Forecasting Cash Flow: Mathematics of the Payout Ratio

Introduction

We all have used the Discounted Cash Flow (DCF) method. Many of us would agree that it is generally the best, most comprehensive, theoretically correct valuation model. It also has an empirical reason to be the best, which is that many of us calculate our discount rates using the Ibbotson data in the SBBI annual yearbooks, which are based on publicly traded stock data. Those stock returns are cash returns-the dividend yield plus the capital gains, which can be converted to cash at any time.¹ Thus, it is consistent to discount cash flow with discount rates on cash returns. So far, everything is well and good.

Difficulties in Forecasting Cash Flow

Well, almost. The problem is that forecasting net income is work, and forecasting net free cash flows ("net cash flows" or "cash flows") is detailed, exacting work. Few well-adjusted people really like doing it. The most disciplined of us keep a stiff upper lip and do it- especially in the large valuation firms with clients who are willing to pay for doing it right. The American Society of Appraisers' business valuation courses teach DCF, not discounted net income. Nevertheless, in the real world, as we decline in firm size, client budgets, and personal discipline, cash flow often goes by the wayside, and many of the smaller valuation firms end up discounting forecast net income, gross cash flow (net income + depreciation + amortization), EBIT, or EBITDA-and that is always inconsistent. Discounting forecast net income or any of the other above-mentioned measures of earning power normally leads to a guaranteed overvaluation.

In his article, Greg Gilbert states that if you discount net income or some larger number such as gross cash flows, then you must add a premium to the discount rate, and the premium has to increase with the degree to which the measure of economic earning power exceeds net cash flows.² In my opinion, he is absolutely right.

There are two problems with adding the premiums. The first problem is that almost nobody does it, even though it is common to discount forecast net income. The second problem is that there is no empirical evidence as to the appropriate magnitude of the premium. In my opinion, this is reason enough to state that we should never discount forecast net income, gross cash flows, EBIT, EBITDA, or any other measure of economic earning power other than net cash flows. This brings us right back to the DCF and the need to forecast cash flows.

Purpose of this Article

The main purpose of this article is to provide the mathematics that will simplify the mechanics of forecasting cash flow in many situations, thus making the DCF easier to do and reducing the temptation to take the shortcuts that lead to overvaluations.

The Mathematics

This is the main part of this article. We will use the following symbols in our mathematics:

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