Forecasting Free Cash Flows

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Forecasting Free Cash Flows
Where We Are Going
We will discuss forecasting free cash flow and
using that forecast to estimate the value of the
firm
Chapter 10
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The Free Cash Flow Model

Value of core operations
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A Forecast Valuation Model

• Is a set of equations that describe how each
  element of free cash flow behaves

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Forecasting and the Valuation
Has four stages

• Model the free cash flows
• Set the model assumptions and compute the results
  
• The major step in valuation
• Refine the model
• Ex, Break forecast down by produce line, forecast
  sales growth by price and volume changes
• Sensitivity analysis

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Business Analysis
Forecasting and the Valuation
Financial Statement Analysis
Forecast Assumptions
Historical Ratios
Forecast Ratios
GAAP Financial Statements
Historical Free Cash Flow Statements
Free Cash Flow Forecast
Valuation
Time
Historical Periods
Valuation Date
Forecast Periods
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1. Model the Free Cash Flows

• Specify cause-and-effect relationships among FCF
  components
• For example, the equation defining sales might be
  prior years sales increased by a growth rate

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Model the Free Cash Flows Continued
Each component of model is estimated from

• Already computed component of model of historical
  value
• One or more assumptions, often in form of a ratio

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Model the Free Cash Flows Continued
A "good" forecast is

• Reasonable
• Internally consistent

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Model the Free Cash Flows Continued
Reasonableness

• Model is a decent representation of
  cause-and-effect relationships among FCF
  components
• Assumptions are realistic forecasts of actual
  values that will be realized

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Model the Free Cash Flows Continued
Internal Consistency

• The assumptions are logical in relation to each
  other
• If project selling expense as sales times an
  assumed ratio, then these expenses should
  actually vary with sales levels, perhaps due to
  commissions. In contrast, forecasting deprecation
  in the same way would not make sense

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Example of a Free Cash Flow Model (Exhibit 10.2)

• The model allows for a different growth rate in
  every year

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Example of a Free Cash Flow Model (Exhibit 10.2)

• For the REV and COS to be internally consistent,
  COS forecast must depend on REV. The gross margin
  percentage defines that dependency

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Example of a Free Cash Flow Model (Exhibit 10.2)

• Example of internal inconsistent forecast on page
  215
• If gst is increased without changing ht, all the
  incremental revenue will be profit, meaning the
  margin assumed on an additional dollar of sales
  was 100!
• COS do not simply grow at some rate independent
  of sales growth rather sales growth directly
  affects COS

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Example of a Free Cash Flow Model Continued

• Operating expenses include all expenses that
  occur in the normal course of operations except
  for those associated with preparing the product
  for sale, tax expense, and financing expenses
• Eg. Selling, marketing, rent, administrative
  expenses..

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Example of a Free Cash Flow Model Continued

• Whenever we apply a tax rate, we use the tax rate
  that pertains to the associated income
• In this case, we use the effective tax rate on
  core operations

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Example of a Free Cash Flow Model Continued

• Now turn to the components of free cash flow that
  come from the cash flow statement rather than the
  income statement
• The reversals of items included in NOPAT that are
  not cash flows, such as deprecation and
  amortization expense
• Cash flows related to core operations that are
  not included in NOPAT, such as capital
  expenditures and changes in working capital

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Example of a Free Cash Flow Model Continued

• Examine historical changes in depreciation levels
  from year to year and forecasting analogous
  changes
• Assume depreciation is unlikely to change much
  form one year to the next

• The proportion of the income tax provision that
  is not a current obligation to the government
• Arise primarily due to book/tax differences in
  depreciation

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Example of a Free Cash Flow Model Continued

• Represents additional investment
• Generally related to revenue increases
• Changes to the revenue forecast will
  automatically alter the forecast of change in
  working capital

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Example of a Free Cash Flow Model Continued

• Maintenance capital expenditure, ctDEPRt those
  required to maintain the existing level of
  productive capacity
• Expansion capital expenditure, ft(REV-REVt-1)
  capital expenditures beyond those required to
  maintain existing productive capacity

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2. Set the Model Assumptions and Compute the
Results
To Set Assumptions

• Use historical values as guide where reasonable
• Distinguish between forecast horizon and
  perpetuity period

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Forecast and Valuation
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Setting Assumptions in the
Perpetuity Period Continued
How many years in the forecast horizon?
Go out far enough so that

• Regular FCF pattern is feasible
• Competitive advantage likely to have dissipated

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Setting Assumptions in the
Perpetuity Period
Assumptions in Perpetuity Period

• No more comparative advantage
• Implies any incremental investment is zero-NPV

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Set the Model Assumptions and Compute the Results
Using Historical Relationships

• Some historical relation will remain stable,
  others will not
• It is important to adjust the historical relation
  based on business analysis, whenever necessary

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Starbucks Valuation Example

• Ex. 10.3
• Forecast ratios based on 5 years of historical
  data
• Use the forecasted ratios and the relation among
  the components of free cash flow statement to
  forecast free cash flow from core operation

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Starbucks in the Perpetuity Period
Assumptions in Perpetuity Period

• No more comparative advantage
• Implies any incremental investment is zero-NPV
• Okay to ignore incremental investment
• Nominal growth
• CAPEX maintenance only
• No differed taxes

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3. Refine the Model
After building the model, the analyst often
decides to refine it
For example
Separate by business units
Separate a ratio into two or more parts
Link model to external economic forecasts
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Refine the Model Continued
Detailed Cost of Sales Forecast Submodel
Detailed Revenue Forecast Submodel

• Free Cash Flow Forecast
• Revenue forecast
• Cost of sales forecast
• ?
• ?
• ?

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Separate by Business Unit

• Separate forecasts down to some point in FCF
  forecast
• Aggregate separate forecasts
• Most useful when economics of business units
  differ

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Separate by Business Unit Cont.
Unit A
Consolidated Forecast
Unit B
Unit C
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Separating Ratios
Break relationship into two or more
assumptions For example (see equations on page
231)

• Sales growth into volume growth and price changes
• A cost into fixed and variable components

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Link to External Forecasts

• Sales into forecasted market demand and market
  share
• Example first equation on page 232
• Sales based on an indicator of economic activity,
  like housing starts or GDP

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4. Sensitivity Analysis
Analysts commonly use four types of sensitivity
analysis

• Single-assumption
• Combined
• Scenario-based
• Reverse valuation

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Single-Assumption Sensitivity Analysis

• Calculate a range of values given optimistic and
  pessimistic values for the assumption (ex. 10.9)
• What would happen if revenues were higher or
  lower than what we projected in the base case
  forecast

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Combined Sensitivity Analysis

• Vary two or more assumptions simultaneously (ex.
  10.10)
• Variables do not usually change one at a time
• Changes in advertising affect sales volume and
  operating expenses

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Scenario-based Sensitivity Analysis

• Recalculate value given some event, such as a new
  entrant in the market
• For example, assume a new competitor enter the
  market
• Revenue growth and operating margin percentage
  might decline as the competitor takes market
  shares and forces prices lower
• Other operating expense might increase as the
  firm responds by increasing its advertising and
  promotion

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Reverse Valuation Sensitivity Analysis

• Determine the assumptions that are consistent
  with the observed market price and assess whether
  these assumptions are reasonable

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Summary
We have learned

• A forecast model is not just numbers it is a set
  of equations describing cause and effect of free
  cash flow components
• Assumptions must be reasonable and internally
  consistent

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Summary Continued

• To get basic model in place first then refine
• To understand potential errorssensitivity