Estimating free cash flows and valuing a growth company
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Nancy L. Beneda is an assistant professor of finance at the University of North Dakota. Dr Beneda teaches courses in corporate valuation and corporate risk management. Her areas of research also include corporate valuation, risk management and investing. She obtained her PhD in finance from St Louis University and became a Certified Public Accountant in 1989. Prior to her career in academia, Dr Beneda earned the rank of manager at Price Waterhouse. She has published a multitude of articles in such journals as Bank Accounting & Finance, CPA Journal, Credit and Financial Management Review, Journal of Asset Management, Journal of Business and Economic Perspectives and Journal of Financial Regulation and Compliance. University of North Dakota, College of Business and Public Administration, Finance Department, PO Box 7096, Grand Forks, ND 58202-7096, USA Tel: ⫹1 701 777 4690; Fax: ⫹1 701 777 5099; e-mail: [email protected]
Abstract Financial analysts should be primarily concerned about the operating performance of a firm when considering whether to invest in a company. In light of the recent Enron bankruptcy, the largest in US history, financial managers are reviewing and evaluating valuation techniques and procedures. These techniques, used in conjunction with qualitative evaluation and judgment, may help financial managers to avoid some of the valuation mistakes which occurred in the Enron debacle. This paper sets out a simple, but detailed, step-by-step procedure for computing free cash flows and valuing a growth company. An illustration of the computation of free cash flows and corporate valuation, using Compustat financial statements, for Health Management Associates is used to illustrate the procedures. Health Management Associates was reported in the 12th August, 2002, issue of Fortune Magazine as one of the top 40 growth companies traded. Use of the techniques presented in this paper will bring to light the degree of success of the strategic direction and the ongoing performance of the managers of the company. The application presented would be especially useful to investors who hold growth stocks in their portfolios, equity research analysts, venture capitalists and managers of growth firms. Keywords: bankruptcy, corporate valuation, Enron, dividend discount model, free cash flows, growth companies, operating performance, start-up companies
Introduction and contribution to the literature On 2nd December, 2001, Enron Corporation filed for Chapter 11 bankruptcy protection, the largest bankruptcy petition in US history. Enron executives, through a variety of accounting tricks, were able to mislead their employees and the general public
䉷 Henry Stewart Publications 1479-179X (2003)
about the company’s financial position. The use of partnerships, reported as assets, on the balance sheet of Enron permitted company executives to hide large amounts of debt and report excessive value to metaphysical derivative instruments. Accounting scandal has been named as the culprit in the Enron debacle,
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