Optimistic cash flows

Last month my colleague Sofia discussed risk (one of the three key components of any valuation) and more specifically betas used in calculating a required rate of return for equity, which in turn is one of the parts making up a WACC.

Cash flow forecasts are another important part of any valuation. A valuation based on multiples tries to get around forecasting, but unless your multiple takes growth into account, your valuation is dangerously close to a guess posing as something more. High cash flow growth should lead to a higher multiple of earnings and low growth should lead to a lower multiple.

The problem with forecasting cash flows is that everyone has a tendency to assume that any business will grow in the future. In terms of cash flow forecasting this tendency usually shows up in a way that forecasts assume that revenues grow and at the same time relative profitability (such as EBITDA percentages) increase as well. This can have a powerful effect on a valuation based on discounting cash flows (DCF), especially as growth is also often assumed to be possible with the current assets of the business, thus with no discernible new investments. To round things off, it might be estimated that working capital levels can be brought down, releasing cash from the balance sheet.

The tendency to assume that things will go really well is probably the main reason why DCF methods have such a bad reputation. The effect is multiplied by the fact that many DCF models have three or five years of cash flow forecasts built into an Excel spreadsheet, followed by a terminal year, which represents all the cash flows after the explicit forecast years. Since the terminal year is usually a replica of the last forecast year, all the optimism built into the forecast years will be included in perpetuity in the terminal year cash flows, which in turn leads to silly values. 

The fault does not really lie with DCF models but with the forecasts. A DCF model requires realistic forecasts and problems arise when a DCF model is paired with optimistic forecasts. A business forecast can be optimistic by design, for example when it is used as a benchmark for employee bonuses, but such a forecast should not be used as a starting point for a valuation.

How to deal with this issue? One option is to use a high discount rate. This is especially tempting if you have gotten the forecasts from someone, a client perhaps, with whom you do not want to disagree with (a disagreement over us adjusting cash flows that led to some angry words actually happened to us recently). The downside is that then both your discount rate and cash flow forecasts are faulty.

The best option is to look at your cash flow forecasts critically and start questioning assumptions behind the forecast. Asking questions such as which sources the growth would materialize from, does the business have the assets and personnel to take advantage of the opportunities and how would competitors react usually helps a lot. This is something you should be doing anyway as part of any valuation and it will very likely lead to a better understanding of the business you are valuing.