Forecasting Cash Flows
There are three components to forecasting cash flows
To determine the length of the extraordinary growth period
Estimating cash flows in the high growth period
Terminal value calculation
Length of extraordinary growth period
High growth period means firm has earned excess return over the cost of capital i.e. return on capital is more than cost of capital
High growth period is dependent on three factors
Size of the firm – Smaller the size of the firm greater the chances of longer high growth period because they have more room to grow and a larger potential market
Existing growth rate and excess returns – Firms with higher growth rate historically have greater chances of high growth rate in near future
Magnitude and sustainability of competitive advantages – Higher entry to barrier will lead to higher growth rate for longer period
Estimating cash flows in the high growth period
Once the length of high growth period is estimated, it is needed to estimate growth value itself of the company, We use growth estimates either supplied by management or by other analysts tracking the company along with the historical growth rates
For historical growth rates, should we take arithmetic average or geometric average of historical growth rates?
The geometric average is better estimate in case the historical growth rate has been highly erratic
Services like Institutions Brokers Estimate System (IBES) and Zacks aggregate and summarize analyst forecast and make them widely accessible. Analyst generally provide forecast about earning per share but for valuation purpose we need growth in operating profit and not growth in net income so we have to make downward adjustment in the growth provided by the analysts because growth in operating income is lesser than the growth in earning per share
Growth in net income can also be linked with retention ration and return on equity i.e. g = Retention Ratio * ROE. The implicit assumption here is that the only source of equity is retained earnings. If we drop this assumption then source of equity debt raised net of debt payment. In this case, equity reinvested in business = (Capital expenditure – Depreciation) + Change in working capital – (New Debt issued – Debt Repaid).
Equity Reinvestment Rate = Equity Reinvested in Business/Net Income and growth rate of net income = Equity Reinvestment Rate * ROE
Return on Equity (ROE) is dependent on leverage of the firm, more the leverage higher the ROE if pre interest after tax ROC is more than the after tax interest cost.
ROE = ROC + (D/E) * [ROC – i*(1-t)]
Growth in operating income is dependent on the reinvestment rate and Return on Capital where Expected Reinvestment Rate = [(Capital Expenditure – Depreciation) + Change in Non-Cash Working Capital]/EBIT*(1-t)
Revenue Growth Estimation – We have to make many subjective judgments about the nature of competition, the capacity of firm being valued to handle the revenue growth and the marketing capabilities of the firm. We link the revenue growth with the capital invested in the firm, the ratio sales to capital reflects how much additional revenue has been generated by investing one dollar. This investment can be in internal projects, acquisitions or working capital.
We can calculate the sales to capital ratio for the firm and assume it to be constant for near future, if we have already forecasted revenue growth number we can get revenue numbers. Using this revenue number and sales to capital ratio we can estimate the capital investment needed every year. With this capital investment we can calculate the total capital of the firm every year which can be used in finding out the return on capital. There should be consistency in these numbers e.g. if ROC calculated using above method is very different from the industry average then there is some adjustment to be made in sales to capital ratio.
There are three methods to find the terminal value of a firm
Liquidation method – It is assumed that assets of the firm will be liquidated and sold off in the terminal year. The liquidation value can be based on book value adjusted with inflation or it can be estimated by the discounting the cash flow generated by the liquidated assets terminal year onwards till the life of the assets with the cost of capital
Perpetuity method – It is assumed that firm will grow at a constant rate after terminal year
Multiple method – Ratio is used to estimate the terminal value of the firm. Using multiples to estimate terminal value, when those multiples are estimated from comparable firms, results in a dangerous mix of relative and discounted cash flow valuation. Multiple can also be estimated using fundamentals but then it boils down to constant growth rate method
If the firm has a constraint of operating in the domestic country then the stable growth rate of the firm will be limited by the growth rate of the economy of the country. In case the firm is operating in multiple nations then the limiting value will be the growth rate of these nations.
If the valuation is done in nominal terms then the stable growth rate will be nominal growth rate i.e. inflation effect will be considered in the growth rate. Also the currency in which the valuation is done limits the stable growth rate. If a low-inflation currency is used to estimate cash flows, the limits on stable growth rate will be much lower.
Nominal riskless rate = Real riskless rate + Expected inflation rate. In the long term, the real riskless rate will converge on the real growth rate of the economy. Cost of capital will be more than riskless/risk-free rate therefore cost of capital will always be more than the long term growth rate.
Characteristics of Stable growth firm
Less Risky – Stable companies have lesser exposure to market risk compared to the high growth companies because high growth companies generally tend to be niche players, provider of discretionary products and services and have high operating leverage. Two-thirds of US firms have betas that fall between 0.8 and 1.2. That becomes the range for stable-period betas.
Use more debt – Stable growth firms have higher debt taking capacity
Have lower or zero excess returns – In stable growth firms it is difficult to sustain excess returns thus return on capital becomes equal to cost of capital. We can also take return on capital of the firm to be industry average in long run. Growth without excess returns will make a firm larger but not more valuable.
Reinvest less than the high growth firms – If we estimated growth rate and we also know the ROE then we can calculate the retention ratio. It should be consistent with the reinvestment done by the firm. Linking reinvestment rate and retention ratio to the stable growth rate also makes the valuation less sensitive to assumptions about stable growth rate.