Business Valuation & Cash flow modelling

Cash Flow Modelling

At Lotus Amity when we carry out a business valuation, cash flow modelling is as the heart of our valuation process. Put simply, the value of a business is the value of the expected future cash flows and the risk attached to those cash flows. Consequently, future cash flows are the foundation of business value.

In each business valuation the question we answer is:

“What cash flows can this business reasonably be expected to generate for debt and equity holders in the future?”.

Types of cash flow modelling

When we model cash flows, our first step is to ensure that we are selecting the appropriate type of cash flow to value the business. This means that the cash flow modelling is consistent with the discount rate that we are using to reflect risk.

The type of cash flows we model include:

• Free Cash Flow to the Firm (FCFF) or Free Cash Flow to Equity (FCFE), Usually we model free cash flows to the firm. Cash flows to the firm are all cash flows and before any deduction for debt. These cash flows provide a value of the whole business, including the value to both debt and equity holder. To get to the value of the equity, if required, we then deduct the market value of the net debt.
• Pre-tax or post-tax cash flows. Typically we model post-tax cash flows. Post-tax cash flows are the cash flows available to both debt and equity holders. We use after-tax cash flows based on the tax rate for the business (not the owners). We also take account of any tax losses brought forward which may reduce future tax outflows.
• Nominal cash flows or real cash flows. Usually we model nominal cash flows. Nominal cash flows incorporate inflation. Real cash flows are after adjusting for inflation. Modelling real cash flows can cause confusion and a possible mismatch with the discount rate. 
• Probability weighted cash flows or cash flow scenarios. Typically we use cash flow scenarios. For example, we may model cash flows on a low-case scenario and a high-case scenario. The scenarios assume the worst and best likely expected earning outlooks. 

Cash flow period and terminal value

As part of our case flow modelling we also need to consider the time period for the modelling. To assess the forecast period the factors that we consider include:

• The expected life of the business, which in turn depends on factors such as the stage the business is at in the life cycle or there is a finite period for the cash flows, for example, customer, supplier or licensing agreements with finite lives
• The expected time by which the business should achieve a stable level of growth and profits
• The cyclical nature of cash flows and ensuring the forecast period reflects an entire cycle
• The time the asset is expected to be held until it is sold, for example, in the case of valuing a minority interest and the future sale of the business

Terminal value

If the cash flows are expected to continue after the forecast period, then a terminal value is estimated. Te terminal value is the expected value today of the value business at the end of the forecast period. When we estimate the terminal value, we consider:

• If the cash flows from the business will deteriorate or grow
• If the business has a finite or indefinite life
• If the business will cease operations and the assets liquidated
• If the business is to be sold

Modelling revenue

When we model cash flows we begin by modelling future revenue. We model revenue at a granular level, for example, we consider:

• Expected number of units to be sold next year and expected price per unit next year and subsequent unit quantity and price growth
• Expected number of clients next year and expected average fees and subsequent growth in the number of clients and average fees
• Expected volume or value of assets next year, expected utility of assets and expected average fees and subsequent growth in volume of assets, utility and fees
• Expected funds under management (FUM) next year and expected average FUM fees and subsequent growth in FUM and average management fees

Modelling other cash flows

After we have modelled future revenue we model factors such as:

• Expected gross profit margins and link to foreign exchanges and commodity prices
• Expected number of employees, average salaries and potential productivity improvements
• Expected renewals of leases and lease cost increases
• Expected one off costs, for example, redundancy expenses
• Expected tax outflows or tax benefits, for example, R&D tax offsets
• Expected working capital requirements consistent with the revenue and cost projections and possible opportunities to improvements in working capital
• Expected capital expenditure, timing and potential tax benefits
• Expected reinvestment expenditure to improve capacity, consistent with the revenue forecast