I start off by using a free cash flow to equity model assuming all equity and no debt, which is basically a free cash flow to firm model. I find the present value of operating cash-flows + non-operating assets. Then I subtract out the current debt and off balance sheet liabilities and add back in the debt tax shield. I was taught to discount the debt tax shield with the risk free rate, but when I think about it, the debt tax shield is expected and sort of counted in as working capital. Therefore if firm looks like they run a tight working capital budget, I will discount it back with the same discount rate as equity. If the firm looks like they operate with extra working capital, I will discount the debt tax shield back with the risk free rate.
I use the current 10-year Treasury yield for the risk free rate, a 6 percent market risk premium, and the current 30 year Treasury yield for terminal growth rate. I typically use a three year beta (β) calculated with weekly data, but it depends on how much the business has changed over the years. I look at the 5 year, 3 year, 1 year, and 6 month β’s for any patterns. β is usually my only metric for market timing. It is a bit of intuition voodoo, and I could explain it, but it’d take too long, maybe later. I also unlever the β assuming a debt β of 1.0 unless I have reason to adjust it. I am inexperienced at evaluating distressed assets, so I typically stay away from them.
The main variables I forecast are revenue, earnings before interest, taxes, depreciation, & amortization (EBITDA), depreciation, capital expenditures, working capital, and debt. I carefully analyze historical SEC filings to determine the drivers of the changed, and then try to figure out the driver to the driver. I continue to find drivers to drivers until I am satisfied.
These are my definitions of the variables I listed above. The definitions are for companies in general. Certain industries may have different accounting rules or definitions. Revenue is a measure of the size of a company. If revenue grows it means the business grew and vice-versa. I believe there is only a few fundamental reasons for revenue to change:
1. Market size
2. Products line and/or upgrades
Changes in market size include things like competition, target demographic change, expansion in territory, ect. Once you have isolated why the revenues are changing, try to figure out what are the drivers of that change. There is almost always an additional cost to additional revenue. It is important to note if that cost is fixed or variable expense. For instance, Starbucks increased y/y revenue due to increase number store locations. The driver of revenue is store locations. The driver of store locations is a study on a specific demographics and coffee shop density. Additional store locations require capital investment in the prior year.
EBITDA measures profits after accounting for variable cost. It isolates cost to cost-of-goods, sales, general & administration SG&A, R&D, ect. If revenue changes you expect cost to change by the same percentage, thus EBITDA would remain the same. If EBITDA changes then the variable cost of the firm changed, and they are either becoming more or less efficient. Changes in EBITDA could be increased/decreased product prices while cost remain the same or the opposite.
Depreciation measures fixed cost of operations. Depreciation accounts for capital investments made in some prior reporting period. It usually calculated based on time (age) of the capital equipment. In some cases depreciation maybe estimated differently. For example, a truck’s value may depend more on miles driven than on time. Extending the truck example, EBITDA would be revenue minus the cost of gasoline and wages of the driver. Depreciation would account for the lower value of the truck.
I separated capital expenditures (capex) into two categories, maintenance & expansion. Maintenance capex is investments required to maintain current revenue. Expansion capex is investments made to capture additional revenue. In other words, maintenance capex is replacing your current truck after it falls apart. Expansion capex is buying an additional truck to increased revenue. A good estimate of maintenance capex is depreciation. One ratio to check if you are forecasting capex correctly is return on assets (ROA). You should question if ROA changes significantly.
Working capital is a measure of short term financial efficiency in my opinion. Assuming no interest or penalties, you want to get paid first and pay everyone else last. It also sort of measures the logistical efficiency of an operation.
I project debt, because most firms have an optimal debt level. Additional debt means more assets to generate revenue. Less debt means negative cash-flow.