5 Year Forecasting through Discounted Cash Flow (DCF) analysis.
The majority of our reports assume a given company will have enough cash to run its business for 5 years. Most reports assume cash is raised over a 5 year period to reach or forecasted price targets and valuations. The academic community has various accepted methods for forecasting 5 years of the Income Statement, Balance Sheet and Cash Flow statements. One method is Discounted Cash Flow (DCF) analysis. Another is the Gordon Growth Model. We mostly use DCF. We have included DCF calculations and explanations for all interested parties and investors who wish to understand the heart of The Cohen Price Target.
The theory behind the DCF model is that investors are willing to pay for a stream of future cash flows. Future cash flows are discounted with a present value formulation to determine a fair stock price today, given what we know and how we forecast the future. Present Value (PV) is the value in today's dollars assigned to an amount of money in the future, based on our estimate of rate-of-return over the long-term. In this analysis, rate-of-return is calculated based on annual compounding. A given amount of money is always more valuable sooner than later since this enables one to take advantage of investment opportunities. Because of this, present values are less than corresponding future values.
Our key input is the rate used to discount future cash flows to their present values. Most firms have a well-defined policy regarding their capital structure. Therefore, the Weighted Average Cost of Capital (WACC) (after tax) is appropriate for use with all projects. Present value is additive. The present value of a quantity of cash flows is the sum of each one's present value.
There are three main steps to calculating a DCF
1. First, we calculate the stream of cash flows in the five-year forecast period. Then we discount these cash flows back to the beginning of the first forecasted fiscal year. The method we use to discount back to the present is the Present Value Method where we discount the free cash flows of the company by the WACC.
2. The second step is to determine the company’s value at the end of the forecast period. This is the Terminal Value. The Terminal Value is then discounted back to the beginning of the first forecasted fiscal year. The method we use to discount back to the present is the Perpetuity Growth Model. The Perpetuity Growth Model accounts for the value of free cash flows that continues into perpetuity in the future, growing at an assumed constant rate. To determine the present value of the terminal value, one must discount the Terminal Value by a factor equal to the number of years included in the initial projection period. If N is the fifth and final year in this period, then the Terminal Value is divided by (1 + r) ^5.
3. The final step is adding these two to determine a fair value today based on what we know about the future.
An important decision in using Present Value models is deciding what cash flow or earnings stream will be forecasted and eventually discounted to compute an evaluation. We forecast Free Cash Flow which requires more input than simply using EBITDA (Earnings before Interest, Tax, Depreciation and Amortization).
A simpler method for discounting cash flow forecasts is using EBITDA (not a GAAP reporting required item). EBITDA can be defined as gross cash flow. This method of discounting is appropriate when EBITDA forms the basis of evaluation for the company. This method works well with small companies that have yet to post positive earnings. For all other companies, it is a good idea to examine at how the valuation methodology is applied.
DCF is a more involved forecasting method because it calculates the forecasted Free Cash Flow. The method requires forecasting of items such as the Operating Margins, tax rates, capital expenditures and changes in working capital. In addition, Debt is not subtracted from the discounted Free Cash Flow since Free Cash Flow is, by definition, net of the debt payments.
For the most part, free cash flow is a trustworthy measure that cuts through much of the arbitrary “guesstimates" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors.
DCF analysis treats a company as a business rather than as a ticker symbol and a stock price. It requires us to think through all the factors that will affect the company's performance. DCF analysis really gives the investor an appreciation for what drives stock values.
Five years of forecasting in the Income Statement must be forecasted for the complete 5 year forecast timeframe. We analyze prior year’s data to aid in making better forecasts.
Since we cannot estimate cash flows forever, we generally impose closure in discounted cash flow valuation by stopping our estimates of cash flows five years (Y+5) in the future and then computing a terminal value that reflects the value of the firm at that point.
The Terminal Value is the forecasted value of the stream of cash flows the company will have at the end of the forecast period. We base this on the company’s prospects at that time. We assume that the cash flow in year five (Y+5) will continue at a stable growth for five more years. Since this is too far in the future to accurately forecast, we do not attempt to forecast the individual line items that compute cash flow. We use the Long Term Sustainable Growth Rate as the primary determinant of the Terminal Value.
Therefore, our DCF computes a value for the company in year five. We have found that calculating the terminal value using the stable growth method provides more accuracy because of the multiple or sum of years method we employ.
The Terminal Multiple is an important component of equity valuation. This is the value one expects will be the growth rate at the end of the forecast time period, Y+5. Since it is difficult to accurately forecast this, it is common to use the Long Term Growth Rate as the proxy for the Y+5 growth rate. As analysts, we can experiment with Terminal Multiples that are appropriate for the company in which we are analyzing. We normally forecast a long term growth rate in the middle of this range. Our output graphs then describe the range of target prices based on a range of assumed growth rates. When studying the target price output, one quickly sees the target price sensitivity to the terminal multiple. Our sensitivity index is defined as “A technique for determining the outcome of a decision if a key variable (discount rate) differs from projected one.” This makes empirical sense. When the perception of growth prospects changes for a company, the stock typically reacts strongly. Note that our analyst has to project the three statements for five years in order to calculate our DCF