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Present Value of Future Cash Flows

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Can't they also pay out of previous retained profits or similar? But you could be right... not all companies will have retained profits as not all companies have been historically profitable.

I would need to do some further research, took me until this morning to click with how you came up with your calculations.

What’s the implications for valuation?

What companies are best placed to mitigate this absurdity?

Will something get legislated to overcome the situation? or does it exist already - can they frank above the tax rate etc?
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Some companies have very large franking account balances, such as PMV, which we have discussed before. It would obviously restrict investors access to this pool in less can be paid at any one time.

I do my valuations pre-tax, so I am not sure if there is any direct impact. But you could argue that you may need to adjust the hurdle rate to reflect the fact that more tax will eventually be paid by investors.

EDIT: Here is a link to an article that was written in 2012 when the ATO released their latest ruling on the franking and payment of company dividends.

The ruling number is mentioned in here.

http://www.mallesons.com/publicatio...dividends-final-Taxation-Ruling-released.aspx
 

1. Get your point, but 70/100*28.5 = 19.95? Hence, if the company can only distribute $19.95 million if the Net free cashflow before dividend payments are $70m. This assumes all financing activity has been considered (ie. repurchase plans etc). This also assumes that there are retained profits or unrealized capital gains availalable on balance sheet.

2. If you are doing DCF, you will get more cash due to lower tax rate. This may or may not lead to capital drain due to increase in acquisitions, capex, working capital etc. that may result from a reduction in tax rate leading to more business activity. You also need to make a separate assumption about franking being released with FCF which does not have to equal that which would be attached if the full dividend amount equaled FCF. If you are using EVA style analysis, for example, FCF is calculated as if the whole company was financed using equity and thus FCF in reality for a the levered alternative will differ from this style of valuation.

If you are using DDM, you can assume an attaching franking credit to each dividend and discount this. You would possibly expect an increase in dividends as there is more cashflow as a result of lower tax. If the payout ratio is less than 100%, then any business changes emanating from the tax reduction ought not impact on the ability to pay the dividends and, if the pay-out policy of the company is unchanged in dollar terms, all that changes is a reduced valuation for franking credits. In reality, there will be at least some firms that will increase the value of dividends distributed as a result of the increased FCF due to lower tax rate.

For PE style valuation approaches, E will rise but attaching franking will decline. You will need to make assumptions regarding distributions, changes in ROE and cash requirements. It probably won't change the P/E materially in absolute or relative terms.

Now, if you are in a marginal position where the retained profit is marginal or earnings exceed cashflow, the right thing to do is use option based valuation scenarios. Good luck with that.

Overall, it's not a game changer.

3. Those with a clear delineation between their ability to pay franking credits (ie.profitable and FCF sufficient to meet their ideal dividend policy) and those that can't. They are easiest to value. Everything else is full of wobbles and you'd just have to pull a number out of someplace where the sun doesn't shine...much.

4. You cannot attach more franking credits to a distribution than the franking rate associated with the dividend as implied by the tax rate. You cannot over distribute. However, there are funky-called-medina methods for extracting more franking credits than might be implied from continuing a standard dividend policy, but that requires various unusual steps that manipulate the balance sheet quite a bit. However, it can be done.

Cheers
 

....
 
.... Get your point, but 70/100*28.5 = 19.95? [1/.715*70-70=27.9 The net dividend will be 70K; grossed up will be 97.9K; Franking credit and hence debit to the company’s franking account will be 27.9K]

Now I actually get your point. I was just kidding before.. Misread your statement.

Ran some figures using your scenario comparing the former and proposed tax regime for 100 Before Tax with full payout of FCF. New regime includes PPL levy for reasons you have mentioned.

Tried different (zero and positive 2% and 5%) growth rates and used a discount rate of 10% via gross-up dividend discount model.

Basically the difference caused by the new regime is -2% relative to pre-change valuation. This is essentially the effect of reduced franking credits (28.5% vs 30%) attaching to any dividend. If a company is growing or at zero growth rate, it is paying out all of the franking it can. Although stranded franking exists, this component is not worth anything under these scenarios because they get pushed out to infinity...they simply can't be paid under normal circumstances. There are ways, as you have noted, that FCF might be engineered to be higher than NPAT, but distributions must be from retained profit and unrealized capital gains which imposes a limitation to the concept.


.....I'm wondering if they will amend legislation to allow the franking at a higher rate when the rate drops to 28.5% to avoid this stranding effect.

Don't know, but I personally doubt it. Franking does not exist in other jurisdictions of note. It is regarded as an anachronism. The direction of movement is towards removal of franking in favour of a low company tax rate to make the company tax system competitive in a world sense. At present the Budget papers have indicated that all future dividends will have franking at 28.5% and all existing franking balances will also be amended to that figure. The recent developments here can be seen in the light of movement to international competitiveness, albeit that the corporate tax rates plus levy for large companies did not move down, although smaller companies did benefit in net terms.


....opportunity before the market fully reacts - maybe

Could be, I guess. 30% of the market assigns no value to franking at all (overseas). A further 30-40% are in the professional market but compete largely on pre-tax terms or simply index Maybe retail and HNW will move it to some degree, but it will be balanced off by others. Ultimately, the full adjustment as calculated above will likely not be realized.


Cheers
 
DeepState said:
Don't know, but I personally doubt it. Franking does not exist in other jurisdictions of note. It is regarded as an anachronism.
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I agree it's unlikely. This always looked to me like a neat back handed dividend tax that would (and has) largely go un-noticed. There is a fairly strong argument to move away from imputation. If personal tax rates keep rising and the company tax rate keep falling it's going to increase the already large motivation to corporatise personal income. The current system is extremely generous by global standards, especially around super funds.
 
DCF Question for Craft / RY and others. I could be having a silly moment, so feel free to slap me.

I was wondering how others are factoring the cost of growth into their DCF valuations. Obviously growth is not free, and only increases the net present value of the company if future profitability (ie. return on invested capital) is in excess of the cost of capital required for that growth.

I am ignoring that growth can also come from improving efficiency on already owned assets for this example. And a lot of other things (ie. debt finance, share dilution).

Here are two valuations A & B. Exactly the same assumptions (as listed below) for each valuation.

Hopefully calculations are mathematically sound.

Both Companies (same assumptions)

Net Invested Assets - $500.00
Return on Invested Capital - 20% pre-tax
Reinvestment Rate - 50%
Cost of Capital - 11% - used for the discount rate

Valuation A

Year Before Tax FCF Growth
1 $100.00
2 $110.00 10.00%
3 $121.00 10.00%
4 $133.10 10.00%
5 $146.41 10.00%
TV $1,331.00

Discount Rate 11.00%

NPV $1,232.29

Valuation B

Sorry about the messy columns, pasting from Excel was not kind to me... hope you can read them (FCF / Growth Rate / Reinvestment / Dividend)


Year Before Tax FCF Growth Reinvestment Dividend
1 $100.00 $50.00 $50.00
2 $110.00 10.00% $55.00 $55.00
3 $121.00 10.00% $60.50 $60.50
4 $133.10 10.00% $66.55 $66.55
5 $146.41 10.00% $73.21 $73.21
TV $1,331.00

Discount Rate 11.00%

NPV $1,011.09

In Valuation A - the NPV is calculated based on the Before Tax FCF.

The Terminal Value is the 5th year Before Tax FCF / the discount rate. After year five the company is not expected to grow. ROIC will revert to the cost of capital. It is a perpetuity. A perpetuity obviously has it's own embedded assumptions (assume a company will never fold at your own peril) but that is most likely a different conversation unless you think there is something relevant to the cost of growth that I am missing. Used simply for the sake of comparison.

In Valuation B - the NPV is calculated based on the dividends paid (or distributed cash flow, no reinvested cash flows are included).

The Terminal value is the same as Valuation B. Same assumptions. Company will be stable.

Which valuation do you believe is most suitable?

If my example needs more complication, feel free to add it. I've made it as simple as possible.
 

I think your NPV calc is a bit wonky so couldn't recreate exactly – but I think I still get what you are asking and my answer is defiantly B.

Valuation A counts the growth in the first 5 years twice as your terminal value calculation includes that growth and doesn’t acknowledge the cash flow distributed after paying for growth.

Do you see it or do you want me to expand.
 
Hi V

There's two streams you need to worry about...

a) the dividends being paid and their present value

b) the ending cash flow, and it's terminal value.

In your valuation A, it doesn't look like you've included the value of the dividends being paid to you, which of course do have value! ETA: I'm actually a little confused how you've reached NPV for both, although it looks like you might not have discounted TV, which occurs at the end of year 5.


Here's a quick example I just put together. Maybe it will help...

 


I think you guys are being too clever.. I don't mean that as an insult, but I think your approach is a bit fanciful and extreme.

I understand it's precise and scientific or whatever "proper" finance is... but you are applying a precise value to something that cannot be predicted with any precision.

How do you know the company will grow at g? then at g2?

How do you know it will pay dividends, and its dividends will be at x growing at g in the future? That it could earn and pay dividends from net profit and not borrowed cash to keep you guys happy?

And why do you separate dividends from total net earnings: the company actually earn both the dividends and also what it kept back, right? And if its dividend policy is reasonable, intelligent: that it does try to keep the institutionals and some investors happy so have to pay dividends, but not just pay even when it can't afford it or when it could clearly invested it at a higher rate thereby profit the owners more etc etc...

Why are you setting the terminal value at 2 or 5 or 10 years? Will that be when you plan to sell the stock?

Anyway, if any of your estimates on the variables above are a slight fraction off, the value of the company will be off.
 
....
 
craft said:
I think your NPV calc is a bit wonky so couldn't recreate exactly – but I think I still get what you are asking and my answer is defiantly B.
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Hi guys, thanks for the replies.

My apologies but it looks like the formatting of my original post has caused a bit of confusion. McLovin, how do you take a screenshot of the Excel cells like that? Would be very helpful by the looks of it. I'm using Excel 2010 here at work, think it's 2007 at home.

I'll try again with the table function on the forum (which is time consuming, and hard to use if you're not used to it!). Here is valuation B again, since it is, we agree, the most suitable for the exercise.

YearFCFGrowthReinvestmentDividend
1$100.00$50.00$50.00
2$110.0010.00%$55.00$55.00
3$121.0010.00%$60.50$60.50
4$133.1010.00%$66.55$66.55
5$146.4110.00%$73.21$73.21
TV$1,331.00

The Terminal Value is just the 5th year cash flow of $146.41 divided by the discount rate of 11%.

Discounting back the dividends paid in years 1 to 5, and the terminal value from year 5, I get an NPV of $1,011.09.

Looks like we have different dividends and that is the reason for a different NPV. To achieve 10% growth at 20% ROIC they would need to reinvest 50% (10% growth / 20% ROIC) of FCF (assuming that they are not using any other source of funds). Therefore the payout ratio is 100% - 50% = 50%.

Hopefully my calculations are correct, and it was just the way that I presented the information that caused the confusion.

I will post some more later in the day, but thank you both for clarifying that it is Valuation B. Yes I do see that valuation A is double counting the growth. There are a lot more considerations that I would like to explore if that is OK.
 
PS: In my original post I said pre-tax FCFF, and it turns out my calculations ignore tax, so they're obviously based on after-tax FCFF. An oversight that probably does not detract from the exercise, but a very important one in practice.

I am still a bit torn on whether to do valuations based in before tax or after tax dollars, and confused how franking credits would come into the valuation? What impact does this have on the valuation? Surely the discount rate would need to be adjusted to take the tax into account as well.

Other things to consider - as craft mentioned it's the amount of discretionary FCFF that needs to be considered. You need to value the whole enterprise, so the impact of any debt needs to be included.

Discretionary FCFF in my opinion should include any cash flow that is a) paid as a dividend b) used to repay debt principle c) is retained as cash reserves (ie. it is not used for growth and may be distributed in later years). The dividend probably only tells part of the story in some cases.

I guess what I am saying is that FCFF less funding required for any forecast growth (working capital impacts need to be also considered too) is discretionary cash flow and this is what you include in your valuation at NPV?
 

Sorry, ignore my dividends, they're wrong! For some reason I did FCF*0.2*0.5=Dividend. Based on the simplicity of the assumptions in your example, it would seem the easiest way to approach it is to think of it like a savings account; in order to grow tomorrow's interest income you have to reinvest some of that interest today.

I used a Mac to create that sheet. I like the screeenshot simplicity but hate everything else about their spreadsheet program! FWIW, if I'm using Windows then Snagit is pretty good.
 
craft said:
....
Click to expand...


I've seen CFO and Finance Managers struggling to get enough data from their own company to know their company's income and expense each quarter... and it's just one division. For an outsider to try and predict profit, growth.... not saying it can't be done, but saying maybe that brainpower should be put to better use.

Maybe i'm just too simple but I just assumes that companies will have to pay taxes, pay interests, their properties will depreciate... and the future, given where they are in the industry, they are most likely to do business in the next few years as they have been the past few years... that with their financial and competitive position, they'll grow, and maybe grow at a faster and slower rate than previous given general business cycle, given initial costs in certain r and d etc...

So, in not being smart enough, i'll ignore future positions.. .just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on.

And next year or next two years, i'll take another look and see how the business is doing, then repeat.

I think you might be putting too much faith in accounting and finance and not enough in the business.


I built a house frame once. You should've seen how precise my roof pitch was. The angles and struts were placed with computer guided, laser measured precision... then a real pro turned up and knock the whole roof together using a tape measure and couple of sticks at each end... not as pretty as mine but you know, holds the roof up and done in a couple of days.
 

You are asserting things about us that are not correct to launch your attack on how we overcomplicate things. We are not interested in quarterly detail etc just the divers of long term valuation.

That nothing will change is in itself an assumption - Do you realise how many of those nothing will change assumptions are imbedded in a static earnings power calculation and how few companies such a valuation method is suitable for? How many of those price is 'approximately good enough' are a result of true under valuation or mis-valuation by you?

Accounting is just the language - estimating a valuation is a small end of process part of the picture. The entire focus is the business, despite what you may assert about our approach.
 

OK, another example to demonstrate what I mean by this. Here is how I think it works. Would be happy to see what others think. One valuation is based on pre tax cash flows, one is post tax cash flows. Say I want a 15% return before tax. If I am on 30% marginal tax rate in my own name that is 10.5% after tax.

Assumptions

Company tax rate is 30% (this includes 28.5% tax + 1.5% PPL Levy).
Net Invested Assets - $1.00
Return on Invested Capital - 28.57% pre-tax
Return on Invested Capital -20% after-tax
Growth years 1-5 - 10%
Reinvestment Rate - 50%

Same as my last example. The company becomes stable after year 5. All free cash flow is paid out as dividends.

Valuation

YearBefore Tax FCFTaxFCF After TaxGrowthReinvestmentDividendFranking Credits 28.5%Total Dividend
1$0.286$0.086$0.20$0.10$0.10$0.041$0.141
2$0.314$0.094$0.2210.00%$0.11$0.11$0.045$0.155
3$0.346$0.104$0.24210.00%$0.121$0.121$0.049$0.170
4$0.380$0.114$0.26610.00%$0.133$0.133$0.054$0.187
5$0.418$0.125$0.29310.00%$0.146$0.146$0.06$0.206
TV$0.42$0.171$0.591
TV$4.00$3.94

Before Tax NPV $2.78 (discount rate 15.00%)
After Tax NPV $2.88 (discount rate 10.50%)

As I expected the valuations should either be exactly the same or at least very close.

I am not sure why the After Tax NPV is 3.6% or $0.10 higher. I assume that it has to do with the difference between 28.5% and 30% and the effect on the discount rate....
 
luutzu said:
just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on.
Click to expand...

(my bolds)

This is a pretty absurd statement given what you seem to be saying about forecasting anything

Projecting to infiinity at any point in the earning cycle other than dead centre will produce useless results. Take a look at mining services for a real world example.
 

V your franking credits look weird. 28.5% should be 1/.715xdividend-dividend.
Where you have the div of $0.42 shouldn’t that be the after tax amount of .293?

Anyways , using your assumptions I get FV$2.79 by using Pre tax FCF and FV$2.73 by using the gross dividend flow. The difference is entirely the franking credit/levy issue.

I always use before tax and interest (i.e. eliminate the financial structure) to compare. I want to establish the best business not who's got the best tweaked financial structure - that's a minor(unless its tweaked to aggressively) and later consideration.

The question to me is whether because of the PPL levy I should push up my pretax hurdle rate as less will now stick to my ribs and more to the governments.

End of the day my decision was to stick with my current figure because the change is not that big and the hurdle really only comes into play for me if there is only one available investment and it’s just over the hurdle rate. Normally there is quite a few competing options all well above the hurdle rate.
 

Agree with both - I divided by 0.7 out of habit, and you are correct I forgot to take out the company tax on the terminal value.

I am (un)happy to admit that I have been using a model closer to Valuation A in my first post than Valuation B.

It makes some quite incorrect assumptions, and if I'm not happy with it at all. It's an on-going process to improve, and obviously the more I contribute to my portfolio the bigger an issue it becomes. So I'm dedicated to improving my technique.

I have been using EBIT as a starting point, and working from there, making adjustments for certain non-cash items, looking at cyclicality as best as I know how.... after reading a lot of "crap" valuations on blogs and forums, and then comparing them to the work of authors like Damodaran, I decided that I definitely need to pay more attention to cost of growth (and factor that into my valuations) and considerations like adjustments for working capital (in some cases this offsets some or if you are really lucky a lot of the cost of growth, in other it adds to it).

Obviously it is important to distinguish between growth from additional investments and growth from better operational efficiency / improvement from cyclical lows etc.

I agree that it looks fairly minor in its impact after playing around with some spread sheet calculations over the past few days.

Does your hurdle rate change over time? In particular, for interest rate changes?
 

It's just a mathematical representation of a known factor [earnings], and assuming it will do pretty similarly in the future... not literally saying it will be like so forever.

If you do that, and revised your earnings, not revising your growth rate assumptions and kept the same earnings results, but earning stream only then when you see high probability of that earning changing for the company. It will be more accurate, and much simpler, than all the other assumptions about growth rate/s.


There's a 101 factors that could affect a company's growth rate... from inflation to changing climate to new political leaderships to interest rates to capital structure to customer tastes, new competition, management being bored... how anyone could think they can know the first stage, then the second stage of growth is quite amazing.

I mean, i can't even predict how my bank account will be like in next 3 or 5 years with any precision, let alone a multi million billion dollar enterprise.


A business is not a dead asset. It's a living organism, operating in a constantly changing economic environment. And just because your estimates came true, it might not even came true because of the reasons and factors and weighing you use anyway.

Anyway, a matter of approach and capability i guess.

All i know, and can guess at, is that ey, i don't owe people money... i have and earn enough to pay the bills... i work hard, try to also build something i think will sell, and might sell well because i think it's quite valuable to people's needs... and so over the next few years, my bank account will be at least this much, could be a bit more... but when it will be that, not too certain.

I probably could draw you my account's growth rate, but that will depends on my mood... I might be depressed and assume it's all going to end... or be optimistic and say i'll take over the world. And i honestly can't tell you what mood i was in when i make those projections.
 
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