Free cash flow valuation is a technique widely used to forecast the valuation of companies and projects. In this short article I discuss a few techniques and practices you can apply to improve your results.
Forecasting cash production: Regardless of the type of investment you are valuing, the first concern is always to utilize all available information to forecast cash production accurately. Free cash flow valuation depends on discounting a string of numerical values, with the nearest values inherently garnering more weight. During a healthy economic cycle it is much easier to forecast cash flows because business is more predictable. Likewise, for larger, more diversified companies, or businesses in a normally stable industry such as utilities, predicting cash production is relatively straightforward. But what if you’re valuing a growth company or a new project with no history? For these types of growth or start-up investments, one method is to compare the average cash flow growth rates of similar expanding businesses in the same or similar segments. For example, a high-growth telecommunications equipment company can be compared to other telecommunications equipment companies who went through the same development trajectory in the past. Since you are looking for growth patterns, as opposed to exact matches in product and timing, it doesn’t matter what series of years you compare, although it does help to consider the economic cycle. Once you have average annual percentage multipliers, you can apply those to your subject company and derive your future cash flow projections.
Deciding on a terminal value: A typical free cash flow valuation forecasting period is 10 to 15 years. Beyond that point, it is impossible to forecast cash flows with any real accuracy. Building a giant spreadsheet that forecasts 30 years into the future is not particularly useful except for the most long-dated investments such as mortgages and utility plants. To deal with this issue, analysts utilize two main techniques. The first method is to project that you will sell your investment at the end of the forecast period for an amount known as the terminal value. How do you get this number? You can apply a capitalization factor by dividing the last cash value by your expected return per forecast period. Or you can take a multiple of the of the free cash flow valuations of similar public or private companies. The second method is to calculate an annuity or perpetuity value of all future cash flows beyond your last forecast period. This can be a fixed or growth annuity. These are popular with predictable investments such as large cap dividend-paying stocks, health insurance, and pipeline projects.
Customizing your discount factors: Beyond your cash forecasts, the next critical component in free cash flow valuation is the discount factor. Historically, the U.S. total market equity premium above long term U.S. Treasury yields has been about 6-8% to offset historical volatility. Using the CAPM, you can estimate your discount factor by changing the beta factor. Market-derived betas can be obtained from any major data provider such as Morningstar or Reuters, for most industry segments and public company sizes. But what if you’re not valuing a publicly traded stock, or your investment has no equivalent in the markets? Beta becomes meaningless then. Valuators turn to the buildup method, which starts with the risk-free rate and equity risk premium derived from a relatively close market proxy. Then, a liquidity discount is added, which can range from 5-50%, depending on the ability to sell the investment to somebody else. Finally, any unique risk factors are added or subtracted, such as key personnel concentrations, risky contractual terms, government contracts that make cash flows highly predictable, majority control, etc. These factors are combined in a cumulative, as opposed to additive, formula to derive a customized discount factor. You can then use this in your free cash flow valuation model to get your NPV.
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