Cash flow modelling

Cash Flow Modelling

The intrinsic value of a business is a function of the expected future cash flows. Consequently, at Lotus Amity,future cash flow modelling is a fundamental part of the valuation process. The simple question we try to answer is:

 “what cash can this business reasonably be expected to generate for the firm and for equity holders in the future?”.

Type of cash flow

When modelling cash flows the first step is to ensure that we are selecting the appropriate type of cash flow for the valuation and that those cash flows are consistent with the discount rate. The type of cash flows we consider include:

• Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE); usually we use FCFF as we first seek to value the firm before then calculating the value of equity
• pre-tax or post-tax cash flows; typically, we use an Average Weighted Cost of Capital (WACC) for our discount rate and so we use after-tax cash flows based on the tax rate for the business (not the owners), we also take account of any tax losses brought forward
• nominal or real cash flows; typically, we use nominal cash flows, which are cash flows that incorporate inflation as our discount rate is built on a nominal risk-free rate
• probability weighted cash flows or cash flow scenarios; typically we will model a low-case scenario and a high-case scenario and we may use Monte Carlo Simulation to estimate the most likely outcome

Forecast period and terminal value

In assessing the forecast period for which we will project cash flows the factors we consider include:

• the expected life of the business, which in turn depends on factors such as the stage the business is at in the life cycle or there is a finite period for the cash flows, for example, customer, supplier or licensing agreements with finite lives
• the expected time by which the business should achieve a stable level of growth and profits
• the cyclical nature of cash flows and ensuring the forecast period reflects an entire cycle
• the time the asset is expected to be held until it is sold, for example, in the case of valuing a minority interest and the future sale of the business

If the cash flows are expected to continue after the forecast period,then a terminal value is estimated. In estimating the terminal value, we consider:

• if the cash flows from the business will deteriorate or grow
• if the business has a finite or indefinite life
• if the business will cease operations and the assets liquidated
• if the business is to be sold

Cash flow components

The starting point for cash flow forecasts are the revenue projections. These projections are where the granular detail becomes important, examples of revenue forecasts include:

• expected number of units to be sold next year and expected price per unit next year and subsequent unit quantity and price growth
• expected number of clients next year and expected average fees and subsequent growth in the number of clients and average fees
• expected volume or value of assets next year, expected utility of assets and expected average fees and subsequent growth in volume of assets, utility and fees
• expected funds under management (FUM) next year and expected average FUM fees and subsequent growth in FUM and average management fees

After revenue we model factors such as:

• expected gross profit margins and link to foreign exchanges and commodity prices
• expected number of employees, average salaries and potential productivity improvements
• expected renewals of leases and lease cost increases
• expected one off costs, for example, redundancy expenses
• expected tax outflows or tax benefits, for example, R&D tax offsets
• expected working capital requirements consistent with the revenue and cost projections and possible opportunities to improvements in working capital
• expected capital expenditure, timing and potential tax benefits
• expected reinvestment expenditure to improve capacity, consistent with the revenue forecast