September 11, 2013
This blog is an extension of our previous blog on “Identifying Revenue Drivers in Financial Modeling”.
Many a times, I have seen analysts, modelers and participants of the class choosing the horizon of projections in their financial model arbitrarily. Most of the times, many of them when asked why they have made projections for “n” numbers of years, will say that the horizon period has been chosen based on their experience in the modeling. I have so far not come across any solid backup behind answer to this question.
This article explains what should be the guiding factors behind the selection of a horizon of projections. But before that let’s understand why the horizon of the projection has an important role to play. In a financial modeling exercise, the usual practice is to project the financials for a finite number of years and then apply a Terminal Growth Rate (“TGR”) after that to arrive at a terminal value. Remember that TGR should be a small, steady state growth rate good enough to capture the performance of a company on a going concern basis beyond the finite projection period till eternity.
Refer to the diagram in Exhibit 1. Each of the company typically passes through the phases shown above. Note that on the LHS we have the size of the company, the slope of the curve (and not the curve itself) measure the growth rate of the company. Let’s say that we are modeling the projections of the company currently at any position in very high growth phase in the graph above. Let’s say that we select the horizon of the projection such that at the end of the projection company reaches point A. If we now apply a TGR on the projections at point A, we are forcing the company to take the trajectory shown by the green line for the period beyond horizon period till eternity. We are thus undervaluing the company by the area between the green line and the maroon line. Similarly, if we choose a projection period such that the company is at position B after the projection period, we are undervaluing the company by the area between the yellow line and the maroon line.
Ideally, we will like to project the company till it reaches in close vicinity of point C that represents a point in stable growth phase and tending towards steady state growth phase. If we do so and then apply a TGR on financials corresponding to point C, we are now forcing the company to take the trajectory shown by blue line which is very similar to the actual trajectory itself, thus nearly omitting entire undervaluation.
While theoretically this graph makes sense, the questions that hit us almost immediately is how do we know when the company will reach point C. What is the numerical year count that corresponds to the phases4 shown in the graph?
And these questions are very relevant and pertinent. Let me now address this by saying:
“We should project the financials of the company till the time its cash flows become mature, steady and stable”
Almost immediately the next question that hits us –
“How do you know that cash flows have become mature, steady and stable?”
I will address that by listing following signs of maturity and stability in the cash flows:
1. Single digit growth rates in sales, EBITDA, PAT etc
We have seen the impact of not allowing this to happen in the explanation above. If the company is still in high or moderate growth phase, and we are applying a TGR then we are short circuiting the growth phase and undervaluing the company.
2. Stable and positive EBITDA / EBIT / PAT margins
Recall the nature of fixed costs. It remains fixed in a particular slab of sales / production volume. If a company moves from one slab to another, it incurs heavy fixed cost in that year and will display relatively lower EBITDA margin. Allow the Company to take benefits of economies of fixed cost and improve its EBITDA margins in the next few years. In other words, allow the Company to stabilize before you apply the TGR. If you do it pre maturely, you will undervalue the Company.
3. Capital expenditure is approximately equal to depreciation
Highly important criterion is capital expenditure in the outermost year of projection should necessarily be equal or approximately equal to depreciation in that year. Assume that a company had done a high capital expenditure in year N. The complete benefits of capital expenditure will be realized in sales figures in year N + 2. Now if you apply TGR in year no. N or N+1, what will happen? Your capital expenditure will continue to be stated higher because the base year capital expenditure itself is high and sales will always be understated as the base itself is not adequately captured. => Gross undervaluation. Similarly, assume the other way round. Sales grow by a good %age in year N+2 at the back of capital expenditure done in year N. So there is a situation where there is a good sales growth against a near zero capital expenditure in year N+2. If you apply TGR on values in year N+2, your sales will continue to grow, expand and multiply at the back of virtually no capital expenditure. There is no business which continues to grow without capital expenditure. So you will end up with gross over valuation. Hence, towards the end of horizon period capital expenditure should be just a maintenance capital expenditure kind of thing, good enough to keep the business growing at a steady rate but not at an abnormal rate.
4. Cash flows are positive, may fluctuate in magnitude but not in sign.
And last but not the least, if cash flows are fluctuating in sign, you don’t have a steady position to apply TGR. You will grossly over / undervalue depending upon whether you are applying TGR on positive / negative cash flow. So, if cash flows are fluctuating in sign, DCF is not the right method to value the Company. One should seek an alternate method to value the Company.
Remember and understand fully, setting a horizon of the projection to 5 years doesn’t mean that we are ignoring the cash flows after that. We are valuing the Company till eternity as a going concern. Horizon of projection is only a cut off time till when we are going to project things rigorously and after that simplify the things. It’s just of question when to stop the rigor and introduce simplicity.
In real life, if you come across all these signs of stability. As long as you have 2 or 3 of them, it’s good enough.
Based on this, thumb rule for horizon of projection:
Needless to say, there can be exceptions to these rules. You may find in some cases that cash flows starts showing sign of maturity even earlier than the period said above. And also, you may come across cases here maturity has not been achieved even after the periods indicated above. You, therefore, need to adjust the case accordingly.
As long as you understand the concept of the selection of horizon period and roll out the concept in front of however matters to you (clients, colleagues, students etc) and keep that at the back of your mind, your experience soon will help you develop your on thumb rule.
Do you have any thoughts on this article? Want to make any suggestions? Need any clarifications on the subject discussed here. Feel free to start a discussion thread below.