Cash flow is literally translated as cash flow, which represents a cash flow generated by a company’s activities. It is an accounting balance indicating a company’s ability to finance itself. In order to make a cash flow valuation, cash flow must be calculated by taking the net profit at the end of the year, adding depreciation charges, subtracting write-backs on provisions and other depreciation, then subtracting capital gains on the sale of assets and adding capital losses on the sale of assets.
The Free Cash Flow (FCF) method
A cash flow valuation requires the definition of the company’s cash flow at the end of a period. This is the money that comes in or goes out of the cash registers. In this valuation method, these flows are used in particular to value companies using the Discounted Cash-Flow (DCF) method: they measure a company’s financial performance, i.e. its ability to generate cash. The latter is used to invest or distribute dividends in the company. This is why it is very important.
The algebraic formula for DCF valuation is as follows:
V = Σ FCF a* (1 + t) ‾ ª + FCF n * (1 + t) ‾ ⁿ
FCF a = Free cash flow for the year a
t = discount rate (weighted average cost of capital)
FCF n = Free cash flow for year n (last year of the reporting period)
Discounted Cash-Flow (DCF) method
This valuation method consists of determining the revenues that a company will earn, referred to here as future cash flows. Then discounting them to indicate the value of the company at a given date. However, the problems encountered in cash flow valuation are usually found in the choice of a duration and a discount rate.
– Duration: this depends on the visibility of the company, in other words, its reasonable forecasting horizon. If this is too short, it will attach considerable importance to the terminal value. If it is too long, it reduces to a simple theoretical extrapolation without interest. It will be necessary to choose the length of time that allows the company to reach a good plan.
– The discount rate : it is important in the calculation but its method of determination is questionable since it is mainly feasible only for stock exchange oriented companies.
To calculate DCFs, the following formula is used:
Let C1, C2, … Cn be the cash flows generated in years 1, 2, … n
DCF valuation = C1/(1+K) + C2/(1+K)² + … + Cn/[(1+K) power n] + VF/[(1+K) power n]
– C1, … Cn are the net cash flows to shareholders, years 1 through n.
– n is generally between 4 and 6 years old
– K is generally between 15% and 20% for existing profitable companies with slow to moderate growth. It is higher for start-ups or companies on the threshold of a strategic turn. It increases and decreases according to the risk.
– VF is the final value, calculated by Gordon Shapiro’s method:
VF = Cn+1 / (K-g), where Cn+1 is the net cash flow and g is the annual growth of this cash flow after n+1, assumed to be constant, or by a multiple method, e.g. REX (operating profit).