Hi, and welcome to this webcast. My name is Han Smit, I'm a Professor of Corporate Finance at the Erasmus School of Economics. After this webcast, you will be able to analyze the historical performance of a company and use that to estimate the company's free cash flows. So, what is free cash flow? Free cash flows represent the amount of cash a company is able to generate, after having made all the required expenditures to operate and maintain or expand its asset base. These free cash flows represent the value available to all investors or to grow the business. As shown in the figure, there are five main drivers to consider when estimating the free cash flows, and we relate the historical analysis to this. Estimating the free cash flows is based on a simple set of adjustments to the accounting earnings before interest and taxes. One: for free cash flow, it is profitable growth that matters. We typically base free cash flow by trying to understand the operational profitability, called EBIT, and the growth rate of its revenue. Two: we adjust EBIT for corporate tax. Three: we increase the earnings for costs that are not expenses such as depreciation and amortization to arrive at the operational free cash flow. Fourth: we adjust EBITDA for changes in working capital, which equals to short-term assets minus the short-term liabilities. This is often connected to the revenue growth because the growth of a company may require more working capital. Five: finally, capital expenditures also affect the free cash flow. They reveal how much the company is investing in the business. The recommended way for approaching the discounted cash flow procedure is to forecast the complete income statement and balance sheet first, based on the trends in the key value drivers and use those as inputs for trends in the free cash flow forecast. It is always important to make relative comparisons and benchmark against rivals in the industry. We consider these key drivers in particular, because they are the fundamental components and they are relatively straightforward to estimate. A historical analysis assesses which company fundamentals influence these drivers of free cash flow and makes forward projections based on that information. We start by looking at the income statement. One: the first important item to evaluate for estimating the evolution of free cash flow is company revenue. The timing and structure of a company's revenue is important to forecast the future income statement and the free cash flow. Is there a structural historical growth pattern in the revenue? Is the historical revenue stream cyclical? And are revenues one-off or are they recurring? Managers may use company-specific ratios to assess the health of a revenue stream. For examples, for retailers this could be revenue per square meter. Other frequently used ratios to help estimate free cash flows are cumulative average growth rates or year-on-year growth. These ratios can especially be informative when comparing years with each other, and to understand trends over time. Two: next there is the analysis of cost of goods sold. These represent all the costs directly related to the company's production. Typical ratios to analyze cost of goods sold are gross margin as a percentage of revenue or gross margin per unit of volume. Three: another item on the cost side that impacts the future free cash flows are other operating costs, which usually consists of personnel costs, marketing and sales costs, distribution, housing and IT costs. The future costs are often estimated as a percentage of revenue or per unit of volume. For those costs that are not clearly linked with sales year-on-year growth is a more appropriate metric for analysis, or alternatively, one can look at how it relates to fundamentals. Based on these items we can make an estimate of EBITDA. A profitability analysis using the income statement can help you assess normalized proforma profitability of the business using ratios such as EBITDA to revenue or net profit to revenue. Fourth: lastly, a key influence on cash flows are taxes, and therefore you should examine in what countries profits are being reported and at what rates the business is being taxed, and does the company have tax deductible items or tax credits? Does it have deferred tax assets or liabilities on its balance sheet? Next, we move to the future proforma balance sheet. Five: changes in the required working capital affects the free cash flows. Particularly trade working capital, which focuses on accounts receivable, accounts payable, and inventories, provides an insight into a company's operating efficiency. Rather than simply looking at the absolute levels of working capital, you should express the working capital items in terms of trade days. These trade days provide an insight into how many days it takes the company to turn working capital into revenue. Understanding how they develop over time and how they compare to competitors in the same industry can provide meaningful information about the company's operating efficiency. Six: year-on-year changes in property plant and equipment and intangibles reflect the company's capital expenditures, also known as capex. You can distinguish between maintenance and expansion capex. Of course, with high growth in the long run, you cannot be funded with maintenance capex only. It's also important to understand the patterns of the company's capex. Capex can be lumpy, e.g. for purchasing a new factory plant. Alternatively, it may be incremental when small investments are made continuously. In estimating trends, capex are often analyzed as a percentage of revenue or as a fixed asset turnover, which is calculated by dividing net sales by property plant and equipment. Besides scrutinizing the income statement and balance sheet, there are many other relevant aspects to look at and question when analyzing company performance. For instance, what is the company's capital structure? What is its solvency? This represents the company's ability to meet its long-term obligations. And can it meet its required debt servicing? This includes, required interest payments and amortization of outstanding loans. You should also be careful to distinguish between operating cash, which is necessary to cover day-to-day expenses and excess cash, the amount of cash left that can be used for expanding production, pursuing acquisitions, paying out dividends or reducing debt. Lastly, in takeovers, practitioners often look at profitability-to-price metrics such as earnings per share. Now, having analyzed the historical ratios of these values drivers and having forecasted them, you can plug the values into the following formula to calculate free cash flows: So EBIT, or earnings before interest and taxes, after the tax rate, so compensated for taxes, plus the depreciation, plus the amortization, minus the change in net working capital and minus the capital expenditures. That equals the free cash flows. We will cover a more detailed example of this calculation in the next webcast. In summary, the recommended way for approaching a DCF is to forecast the complete income statement and balance sheet first, then forecast the future free cash flows, which in turn are used to derive an estimate of the company's value. The key drivers of free cash flows are revenue growth, EBITDA margin, taxes, working capital, and capital expenditures. Looking at how these drivers have developed in the past, breaking them up and understanding their components is vital for making realistic and accurate forecasts. In this webcast, you learned how to examine the respective value drivers and make informed predictions. In the next webcast, we will walk you through a detailed example of how to perform a discounted cash flow calculation based on forecasted free cash flows. Please look at the additional provided sheet in our portal for the calculations of some of the ratios mentioned in this video. You are able to understand and estimate one of the most important performance measures. Use it in your advantage. Thank you for watching this video, I look forward to seeing you in the next webcast.
