The forecast period
Revenue Growth Rate
We have decided that we want to estimate the free cash flow that The Widget Company will produce over the next five years. To arrive at this figure, the standard procedure is to forecast revenue growth over that time period. Then (as we will see in later chapters), by breaking down after-tax operating profits, estimated capital expenditure and working capital needs, we can estimate the cash flow the company will produce.
Let’s start with top line growth. Forecasting a company’s revenues is arguably the most important assumption one can make about its future cash flows. It can also be the most difficult assumption to make. (For more on forecasting sales, see Great Expectations: Forecasting Sales Growth.)
We need to think carefully about what the industry and the company could look like as they evolve in the future. When forecasting revenue growth, we need to consider a wide variety of factors. These include whether the company’s market is expanding or contracting, and how its market share is performing. We also need to consider whether there are any new products driving sales or whether pricing changes are imminent. But because that future can never be certain, it is valuable to consider more than one possible outcome for the company.
First, the upbeat revenue growth scenario: The Widget Company has grown revenues at 20% for the past two years, and your careful market research suggests that demand for widgets will not let up any time soon. Management – always optimistic – argues that the company will keep growing at 20%.
That being said, there may be reasons to downplay revenue growth expectations. While the company’s revenue growth will stay strong in the first few years, it could slow to a lower rate by Year 5 as a result of increasing international competition and industry commoditization. We should err on the side of caution and conservatism and assume that The Widget Company’s top line growth rate profile will commence at 20% for the first two years, then drop to 15% for the next two years and finally drop to 10% in Year 5. Posting $100 million of revenue in its latest annual report, the company is projected to grow its revenues to $209.5 million at the end of five years (based on realistic, rather than optimistic, growth expectations).
Forecast Revenue Growth Profiles
| Current Year | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Optimistic: Growth Rate Revenue |
- $100 M |
20% $120 M |
20% $144 M |
20% $172.8 M |
20% $207.4 M |
20% $248.9 M |
| Realistic: Growth Rate Revenue |
- $100 M |
20% $120 M |
20% $144 M |
15% $165.6 M |
15% $190.4 M |
10% $209.5 M |
Forecasting Free Cash Flows
Now that we have determined revenue growth for our forecast period of five years, we want to estimate the free cash flow produced over the forecast period.
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Free cash flow is the cash that flows through a company in the course of a quarter or a year once all cash expenses have been taken out. Free cash flow represents the actual amount of cash that a company has left from its operations that could be used to pursue opportunities that enhance shareholder value – for example, developing new products, paying dividends to investors or doing share buybacks. (To learn more, see Free Cash Flow: Free, But Not Always Easy.)
Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand.
Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.
The Trick of Hiding Receivables
Let’s look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.
