Welcome back to The Language and Tools of Financial Analysis. In this fourth module, we will discuss value measurement using discounted cash flow analysis. In the previous modules, we've introduced the financial statements of the corporation, the balance sheet and profit and loss. We've seen how analysts derive information from those statements, and summarise it. We've discussed the limitations and shortcomings of that information. So now, it's time in this final module to actually extend their analysis in a forward looking manner by discussing discounted cash flow analysis We will be moving from accounting to finance. We've seen in the previous model that accounting information has got its limitations. Corporate financial analysis needs to account for those limitations. So for example, we've seen that there are occasionally large differences between the market value and the book value of certain line items on the balance sheet. Consider our example of Kellogg's. Let's assume that a competitor, Kraft, is interested in taking over Kellogg's. What would it have to pay to become owner of Kellogg's? First, it would have to buy all the outstanding shares in Kellogg's. That we label as the market value of equity. The price that Kraft would have to pay on the stock exchange to buy the full ownership of Kellogg's. But that's not the end of it. Kraft would also have to take over the liabilities, the debt of Kellogg's. But there is an offset, Kellogg's has got a cash position. When Kraft becomes the owner of Kellogg's, it would be entitled to that cash so we subtract that from the sum of the cost of equity and the cost of debt. The sum total would be labeled enterprise value. Now, Kraft would be interested in paying enterprise value to become owner of Kellogg's if it can be assured that Kellogg's equity value, the market value of equity, is going to improve over time. Growth expectations of Kellogg's would be all important in debt consideration. So, for Kraft to maximize shareholder wealth, would require it to acquire forward-looking information. But of course, it needs to take the decision at present. So it would have to bring the information in the future back to the present, to take an informed decision. Now let's take a step back. And rather than taking over all of Kellogg's, let's consider an investor who is just interested in buying a single share in Kellogg's. That investor would then be entitled to the cash flows that Kellogg's is going to generate in the future, in the shape of dividends and capital gains. So, to help that investor make an informed decision, whether to buy the shares in Kellogg's today, the investor needs to answer a few questions. First, what are the expectations of the future cash flows that Kellogg's will generate? Second, are these expected cash flows guaranteed or are they, indeed, risky and could they vary in value, depending on circumstances? Third, regardless of the riskiness of those cash flows, does the cash flow itself, the dollar amount, lose value over time? And last, are there alternative investments that provide a better return to the investor - that have a higher present value to the investor? Take a look at this graph where we've plotted the dividends, the payments to the owners in the corporation Kellogg’s, against the share market price, the market value of equity. We see that there's a nice pattern, whereby Kellogg's has been paying successively higher dividends over time. It looks like that particular cash flow, the entitlements to dividends in Kellogg's, has been fairly predictable. A nice stepwise function over the past 15 years. And the share price has reflected that increasing entitlement of the shareholders. But other cash flows are probably not quite as predictable. So future sales and expenses for example are uncertain and they're due to a variety of risk factors that confront every corporation. The level of competition, the more competitive the market, the more pressure there will be on prices, and therefore on future sales. Labor costs, negotiations, with unions. Raw material prices, the wheat price varies dramatically from season to season. External factors, health recommendations for example. Suggesting that cereals might not be good for your health would have a major impact on those cash flows. But we don't know at present how that is going to pan out in the future. And there are other risks. Risks that are not directly related to the actual business operations of Kellogg's. But are nonetheless very important for the investor to make the right decision. Like inflation and opportunity cost. So, how do we deal with these risk factors? The corporation-specific risk factors? The more macro risk factors? We deal with them in a technology called discounted cash flow valuation, DCF. It's considered to be the gold standard in finance. Whereby we provide absolute valuation of an investment opportunity. We will be looking for intrinsic value in the cash flows that the corporation is going to generate in the future. But that valuation technique will still be supplemented by many financial analysts by other techniques that provide what we label as relative valuation or multiples valuation. We've seen some of that when we were discussing financial ratios.
