How do you forecast the free cash flows for a DCF valuation? (2024)

In the Free Cash Flow (FCF) Model, the primary inputs include the cash flows, the discount rate, and the growth rate. The calculated intrinsic value is highly sensitive to assumptions about the discount rates and growth rates. The choice between a two-stage or three-stage DCF model hinges on the company's current growth phase.For companies in a mature phase, a two-stage DCF model is suitable. This model involves forecasting explicit cash flows for the initial stage and calculating a terminal value with the Gordon Growth Model for the second stage.For companies expected to transition through different growth phases, a three-stage DCF model is advisable. This approach includes an intermediary growth phase for a more nuanced forecast.

Focus on the business and the big numbers, the drivers are there. Although it's important to be analyze the financial statements and business plan completely, one should not spend a big chunk of the project's time by going through the least relevant aspects.Understand the business as a whole, find out which are the most sensible numbers (maybe margins, CapEx or Working Capital, for example) and go through it. When these are well-understood and appropriately modeled, you might focus on other details.If a slight change on a business aspect vary the cash flows in 15%, why would you start with the line with a 1% impact? Remember of Pareto: 80% of the cash flows are concentrated on 20% of the numbers, and I'd say it is even less than twenty.

Start by being fully aware of the nature of the company. This entails figuring out important sources of income, cost arrangements, and operational dynamics. Think about things like market trends, the level of competition, and any special features that might affect the company's cash flows.

Importante ter a percepção de especialistas no setor e no modelo de negócio. Ajustando expectativas enviesadas por otimismo ou pessimismo. Entenda os modelos de receita, cadeia de distribuição e como está se comportando o mercado e a concorrência.

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There are generally two ways around revenue forecast.For most companies, revenue is simply a function of sales volume multiplied by price per unit of product/service. Hence, the first approach is a bottom-up forecast of potential unit sales volume and price trajectory. For volume, observe past trends and see if there is a pattern, taking reference from industry projections if any. For the unit price, one can either make an estimate based on the company's pricing strategy (for e.g., premiumization), or incorporating the level of pricing needed to stay relevant in a competitive market.On the other hand, another common approach is to estimate the overall industry revenue, and assuming the % that the company can capture over time.

To forecast future revenue, use industry trends and historical financial data. Take into account elements like price tactics, market demand, and possible client base growth or reduction. Be reasonable and consider any outside influences that might affect sales.

Project and estimate all pertinent operating expenditures, both variable and fixed. These expenses include COGS, Capex, and D&A. Take into account variables like production cost fluctuations, inflation, and any upcoming cost-cutting or efficiency-boosting projects. A thorough comprehension of cost drivers is essential for precise estimations.

Generally the approach is to assume the % margin by observing historical trends and incorporating future outlook (for e.g., cost reduction), taking into account the important differences in margins across different divisions in the same company.Note that some companies have contracts that allow them to pass on costs to their customers, hence their margins would be relatively stable. However, in such cases, care should be taken about the lag effects of price adjustments.When faced with overly high margins compared to industry standards, question its sustainability and try to understand if the company deserves it (for e.g., due to a longstanding brand name). Understand that a wide margin can also be threatened in the face of competition.

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When we talk about capex, there are two kinds in general. The first one is maintenance capex, which is recurring in nature. Such capex is usually spent on maintaining the value of an asset as it depreciates over time, hence depreciation is a good proxy for the level of maintenance capex needed in a specific year.The second kind of capex is growth capex, aka expansionary capex. This capex is more lumpy in nature, and is often found in company active in M&A activities. Projecting this capex requires an understanding of the company's growth strategy. Oftentimes, company management would guide to a pre-determined amount of capex they intend to spend over several years, giving us a rough estimate of the annual spend.

Estimate capital expenditures (CapEx) by figuring out which long-term assets will require future investments. Expenses for technology, property, plant, and equipment may fall under this category. Project changes in working capital should also take into consideration variations in current liabilities (such as accounts payable) and current assets (such as inventory, accounts receivable).

Operating Cash Flow (OCF) less Capital Expenditures is the formula for calculating Free Cash Flow (FCF). The general expression for the formula is FCF = OCF - CapEx. For consistency, make sure that OCF and CapEx are taken into account annually. Net income can be used to calculate OCF after accounting for changes in working capital and non-cash expenses.

There are two types of FCF: FCFF and FCFE.For the former, since it is FCF to the firm where the interests of both equity and debt holders are considered, we have to discount it back to the present value using the WACC. If you are valuing a stock's value, there is an additional step where you have to deduct the value of the firm attributable to non-common-equity holders.I prefer the FCFE approach in valuing stocks, where we apply the cost of equity as a discount rate to the cash flows to arrive at a present value that when divided by the number of shares outstanding, represents the theoretical fair value of the stock.For a longer term forecast, we tend to assume normalized cash flows where mostly maintenance capex is considered.

Forecasting free cash flows for a DCF valuation involves, in a summarized manner:Define Revenue Drivers and Assumptions:Identify revenue drivers and establish realistic assumptions.Understand the Market:Analyze market trends, competition, and opportunities.Financial Projection and Integration:Develop integrated financial projections for income statements, balance sheets, and cash flows.Risk Management:Recognize and quantify risks, developing sensitivity scenarios.Regular Review and Update:Establish regular reviews to update forecasts based on new information and market changes.

There are times when we try to calculate the terminal value, we cannot do so reasonably because the final year's FCF is negative. In this case, we can extend our explicit forecast period to a year when the subject company turns FCF-positive, then calculate a terminal value based on it. If you are calculating a terminal value based on a perpetual growth rate, the FCF often has to be a normalized one.When conducting a multi-stage DCF, it is important to note that a company's risk profile throughout the different stages is likely going to be different. For e.g., investors might require a higher rate of return (cost of equity) in the initial phase, while as the company matures, the required rate of return could fall in tandem with risk.