Your Company Is Worth As Much As Somebody Else Is Willing to Pay For It

Projecting Free Cash-Flows

In order to estimate future free cash-flows you will need to make projections of financial statements. This may turn out to be the most difficult and the most time-consuming part of DCF analysis, especially if the company you are dealing with is involved in several different business areas. You will need to make income statement and balance sheet projections for all of its separate business divisions and then decide whether to use consolidated data or to make the-sum-of-the-parts analysis or both. The forecast period for major business areas should be no less than five years, preferably ten. Most valuation models you get to see use five year high-growth period and then apply some terminal value calculation formula, assuming stable growth afterwards. However, in the real world not all companies are currently experiencing high-growth period and their cash-flows during the high-growth period may be eroded by increased capital expenditure and fast-growing working-capital requirements. If the forecast period is too short and only restricted to the high-growth period it can happen that the portion of the value derived from discounting the projected cash-flows will be far less than the calculated terminal value and that does not sound too credible.

The methods of projecting future balance sheets and income statements depend on the given situation and individual analyst approach and it is impossible to describe them in a few words. One should always use a mix of top down and bottom up forecasting and make sure the balance sheets and income statements are inter-linked. A simple ratio analysis is very helpful in assessing whether the whole system makes sense. You will often need to go back and forth between the projected financial statements and the valuation model and make adjustments. This is a normal process, especially if you are using the model developed by somebody else as it will help you understand how it actually works and what drives it. Additionally, a scenario analysis is also an extremely useful and well recommended tool to use, giving you a broader view of things.

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