Dealing with Negative or Abnormally Low Earnings

Steps in Cash Flow Estimation

Estimate the current earnings of the firm
• If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income
• If looking at cash flows to the firm, look at operating earnings after taxes

Consider how much the firm invested to create future growth
• If the investment is not expensed, it will be categorized as capital expenditures. To the extent that depreciation provides a cash flow, it will cover some of these expenditures.
• Increasing working capital needs are also investments for future growth
If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid)

Measuring Cash Flows

Measuring Cash Flow to the Firm


EBIT ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm
Where are the tax savings from interest payments in this cash flow?


From Reported to Actual Earnings

Estimating the Cost of Debt

The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level of interest rates in the market.
The two most widely used approaches to estimating cost of debt are:
• Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded.

• Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm

When in trouble (either because you have no ratings or multiple ratings for a firm), estimate a synthetic rating for your firm and the cost of debt based upon that rating. The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest

coverage ratio.

                                              Interest Coverage Ratio = EBIT / Interest Expenses


Companies in countries with low bond ratings and high default risk might bear the burden of country default risk, especially if they are smaller or have all of their revenues within the country.

Larger companies that derive a significant portion of their revenues in global markets may be less exposed to country default risk. In other words, they may be able to borrow at a rate lower than the government.


The weights used to compute the cost of capital should be the market value weights for debt and equity.
There is an element of circularity that is introduced into every valuation by doing this, since the values that we attach to the firm and equity at the end of the analysis are different from the values we gave them at the beginning.
As a general rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.