In order to get started with a discounted cash flow analysis, we forecast a company’s free cash flows and then discount them to the present value using the company’s weighted-average cost of capital (WACC).
Forecasting free cash flows, however, can be quite complicated – it is truly an art. There are many things that can impact cash flows and as many as possible should be taken into account when making a forecast:
What is the outlook for the company and its industry?
What is the outlook for the economy as a whole?
Is there any factors that make the company more or less competitive within its industry?
The answers to these questions will help you to adjust revenue growth rates and EBIT margins for the company. Let’s assume a hypothetical example in which we have a normal economic outlook for the future, a positive outlook for the industry and an average outlook for our company.
Given these assumptions, we can simply look at our company’s historical performance and continue this performance out into the future. Looking at our hypothetical company’s revenues for the past three years, we can calculate the compound annual growth rate (CAGR) and use it to forecast revenue for the next five years. The formula for calculating CAGR is:
(Year 3 Revenue/Year 1 Revenue)^(1/2 Years of Growth)-1
Next, let’s calculate the company’s EBIT margin so that we can forecast earnings before interest and taxes. The formula for EBIT margin is simply EBIT over Revenues. To forecast EBIT we simply multiply our forecasted revenues by our EBIT margin.
The Taxman Cometh
To get to free cash flows, we now need to forecast taxes and make certain assumptions about the company’s needs for working capital and capital expenditures. We calculate our company’s tax rate by dividing the company’s historical tax expenses by its historical earnings before taxes (EBIT less interest expense). We can then forecast tax expenses by multiplying the tax rate by our forecasted EBIT for each year.
Once we have after-tax income forecasted (EBIT – taxes), we need to add back depreciation and amortization, subtract capital expenditures and subtract working capital investments. We can forecast depreciation and amortization expenses by calculated their percentage of historical revenues and multiplying that percentage by forecasted revenues.
Capital expenditures are made to upgrade depreciating equipment and invest in new assets and equipment for growth. Although capital expenditure is typically higher than depreciation and amortization for growing companies, we will make the simple assumption that capital expenditure is equal to depreciation and amortization in order to forecast capital expenditures in the future.
Finally, we need to forecast working capital investments. In order to grow the business, we would need a growing amount of working capital on the balance sheet in order to achieve higher revenues. This addition of capital to the balance sheet would result in a negative cash flow. For our model we will assume that working capital needs to grow by 1% of revenue, therefore our working capital investment forecast would simply be 1% multiplied by our forecasted revenues.
We can now get to free cash flow by adding depreciation and amortization to after-tax income and subtracting capital expenditure and working capital investment.
With these projected free cash flows, we can now proceed with the rest of a discounted cash flow analysis by calculating a terminal value, a weighted average cost of capital and then calculating the net present value to determine the enterprise value for the company.