Estimating & Forecasting Free Cash Flows

First and foremost it is very important to get comfortable with the historical performance of the company.

In order to come up with a robust valuation, it is crucial that assumptions made are reliable. This will be possible only after enough research and diligence has been done on the company and the industry.  

Company related information includes details on core operations, business model, key performance indicators or KPIs, customers, geographies, major raw material suppliers, costs, future prospects and growth plans etc. Industry related information can include details related to  competition, changes in regulation, barriers to entry, market growth, technological advancements etc.

Before forecasting the business plan and building cash flows, lay out the historical performance of the company over a 2 to 3 year period. Adjust financials for non-recurring and exceptional items, then identify underlying trends.

  • Are revenues increasing or decreasing?
  • How about growth rates?
  • Are costs increasing both in absolute terms and as a percentage of revenue?
  • What is happening with EBITDA, EBIT and margins?
  • Does the company have any expansion plans or plans to upgrade existing machinery?  What are capex margins like?
  • What is happening with working capital?
  • Does it plan to raise any additional debt or repay existing debt?
  • What is the effective tax rate?

For listed entities their annual reports, quarterly reports, call transcripts and investor presentations contain a wealth of information and are publicly available. Equity research and other industry reports provide valuable insights into qualitative and financial aspects. These data sources are instrumental in enabling analysts to forecast financials and build a business plan. If on the other hand, a company is private, then rely on the company website, tax fillings, news runs, sites that collate information on private companies etc. In short, finding information on private companies may be challenging as corporate governance standards vary a great deal between industries and geographies.

FREE CASH FLOWS TO THE FIRM (FCFF)

A company is financed by either equity, debt or both. The most common approach is to calculate unlevered, after tax free cash flows to the firm or FCFF. This is the surplus cash available to both equity and debt providers, after meeting all cash flow needs, but before any payments to providers of debt. Valuing a company based on FCFF gives the operating value of a firm, independent of its capital structure.

FCFF = EBIT – Tax on Operating Profit (EBIT) + D&A +/- Change in Working Capital - Capex

“Firm” in FCFF refers to both equity and debt holders. The profit metric that corresponds to both equity and debt holders is EBIT. In order to get to FCFF, start with operating profit or EBIT which represents the consolidated operating income from core operations.

Firms have to pay taxes on their operations, so taxes have to be subtracted from EBIT. These are obtained by multiplying EBIT with the effective tax rate. Keep in mind that if the company has Net Operating Losses or NOLs, then any future profits can be offset against these unutilised NOLs.  Net operating profit after taxes or NOPAT is calculated by subtracting taxes from EBIT.

Depreciation and amortisation or D&A would have been subtracted earlier to arrive at EBIT. While calculating cash flows, this must be added back as it is a non cash expense.

Adjustments need to be made for changes in working capital. An increase in current assets is a cash outflow and vice versa. If inventory is increasing then money is tied up in stock which represents a cash outflow. Likewise, an increase in current liabilities is a cash inflow and vice versa. If creditors are increasing it implies that cash that should have been paid to suppliers, has not been paid yet and as a result it is a cash inflow.

To sustain operations, a company must invest in  tangible and intangible fixed assets. This is known as capex and must be subtracted as it is a cash outflow.

This gives FCFF or Free cash flow to firm. It is the surplus cash available to equity and debt holders of a company after meeting all capex and working capital needs. 

Therefore, in order to get to FCFF, start with EBIT then subtract taxes. This gives NOPAT. Then add back d&a and adjust for changes in working capital which could be a plus or a minus as the case may be. Finally, subtract capex to get FCFF.

Under this approach, EV is obtained by discounting FCFF at the weighted average cost of capital or WACC. The value of equity can be calculated as EV less net debt less non controlling interests plus associates and affiliates.

FORECAST PERIOD

How long the forecast period should be - 3 years? 5 years? 7 years? 10 years? 20 years? As a general rule, it is better if the forecast period reflects the time it takes a firm to reach steady state. So what is steady state? Simply put, steady state is when a business is achieving stable and predictable revenues, profits and cash flows. As a result, free cashflows for a company in steady state will grow at a constant rate. Consideration should be given to the following additional points:

Short v/s Long : If the forecast period is too short, then valuation may fail to capture a firm’s intrinsic value. On the other hand, if the forecast period is too long, valuation will be at the mercy of assumptions made which may or may not come good.

Economic cycle: Where possible, care should be taken to ensure that an entire economic cycle has played out during the course of the forecast period.

Stage: Another factor to keep in mind is what stage is the company in? 

FORECASTING

The next logical step is to forecast financials and build a business plan from which cash flows can be derived.

As mentioned earlier, the historical performance of the company has been mapped out already. If there is a a financial model, then rely on it for forward estimates. But if not use equity research reports for forward estimates. The problem is that most research reports provide forecasts for only 2 to 3 years. So if the forecast horizon is longer, estimates are still needed for the remaining forecast period.

Sound judgement is a must. There is a key question that must be considered - can management really deliver on this business plan?