Appendix 7

AFTF Behavior Patterns

 

Table A7-I summarizes results for three companies with differing actual cash flow growth patterns: low growth, medium growth, and high growth. Each company's expected cash flows are assumed to match its actual cash flows. It is assumed that the capital markets know and trust these expected cash flows and that the market cost of capital is 15%. Hence the Market Valuations (stock prices) will equal the Company Valuation at 15% discount for each company. As expected, the higher growth companies have higher Company Valuations and the annual value added is larger for the higher growth companies. There are no adjustments from the AFTF validation procedures since, 

  1. The actual-to-expected ratios are equal to one. This means that the model and expected cash flows do not require revision.
  1. The Company Valuations at 15% match the Market Valuations. The expected cash flows are already discounted at the appropriate cost of capital.

 

 

 

 

The graphs below represent three companies with the same assumed steady growth future, but with different expectations labeled: Cautious, Neutral, and Optimistic

 

 

 

Table A7-II summarizes results for three companies with different expected cash flow patterns: low expected growth (cautious company), medium expected growth (neutral company), and high expected growth (optimistic company), as represented by the preceding diagrams.

 

 

 

 

 

It is assumed that for each of the three companies the actual cash flows will match the medium expected growth pattern after the validation period. See the preceding graphs for the patterns of net cash flows. Note that for all three companies the cash flows have been initially exactly validated. It is assumed that the Market Valuations equal the "adjusted" Company Valuations using a discount rate of 15%, i.e., the market cost of capital is 15%. The expected cash flows are adjusted by the actual-to-expected ratio as part of the validation procedure. This implies that the Company Valuations will be similarly adjusted. The cautious Company Valuations are increased compared with Table I and the optimistic Company Valuations are decreased, both reflecting the emerging actual experience. The progress (value added) of the optimistic company is the lowest due to the exaggerated initial Company Valuation. From the perspective of value added it does no good to exaggerate expected cash flows. 

Table A7-III summarizes results for three companies with different expected cash flow patterns: low expected growth, medium expected growth, and high expected growth. It is assumed that for each of the three companies the actual cash flows will match the medium expected growth pattern after the validation period. It is assumed that the Market Valuations equal the Company Valuation for the medium assumed growth case. The validation for the historic cost of capital is activated, but not the actual-to-expected validation. The historic cost of capital is that discount rate which equates the Company Valuation to the Market Valuation. This discount rate substantially offsets any attempt to exaggerate the Company Valuation. The market thus determines its own costs of capital or equivalently the market prices are given substantial credibility in assigning a value to the company. Both the cautious and optimistic Company Valuations converge on the medium growth Company Valuations. This is desirable and not unexpected, since the Market Valuations and actual cash flow patterns are those of the medium growth case. The main point is that Company Valuations are constrained by the market cost of capital. If new cash flow patterns are expected due to changes or business plans implemented during the year then the Company Valuation will increase appropriately.





Table A7-IV summarizes results for three companies with different expected cash flow patterns: low expected growth, medium expected growth, and high expected growth. It is assumed that for each of the three companies the actual cash flows will match the medium expected growth pattern after the validation period. It is assumed that the Market Valuations equal the Company Valuation for the medium assumed growth case. The historic cost of capital will vary to permit the Company Valuations to match the medium Market Valuation for the validation period. The expected cash flows are adjusted by the emerging 5-year average actual-to-expected cash flow ratios. Both parts of the dual validation procedure are thus activated. Understating or exaggerating cash flows will not materially change the realities of market prices or emerging experience.

 

 

 

 

 

It may seem that using the market cost of capital forces the Company Valuation to be close to the 5-year average Market Valuation. In the above examples this is the case, and should be the case, because management expectations or conditions have not changed. During the 5-year validation period the same expected cash flow expectations were used as were used for later Company Valuations. It is assumed that the market has been made aware of these expectations (which may not be true with traditional retrospective accounting) during the 5-year period. Under these assumptions it is proper to force the Company Valuation to be similar to the Market Valuations. As soon as unexpected change occurs, the Company Valuations will break free of the historic Market Valuations. Note also that, as soon as AFTF is implemented, the Market Valuations themselves may break free of the historic Market Valuations.

 Some care is needed to explain the timing of the validation process and the perspectives involved. The validation process is done soon after the completion of the Company Valuation process for the past year and using the expected cash flows as of that valuation. In this way the validation process does not introduce new information that belongs to the current year. The current year new information will be incorporated only in the upcoming Company Valuation so that the difference between the valuations will be due to experience, decisions, or changes from the current year.

  

Conclusions 

The above limited examples show that the five-year dual validation provides a strong discipline on the Company Valuations. It is a discipline based on the realities of the capital market's cost of capital and the emerging reality of actual cash flows. The precise dynamics of market and management reactions to AFTF will follow a complex path, but a more informed and efficient market and management will result.

  

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