Article 21
Tying Free Cash Flows
To Market Valuations
In a companion piece to his article in the last issue*, Robert Howell turns his attention
to the importance of free cash flows in determining valuations.
By Robert A. Howell
L ast month, in this magazine, this author argued in Fix-
ing Financial Statements: Financial Statement Overhaul that
the traditional formats of the primary financial state-
ments—income statement, balance sheet, and cash flow
statement—need major redesign to again be useful for
meaningful financial analysis, decision-making and
value creation.
Since the fundamental objective of a business is to in-
crease real shareholder value, this means increasing the
net present value (NPV) of the future stream of cash
flows. Financial statements must, therefore, put much
more emphasis on the free cash flows that a business gen-
erates. A vivid example of the different impressions one
can get from focusing on profits and cash flows is Xerox
Corp. (see page 18). Focusing on profits could suggest Xe-
rox is doing well; free cash flows tell another story.
Relating Free Cash Flows To Market Values
A firm’s market value reflects the collective judgment of
the shareholders’ expectations of its future cash flows. If
the company produces expected cash flows or expecta-
tions remain constant, the market value should remain
constant. If cash flows, or the expectations, turn out bet-
ter, market value should rise; if cash flows or the expecta-
tions for them turn down, as with Xerox, value should
erode. Recasting financial statements into a much more
explicit and clear free cash flow format permits one to at
least relate the current period’s free cash flows to the cur-
rent market valuation and reach some conclusions re-
garding those valuations.
As a starting point, assume that a firm has positive free
cash flows of $100 million, and that it will continue to pro-
duce that amount in perpetuity. A perpetuity valuation
1
model would capitalize that annuity stream using the
firm’s cost of capital (assume 10 percent) as the discount
rate. Free cash flow of $100 million divided by 0.10 yields
an NPV of $1 billion. This $1.0 billion is equal to the “en-
tity value” of the company, and represents the NPV for a
stream of $100 million in perpetuity; in essence, it repre-
sents the most that should be paid today, to access that fu-
ture stream of cash flows.
Any debt has to be subtracted from the firm’s entity
value to determine how much value accrues to the equity
shareholders or the equity value. If debt is $200 million,
the equity value is $800 million. If the market value ex-
ceeds the equity value, the market is “saying” that it ex-
pects the free cash flows of the business to improve; if the
market value is less, the market expects eroding cash
flows.
It is also possible to work in the opposite direction,
starting with the company’s current market value, adding
back any debt; then calculating the rate at which current
free cash flows must grow, in perpetuity, to support the
current market value. If that required rate of growth is
high, say in excess of 10 percent, one has to question how
likely that is.
In mid-2001, even after the securities markets had
fallen considerably from their early March 2000 highs,
companies such as Oracle Corp., EMC Corp., Cisco Sys-
tems and Siebel Systems’ free cash flows would have had
to grow at 14, 18, 18 and 21 percent, respectively—very
unlikely. Since then, all of these companies’ market val-
ues have dropped further, as could be expected.
Startup and high-growth may be particularly difficult
to analyze. Perpetuating negative cash flows would result
in a negative value, and calculating a growth rate from a
negative starting cash flow to generate a positive market
ANNUAL EDITIONS
value is mathematically impossible. However, one may
start with the firm’s market value, then multiply by the
firm’s estimated cost of capital, to calculate how much
free cash flow, in perpetuity, would be required to justify
the market price. This amount may be compared to the
firm’s current (negative) free cash flows to determine
how much improvement is required.
So, a dot-com with a market value of $10 billion and an
estimated cost of capital of 15 percent would need to gen-
erate $1.5 billion in free cash flows, assuming no debt
(which would have had to be added to the market value
have had to be added to the market value to establish the
firm’s entity value), in perpetuity, to justify its market
value. If the dot-com had negative cash flow, one could
see how much improvement was needed, and decide if
that was even likely. In most cases, it was very unlikely,
as eventually became clear.
These examples make simple assumptions regarding
free cash flows. In the first case, it is assumed that the cash
flows remain constant in perpetuity; in the second case, it
is assumed that they grow constantly in perpetuity. One
may also develop a set of free cash flow projections for a
specific firm, over a period of 5 to 10 years, put a terminal
value on the firm at the end of the period and discount the
projected cash flows at the firm’s cost of capital to deter-
mine its value. This is the process management should go
through when considering acquisition candidates to de-
termine how much it can pay and still add value for
shareholders. Management should regularly undertake
the same process for its own firm; and investors should
do the same for each investment(s).
Indeed, it is possible to directly relate a business’ free
cash flows to its market value. Financial statements
should make this connection easy. Today, they do not.
Managing for Free Cash Flows
And Shareholder Value Creation
It is management’s fundamental responsibility—some
would say obligation—to increase shareholder value.
This requires increasing the NPV of the future stream of
cash flows. There are only three ways to do it: increase
cash earnings, reduce investments and employ financial
management.
1. Increase cash earnings by growing the business “valu-
ably.” Growth, in and of itself, won’t do it, nor will “prof-
itable growth,” if the impact on free cash flows is actually
negative. It’s important that growth improve free cash
flows, which has to take into account additional invest-
ments in working capital and capital expenditures re-
quired to support the growth.
A second approach, cost management, differs from
cost reduction; it may mean spending more to increase
cash earnings and free cash flows, not less. Depending on
the categories of costs across a company’s value chain,
2
good cost management may mean a) spending to develop
new products or support customers, rather than drasti-
cally cutting those costs; b) finding ways to take costs out
of products without affecting their perceived value; or c)
reducing administrative costs.
2. Reduce investments means managing working capital
and fixed and other assets more tightly. That might mean
collecting receivables more quickly—such as Dell Com-
puter Corp.; turning inventories faster; such as Toyota
Motor Corp.; and getting out from under fixed assets via
outsourcing, such as Nike Inc. has done—and focusing
more attention on intangible asset performance, which
placing them on the balance sheet would have a tendency
to do.
3. Financial management has two primary elements.
First, managing the mix of capital to minimize the firm’s
weighted average cost of capital. Generally, this means
increasing the proportion of debt capital that is less ex-
pensive than equity capital. Because fixed assets are fre-
quently undervalued and intangible assets are not even
recognized, many companies understate their book eq-
uity, and overstate their debt to capital. They actually
have additional debt capacity before their cost of capital
begins to rise, due to increased risk.
Second, using free cash flows, or free cash flows after
interest payments and debt service, to increase the com-
pany’s future value. Historically, more mature compa-
nies with positive cash flows have paid dividends—in
effect, giving cash back to shareholders, assuming that
shareholders can invest elsewhere to achieve higher re-
turns. That’s not saying much for the firm—the share-
holder must pay taxes on the dividends, and the company
itself could leverage up the cash it held by not paying div-
idends.
Unless a firm has run out of good investment opportu-
nities, it should think long and hard about the economics
of cash dividends. That’s also true for stock buybacks.
Only if reducing the number of shares outstanding in-
creases the per-share value of the remaining shareholders
is this appropriate. For many companies, buying back
stock has proven dilutive for continuing shareholders.
Most businesses have a variety of products and prod-
uct groups. Each product’s stage of life cycle, positioning,
competitive strength and investment requirements influ-
ences its cash flow pattern and value-creating contribu-
tion. Disaggregating firm-wide cash flows will, in all
likelihood, identify groups and individual products that
are actually destroying, rather than creating value—some
of which may come as a real surprise to management.
The ultimate financial management challenge is to use
free cash flows to invest in new business opportunities
that build shareholder value. Every investment a firm
makes, be it a standalone piece of equipment, a new plant,
an acquisition or the business itself, should be evaluated
accordingly.
 Article 21. Tying Free Cash Flows To Market Valuations

Xerox Corp. — Profits vs. Cash Flows

A 1999 1998 1997 G. Richard Thoman, who had been appointed CEO only
Revenues $19,228 $19,447 $18,144 13 months before, was ousted, attributed in part to a
failed sales force reorganization that he had spear-
Total Costs and Expenses
headed. By that autumn, speculation emerged that
(Before Restructuring) 17,192 17,153 16,003
Xerox might file for bankruptcy. The stock fell to $5
Restructuring Charge and Inventory per share, having lost more than 90 percent of its
Writedown 1,644 value.
Net Income 1,424 395 1,452 Looking at Xerox’s reported profits (before restruc-
(all figures in millions of dollars) turing, as management would want the reader to do)
provides one impression (See exhibit A).
B 1999 1998 1997
Revenues were up in 1998; margins before restructur-
Net Income $1,424 $395 $1,452 ing were better and, without restructuring, profits
+Interest (1-tax rate) 543 627 528 would have been up slightly. Revenues dropped
Net Operating Profit A.T. 1,967 1,212 1,980 slightly in 1999, but profits held up, at least relative to
+\- Non Cash Adjustments 1,316 2,817 1,037 1997 and 1998, before restructuring. The market ex-
Cash Earnings 3,283 4,029 3,017 pected more, however, and the market valuation slid.
Looking at the consolidated statements of cash flows,
Changes in Working Capital (2,547) (4,235) (2,017)
it would be difficult to discern a cash flow problem.
Investments in Capex, etc. (627) (867) (1,251) however, by rearranging the cash flow data to present it
Cash Charges-'98 Restructure (437) (332) on a “free cash flow” basis, the picture changes dramat-
FREE CASH FLOWS (335) (1,405) (251) ically. (See exhibit B).
This says that for the three-year period 1997–1999—
C Interest Payments (A.T.) (543) (627) (528) including 1998, which was described in such glowing
Dividends (586) (531) (475) terms—Xerox “burned” close to $2 billion in cash before
CASH FLOWS AFTER interest payments and dividend distributions. Yet, be-
INTEREST and DIVIDENDS (1,464) (2,563) (1,254) fore the problems came to light, the company’s market
capitalization soared. That would imply the unsuspect-
ing shareholders were willing to pay $42 billion, plus
any outstanding debt, for the opportunity to acquire
X erox Corp. provides a classic example of how poten- this stream of negative cash flows! When one takes into
tially misleading accounting profits can be, especially in account the interest and dividends, the story gets grim-
the context of a troubled company. In early 1999, Xerox mer. (See exhibit C).
management stated in the company’s annual report that During this three-year period, reported earnings ag-
1998 was "an excellent year" in which "earnings per share gregated more than $3 billion, yet cash flows were more
(EPS) from continuing operations were up 16 percent be- than negative $5 billion. Where were its bankers?
fore the restructuring. Income was up 17 percent." Man- It has recently come to light that Xerox had pursued
agement went on to say, "Our company has never been aggressive accounting during this period. In early April,
stronger in the marketplace nor our opportunity it agreed to restate earnings for a four-year period and
greater." And so it might seem from the market’s reac- pay a $10 million fine to the Securities and Exchange
tion. Shortly after the annual report was released, Xerox Commission. Separately, the SEC announced that it was
stock climbed to nearly $64 per share, resulting in a mar- widening its probe of Xerox to include ex-executives
ket capitalization of more than $42 billion. and its external audit firm.
Throughout 1999, Xerox reported a spate of bad news: What Xerox did was attribute more of its leasing
softness in its significant Brazilian market, a profit warn- transactions to current (e.g., ‘98 and ‘99) revenues and
ing for the third quarter that stunned Wall Street, then profits than it shoudl have. Looking at the cash flows
another warning and large earnings shortfall for the eliminates these overstatements, because the added rev-
fourth quarter. By year-end 1999, its stock had dropped enues booked only increased its receivables and had no
to $20. But the problems didn’t end there. By May 2000, beneficial effect on cash flows.

3
ANNUAL EDITIONS
Metrics to Monitor Free Cash Flows
And Value Creation
Traditional financial statement analysis has focused on
measures of “profitability” and “risk.” Profitability has
typically focused on “return on assets” and “return on eq-
uity;” risk measures have focused on “liquidity” and
“solvency.” For many of the reasons that financial state-
ments need drastic overhaul, so, too, do performance
measures.
Return on assets (ROA) suffers on two counts. The “re-
turn” numerator of net operating profit after taxes (NO-
PAT), based on managed earnings, is suspect because of
the many deficiencies of accrual-based earnings. Because
the “assets” denominator is stated at book value, which is
frequently understated, ROA is often overstated. Return
on equity (ROE) measures fail for the same reasons. Here,
the return numerator, net income, is divided by average
book equity. Again, in most cases, the resulting calcula-
tion is overstated.
The ultimate financial management
challenge is to use free cash flows to
invest in new business opportunities
that build shareholder value.
If one wants to use accounting-based return measures,
instead of ROA, one should measure “return on invested
capital” (ROIC), NOPAT divided by the “investments” in
the business—working capital, property, plant and
equipment and intangible assets. Excess cash and other fi-
nancial assets should be netted against any debt. To cre-
ate shareholder value, ROIC must exceed the firm’s
weighted average cost of capital (WACC). To use ROE,
the equity base must be the market value. If the market-
based ROE exceeds the estimated shareholder cost of cap-
ital, then the firm is creating value for shareholders.
The classic “liquidity” measures, such as the “current”
and “quick” ratios, focus on the relationship of current as-
sets to current liabilities. The implication for years that
“more” is better—that a firm is more liquid if its assets ex-
Reprinted with permission from Financial Executive, May 2002, pp. 17-20. © 2002 by Financial Executives International, 10 Madison Avenue,
Morristown, NJ 07962.
ceed its liabilities—is deficient on at least two counts:
First, it fails to recognize the “flow” characteristics of
working capital. Typically, when a firm grows, so do its
working capital requirements. Next, having fewer re-
sources tied up in working capital is better in that it re-
duces the amount of cash required to support growth and
improves ROIC by lowering the investment base.
The most frequently utilized “solvency” measures are
the times-interest earned ratio and various debt-to-capital
ratios. Ratios, however, really say little about absolute
cash flows. If a firm lacks adequate free cash flows to
cover its debt service, it is insolvent, regardless of what
the ratios say. Important measures tracked in a cash and
value orientation are such things as: cash earnings to
sales; the relationship of cash earnings to the changes in
working capital (a measure of liquidity, in that it reflects
whether enough cash is being earned to support the re-
quired changes in working capital); cash earnings to rein-
vestments (both in working capital and fixed and
intangible assets); free cash flows to sales (the single most
important measure); and free cash flows to interest and to
total debt service, two measures of solvency.
In summary, free cash flows have to be the focus of ma-
jor financial statement overhaul, and may be directly re-
lated to current market valuations to determine if the
current free cash flows support current market values.
Focusing on free cash flows also necessitates establishing
a new set of “metrics” that have a cash and value orienta-
tion. Management teams and investors who embrace the
new cash and value-oriented statements and associated
metrics will find that they have new insights into their
businesses and investments, and the opportunity to cre-
ate real value for their shareholders—and themselves.
[*See Financial Executive, April 2002.]
Robert A. Howell is a Visiting Professor of Business Administration at
the Tuck School of Business at Dartmouth. He can be reached at Robert.
A. Howell@Dartmouth.edu