+r\right)^n}\\\\{\rm {FV}}&={\rm {PV}}(1+r)^n\end{aligned}
PV=Present ValueFV=Future Valuer=Interest Raten=Time Period\begin{aligned}{\rm{PV}}&={\text{Present Value}}\\\rm{FV}&={\text{Future Value}}\\r&=\text{Interest Rate}\\n&=\text{Time Period}\end{aligned}
For example, Alex is given a choice between receiving $1,000 today or receiving $1,500 in three years. Additionally, Alex has the option to invest his money in an asset that will earn 15 percent annually. To decide between his options, Alex calculates that the future value of the $1,000 if it is invested today would be:
Alex compares the future value of the $1,000 to the $1,500 received in three years and finds that the $1,000 invested today is worth more. Alex wishes to be thorough, so he checks his work by calculating the present value of the $1,500 he would receive in three years at a discount rate of 15 percent and finds it to be:
Again, Alex compares the present value of the $1,500 discounted at 15 percent and finds that the present value of the $1,000 is greater.

Risk on the Future Cash Flows of an Investment

The future cash flow of a security is associated with risk, and it is the primary driver of the security's value.

The associated volatility or risk of a security, along with the expected return of the security, is a driving force behind the security's market value or market price. Securities with low risk are projected to offer less in future cash flows than higher-risk securities. Investors must be persuaded by the expectation of a high return to allow their money to be placed into uncertainty.

A security's price constantly fluctuates over time. A security's value is established by its projected future cash flow and/or its discount rate. Thus, changes to investor confidence in a security will affect its price. For example, if information is provided that suggests the future cash flows of a security will be more favorable than projected or that factors affecting the security's risk have been alleviated to result in less risk, then the price of the security will increase. For example, Larry's Flower Company won a contract to be the primary source of flowers for Jeff's Wedding Company for the next five years. This favorable news suggests that Larry's Flower Company will have greater future cash flows than expected and that Larry's Flower Company is less risky to invest in. It is likely that Larry's Flower Company's share price will increase as a result.

Inversely, if information becomes available that suggests the future cash flows of a security are in jeopardy or that the security will face factors that will result in a higher risk, the price of the security will decrease. Larry's Flower Company loses the contract with Jeff's Wedding Company after only one year. The news of this loss implies that future cash flows are in jeopardy, thus making Larry's Flower Company a riskier investment. The increased risk will likely result in a decrease in Larry's Flower Company's share price.

The fluctuation in price that results from the information demonstrates market efficiency, or the degree to which valuation of a security fully reflects all available information. A strong form efficient market is a marketplace based on the idea that all information, public and private, is already fully reflected in a security's current trading price.

Formula and Sample Calculation of Future Cash Flows

Future cash flow can be calculated and used by investors to approximate how lucrative an investment may be.
Future cash flows can be calculated, or forecasted, based on a firm's actual cash flows and anticipated growth rate. Once a firm's future cash flows have been forecasted and the discount rate has been determined, the discounted cash flows may be calculated. The discounted cash flow is the forecasted future cash flow reduced by a given discount rate in order to reflect its present value. It is a valuation method used to estimate the value of an investment based on its future cash flows. Investors use discounted cash flows to approximate how lucrative an investment is to determine if it is worth their investment dollars based upon the potential for a return in the future.
Discounted Cash Flow=Future Cash Flow1(1+Discount Rate)1+Future Cash Flow2(1+Discount Rate)2+Future Cash Flown(1+Discount Rate)n{\text{Discounted Cash Flow}=\frac{\text{Future Cash Flow}_1}{(1+{\text{Discount Rate}})^1}+\frac{\text{Future Cash Flow}_2}{(1+{\text{Discount Rate}})^2}+\cdots\frac{\text{Future Cash Flow}_n}{(1+\text{Discount Rate})^n}}
A company's weighted average cost of capital is a frequently used discount rate. The weighted average cost of capital (WACC) is a formula for determining the relative average a company is expected to pay to all its security holders to finance its assets.
WACC=ED+E(re)+DD+E(rd)(1t)\text{WACC}=\frac{\rm {E}}{\rm D+ E}(r_{\rm e})+\frac{\rm D}{\rm D+E}(r_{\rm d})(1-{\rm {t}})
E=Market Value of EquityD=Market Value of Debtre=Cost of Equityrd=Cost of Debtt=Corporate Tax Rate\begin{aligned}{\rm E}&=\text{Market Value of Equity}\;\\\rm D&=\text{Market Value of Debt}\\r_{\rm e}&=\text{Cost of Equity}\\r_{\rm d}&=\text{Cost of Debt}\\\rm t&=\text{Corporate Tax Rate}\end{aligned}
For example, the owner of Larry's Flower Company is ready to retire at the beginning of 2019 and decides to sell the business for $1.5 million. Larry's Flower Company's cash flows for the past five years are made available to interested investors.
Larry's Flower Company
Cash Flow
For the Year Ended December 31, 2019
Year Cash Flow
2015 $20,000
2016 25,000
2017 30,000
2018 45,000
2019 $67,000

Past cash flows are made available to interested investors so they can evaluate the company.

A potential investor uses these historical cash flows to estimate the company's annual growth rate to be 35 percent. The investor is requiring a payback period of five years for their investment.

The investor projects the future cash flows for the next five years. For each succeeding year, the prior year balance is taken times the 35 percent growth rate.

Larry's Flower Company
Projected Future Cash Flow
For Five Years Ended December 31, 2023
Year Cash Flow
2019 $67,000+0.35($67,000)=$90,450\$67{,}000+0.35\;(\$67{,}000)=\$90{,}450
2020 $90,450+0.35($90,450)=$122,108\$90{,}450+0.35\;(\$90{,}450)=\$122{,}108
2021 $122,108+0.35($122,108)=$164,846\$122{,}108+0.35\;(\$122{,}108)=\$164{,}846
2022 $164,846+0.35($164,846)=$222,543\$164{,}846+0.35\;(\$164{,}846)=\$222{,}543
2023 $222,543+0.35($222,543)=$300,434\$222{,}543+0.35\;(\$222{,}543)=\$300{,}434

Investors estimate an annual growth rate and use it to project future cash flows.

Next, the investor computes the WACC for Larry’s Flower Company. The investor researches Larry’s and determines the company's market value of equity to be $350,000, its cost of equity is 15 percent, the market value of debt is $600,000, and its cost of debt is 11 percent. Now, the investor calculates the WACC using the growth rate of 35 percent that will apply to Larry's Flower Company. The tax rate the investor uses is also 35 percent as this is the average rate for both small and large businesses.
Thus, the investor estimates Larry's Flower Company's WACC to be 10%. This means that it costs Larry's 10% to obtain capital.

Finally, the investor calculates the discounted cash flow to be roughly $645,540.

Larry's Flower Company
Discounted Cash Flow
For Five Years Ended December 31, 2023
Year Cash Flow
2019 $90,450(1+0.10)1=$82,227\frac{\$90{,}450}{(1\;+\;0.10)^1\;}=\$82{,}227
2020 $122,108(1+0.10)2=$100,915\frac{\$122{,}108}{(1\;+\;0.10)^2}=\$100{,}915
2021 $164,846(1+0.10)3=$123,851\frac{\$164{,}846}{(1\;+\;0.10)^3\;}=\$123{,}851
2022 $222,543(1+0.10)4=$152,000\frac{\$222{,}543}{(1\;+\;0.10)^4}=\$152{,}000
2023 $300,434(1+0.10)5=$186,545\frac{\$300{,}434}{(1\;+\;0.10)^5}=\$186{,}545
Discounted Cash Flow $645,537\$645{,}537

An investor calculates the discounted cash flow to determine the future value of the investment.

Based on the discounted cash flow, the investor decides not to purchase Larry's Flower Company. The investor deems Larry's Flower Company to be overvalued. Based on the investor's calculations, the valuation of Larry's Flower Company is $645,537; thus, Larry's price of $1.5 million is too much for it to be a wise investment.
Larry's Flower Company
Discounted Cash Flow
For the Year Ended December 31, 2019
Year Cash Flow Annual Growth
2015 $20,000\$20{,}000
2016 25,00025{,}000 25%25\%
2017 30,00030{,}000 20%20\%
2018 45,00045{,}000 50%50\%
2019 $67,000\$67{,}000 49%49\%
Projected Future Cash Flows Present Value of Projected Future Cash Flows Present Value of Projected Future Cash Flows Calculation Anticipated Annual Growth
2019 $90,450\$90{,}450 $82,227\$82{,}227 $90,450(1+0.10)1=$82,227\frac{\$90{,}450}{(1\;+\;0.10)^1\;}=\$82{,}227 35%35\%
2020 181,000181{,}000 100,915100{,}915 $122,108(1+0.10)2=$100,915\frac{\$122{,}108}{(1\;+\;0.10)^2}=\$100{,}915 Weighted Average Cost of Capital
2021 362,100362{,}100 123,851123{,}851 $164,846(1+0.10)3=$123,851\;\frac{\$164{,}846}{(1\;+\;0.10)^3\;}=\$123{,}851 10%10\%
2022 724,300724{,}300 152,000152{,}000 $222,543(1+0.10)4=$152,000\frac{\$222{,}543}{(1\;+\;0.10)^4}=\$152{,}000
2023 $1,448,700\$1{,}448{,}700 $186,545\$186{,}545 $300,434(1+0.10)5=$186,545\frac{\$300{,}434}{(1\;+\;0.10)^5}=\$186{,}545
Discounted Cash Flow

Using the discounted cash flow method, a company's value may be calculated by forecasting the future cash flows and discounting them to their present value.

Using Financial Statements to Calculate Operating Cash Flows and Free Cash Flows

Financial statements can be used to calculate both operating and free cash flows.

Financial statements, such as a balance sheet, can be used to calculate both operating and free cash flows. The balance sheet is a financial statement that provides a snapshot of the assets, liabilities, and equity of a business at a point in time. Cash flows from operating activities comprise all the cash transactions relating to transactions and events that relate to functions of a business directly connected to providing its goods and services. Some examples of cash flows from operating activities are sales revenue, inventory, and payroll. A balance sheet provides a basis for computing rates of return and evaluating its capital structure. It shows what a company owns and owes, as well as the amount invested by shareholders.

For example, Larry's Flower Company had a net income of $37,000 for 2019. The net cash flows from operating activities may be calculated using the balance sheet.
Net Cash Flows from Operating Activities=Net Income+Changes in DepreciationIncreases in ReceivablesIncreases in Inventories+Increase in Payables+Increase in Accruals\begin{aligned}\text{Net Cash Flows from Operating Activities}=&\;\text{Net Income}+ \text {Changes in Depreciation}-\text{Increases in Receivables}\;\\&-\text{Increases in Inventories}+\text{Increase in Payables}\;\\&+\text{Increase in Accruals}\end{aligned}
The net cash flows outflow from operating activities is calculated to be $67,000.
Net Income=$37,000Changes in Depreciation=$70,000$20,000=$50,000Increase in Receivables=$70,000$40,000=$30,000Increase in Inventories=$100,000$80,000=$20,000Increase in Payables=$90,000$75,000=$15,000Increase in Accruals=$60,000$45,000=$15,000\begin{aligned}\text{Net Income}&=\$37{,}000\\\\\text{Changes in Depreciation}&=\$70{,}000-\$20{,}000=\$50{,}000\\\\\text{Increase in Receivables}&=\$70{,}000-\$40{,}000=\$30{,}000\\\\\text{Increase in Inventories}&=\$100{,}000-\$80{,}000=\$20{,}000\\\\\text{Increase in Payables}&=\$90{,}000-\$75{,}000=\$15{,}000\\\\\text{Increase in Accruals}&=\$60{,}000-\$45{,}000=\$15{,}000\end{aligned}
Net Cash Flow from Operating Activities=$37,000+$50,000$30,000$20,000+$15,000+$15,000=$67,000\begin{aligned}\text{Net Cash Flow from Operating Activities}&=\$37{,}000+\$50{,}000-\$30{,}000-\$20{,}000+\$15{,}000+\$15{,}000\\&=\$67{,}000\end{aligned}
Free cash flow is discretionary money that remains after a company has paid its operating expenses and capital expenditures. This money is often used for purchasing additional investments, retiring debt, purchasing Treasury stock, or increasing company liquidity. A capital expenditure is the cost incurred to purchase a fixed asset, enhance an existing fixed asset, or extend its useful life, benefiting future periods. Capital expenditures may be calculated by finding the difference between the company's gross fixed assets. Free cash flow is an indicator of the amount of cash available after all investments and expenses. Positive free cash flow may help strengthen a balance sheet. However, negative free cash flow may not necessarily be a sign of trouble. Larry's Flower Company's free cash flow can be calculated.
Free Cash Flow=$37,000+$50,000$30,000$20,000+$15,000+$15,000=$67,000\begin{aligned}\text{Free Cash Flow}&=\$37{,}000+\$50{,}000-\$30{,}000-\$20{,}000+\$15{,}000+\$15{,}000\\&=\$67{,}000\end{aligned}
In financial accounting net operating cash flow is the cash flow provided by operations that refers to the amount of cash generated from revenues, excluding costs associated with long-term investment on capital items. Free cash flow is the cash a company produces through operations, minus the cost of expenditures on assets. In other words, free cash flow is the remaining cash after a company pays for its operating expenses and capital expenditures, also known as CAPEX. Thus, there can be situations where both the end calculations are the same.

In Larry's Flower Company's case, the free cash flow is a result of investments in fixed assets (plant, property, equipment, and working capital), which may be used to increase shareholder value.

Larry's Flower Company
Balance Sheet
December 31, 2019
2018 2019
Cash $10,000 $77,000
Accounts Receivable 40,000 70,000
Inventory 80,000 100,000
Total Current Assets $130,000 $247,000
Gross Fixed Assets 90,000 270,000
Accrued Depreciation (20,000) (70,000)
Net Fixed Assets 70,000 200,000
Total Assets $270,000 $647,000
Accounts Payable 75,000 90,000
Accruals 45,000 60,000
Bank Loan 18,000 50,000
Total Current Liabilities $138,000 $200,000
Long-Term Debt Obligations 60,000 200,000
Stock Issued 30,000 75,000
Paid-in Capital 40,000 (116,000)
Retained Earnings 2,000 288,000
Total Liabilities and Equity $270,000 $647,000
Net Income $37,000

The balance sheet may be used to calculate the firm's free cash flows and cash flows from operating activities.

Free Cash Flow to the Firm versus to Equity

It is important to understand the difference between free cash flow to the firm and free cash flow to equity because investors base investment value on what is ultimately available for distribution to shareholders.
Free cash flow to the firm can be differentiated from free cash flow to equity. Free cash flow to the firm is the cash available from operations for distribution to investors, both equity and debt holders, after deducting taxes, investments, and working capital.
Free Cash Flow to the Firm=Net IncomeIncrease in Working Capital+DepreciationCapital Expenditures\text{Free Cash Flow to the Firm}=\text{Net Income}-\text{Increase in Working Capital}+\text{Depreciation}-\text{Capital Expenditures}
Working capital is a company's current assets minus current liabilities, which can help determine the business entity's ability to pay current liabilities. Working capital for Larry’s Flower Company is calculated to be $47,000 by subtracting current liabilities of $200,000 from current assets of $247,000. Capital expenditures for Larry’s Flower Company are calculated by subtracting net fixed assets for 2018 from net fixed assets from 2019, or:
Using the Free Cash Flow to the Firm formula, Larry's Flower Company's free cash flow to the firm for 2019 can be calculated.
Free Cash Flow to the Firm=$37,000$47,000+$50,000$130,000=($90,000)\text{Free Cash Flow to the Firm}=\$37{,}000-\$47{,}000+\$50{,}000-\$130{,}000=(\$90{,}000)
Free cash flow to the firm is an indicator of a firm's profitability once reinvestment and expenses are accounted for. Expenses are business costs that are vital to the operations of the firm. Investments are the capital required to maintain a firm's growth by acquiring current assets (e.g., inventory) and long-term assets (e.g., plant, property, and equipment). Free cash flow to the firm is a value that is important to investors and is a useful measure of the firm's operations and overall functional health. Additionally, free cash flow to the firm can be used when determining the actual value of a firm's stock. Free cash flow to equity is the volume of cash that is available to investors once a firm has accounted for expenses, investments, and debt obligation payments. Free cash flow to equity is equal to the free cash flow to the firm minus debt obligation payments.
Free Cash Flow to Equity=Free Cash Flow to the FirmDebt Payments\text{Free Cash Flow to Equity}=\text{Free Cash Flow to the Firm}-\text{Debt Payments}
This serves as an indicator of the firm's value. A common use of free cash flow to equity is to identify the source of dividend payouts. Dividends are the distribution to the stockholders of a corporation's earnings in the form of cash, stock, or property, as voted on by the board of directors. By comparing the sum of dividends paid out and the free cash flow to equity, an investor may determine if the source of the dividend is supplied through a cash surplus or from financing such as loans. Consider Larry's Flower Company's free cash flow to equity. Larry's Flower Company pays 13% of its long-term debt obligations annually. For 2019, the long-term debt payments equaled:
Thus, Larry's Flower Company's free cash flow to equity is free cash flow to the firm ($90,000) minus debt payments $26,000, which results in ($116,000) paid-in capital on the balance sheet for 2019.