The following was originally published on the American Association of Individual Investors (AAII).
This article details how to construct an unlevered discounted cash flow (DCF) analysis for Nike Inc. (NKE) by using finbox.io’s five-year valuation model. Note that unlevered free cash flow refers to the cash a business generates before paying any providers of capital such as debt and equity holders.
The basic philosophy behind a DCF analysis is that the intrinsic value of a company is equal to the future cash flows of that company, discounted back to present value. The general formula is provided to the right. The intrinsic value is considered the actual value or “true value” of an asset based on an individual’s underlying expectations and assumptions.
Cash flows into the firm in the form of revenue as the company sells its products and services, and cash flows out as it pays its cash operating expenses such as salaries or taxes (taxes are part of the definition for cash operating expenses for purposes of defining free cash flow, even though taxes aren’t generally considered a part of operating income). With the leftover cash, the firm will make short-term net investments in working capital (an example would be inventory and receivables) and longer-term investments in property, plant and equipment. The cash that remains is available to pay out to the firm’s investors: bondholders and common shareholders.
I will take you through my own expectations for Nike as well as explain how I arrived at certain assumptions. The full analysis that was completed on January 26th, 2017, can be viewed in this Google sheet. An updated analysis using real-time data can be viewed in your web browser. The steps involved in the valuation are:
1. Forecast Free Cash Flows
- Create a revenue forecast
- Forecast EBITDA profit margin
- Forecast depreciation & amortization expenses
- Select a pro-forma tax rate
- Plan/estimate capital expenditures
- Forecast net working capital investment
- Calculate free cash flow
2. Select a discount rate
3. Estimate a terminal value
4. Calculate the equity value
Step 1: Forecast Free Cash Flows
The key assumptions that have the greatest impact on cash flow projections are typically related to growth, profit margin and investments in the business. The analysis starts at the top of the income statement by creating a forecast for revenue and then works its way down to net operating profit after tax (NOPAT), as shown below.
From NOPAT, deduct cash outflows like capital expenditures and investments in net working capital and add back non-cash expenses from the income statement such as depreciation and amortization to calculate the unlevered free cash flow forecast (shown below).
Capital expenditures or fixed capital investment does not appear on the income statement, but it does represent cash leaving the firm, which is why it is subtracted from NOPAT to reach free cash flow. Capital expenditures used in the DCF model represent a net amount, meaning the figure is calculated by subtracting proceeds from sales of long-term assets from capital expenditures. It is the change in capital expenditures that matters for this model.
Working capital is often used as a measure of a company’s efficiency and short-term financial health. It is generally calculated as current assets minus current liabilities.
Working capital investment, or net working capital, in the DCF model is equal to the change in working capital, excluding cash, cash equivalents, notes payable, and the current portion of long-term debt. It’s important to note that one would add the change in working capital to NOPAT if there was reduction in working capital over the period. It would be added back because it represents a cash inflow. This concept is confusing to many. An increase in working capital implies that more cash is invested in working capital and thus reduces cash flow. Firms with significant working capital requirements will find that their working capital grows as they do, and this working capital growth will reduce their cash flows. It is more common to see a cash outflow for the change in net working capital.
Non-cash charges are added back to NOPAT to arrive at free cash flow because they represent accounting losses required to be reported on the income statement but they didn’t actually result in an outflow of cash. The most significant recurring non-cash charges are typically depreciation and amortization. But other non-cash charges or expenses that are typically non-recurring in nature could include:
- Amortization of intangibles,
- Goodwill impairment,
- Asset write-down,
- Provisions for restructuring charges and other non-cash losses (these expected losses should reduce future free cash flow accordingly in the model’s estimates),
- Income from restructuring charge reversals and other non-cash gains,
- Amortization of a bond discount (add back to net income to calculate free cash flow),
- Accretion of a bond premium (subtract from net income to calculate free cash flow),
- Deferred taxes (if you expect that deferred taxes will continue to increase in the future),
- Acquisition expenses representing the costs involved in acquiring a business or a customer (can be cash or non-cash expenses), and
- Litigation expenses relating to legal matters such as settlements and patents.
Finbox.io’s valuation models retroactively adjust historical financials to exclude these non-recurring items. We exclude these items to gain a better sense of how the company has performed in its normal course of business and since they are typically non-recurring charges, their exclusion helps provide a “cleaner” picture for comparing historical performance to projected performance.
Create a revenue forecast
When available, the finbox.io’s pre-built models use analyst forecasts (data from Zacks Investment Research) as the starting assumptions. To forecast revenue, analysts gather data about the company, its customers and the state of the industry. I typically review the analysts’ forecast and modify the growth rates based on historical performance, news and other insights gathered from competitors. Note that if a company only has a small number of analysts giving projections, the consensus forecast tends to not be as reliable as companies that have several analysts’ estimates. Another check for reliability is to analyze the range of estimates. If the range is really wide, it may be less accurate.
The charts above and below compare Nike’s historical and projected revenue growth to a group of comparable companies that I selected: Adidas (ADDYY), Foot Locker (FL), Skechers (SKX), The TJX Companies (TJX) and Under Armour (UA).
The company’s five-year compounded annual growth rate (CAGR) of 10% trails only Under Armour’s, which has a five-year CAGR of 27%. However, Wall Street expects Nike’s top line to grow at 8.6% annually over the next five years, which is most comparable to Adidas and Skechers.
In my model, I conservatively adjusted the growth figures in the final two years so that revenue growth equals 5% in fiscal year 2021. I brought down Wall Street’s rosy outlook in 2020 because (a) it seems unreasonable based on Nike’s recent growth trends over the last five years and (b) there are reports that the company’s market share is