How to Forecast Free Cash Flow for Investment Banking - dummies

How to Forecast Free Cash Flow for Investment Banking

By Matt Krantz, Robert R. Johnson

Determining free cash flow for any past year isn’t difficult and most analysts and investment bankers would, in fact, agree on its calculation. You simply take historical values and plug and chug into the formulas and — voilà! — you have a value for free cash flow. But valuation models aren’t based upon the past; they’re based upon expected future cash flows.

The basic models and tools used by analysts are the same, but the application of those tools and models — the assumptions made — can differ dramatically. That’s why two analysts can examine the same company, use the same valuation models, and arrive at wildly different valuations. One analyst can believe that a stock is significantly undervalued, and the other can believe that the same stock is wildly overvalued.

The basic models they’re applying are the same, and the historical data they’re reviewing is the same. The difference involves the assumptions about the future that they make. As Shakespeare wrote, “Therein lies the rub.” That’s why financial analysis is part science and part art.

To forecast free cash flow, analysts must forecast cash flow from operations. Cash flow from operations is simply:

Cash Flow from Operations = Earnings before Interest and Taxes + Depreciation − Taxes

Now, this is starting to sound complicated, but to get to earnings before interest and taxes, analysts must forecast sales and how much it cost to produce and sell those products. In essence, analysts must forecast the entire income statement of the firm for the foreseeable future.

The typical income statement of a manufacturing firm looks something like this:

Sales

Less: Cost of sales

Gross Profit

Less: Selling, General and Administrative Expenses

Earnings Before Interest and Taxes

Less: Interest

Earnings Before Taxes

Less: Taxes

Net Income