Valuing Future Benefits

Defining and Estimating the Future Benefit Stream

• The discussion includes valuing future benefits, distinguishing cash flows, and forecasting economic benefits.
• After financial analysis, analysts estimate value, addressing how to define/measure future benefit streams, whether to use historical/projected economic income, and if projecting benefits to equity or total invested capital.

Defining and Measuring the Future Benefit Stream

• The type of benefits relies on the nature of the interest being valued.
• Benefit streams can represent controlling or non-controlling interests, with analysts needing to understand the correlation between interest nature and benefit stream.
• Capitalizing or discounting a controlling interest stream yields a controlling interest value, while doing so for a non-controlling stream yields a non-controlling interest value.
• The type of benefits is dependent on the nature of the interest being valued, whether it is equity, invested capital, intangible asset, or tangible asset
• Net cash flow to equity results in equity value, while net cash flow to invested capital results in invested capital value.
• The type of benefits is defined or suggested by the valuation's purpose
• Parties may define the benefits type, especially in buy-sell agreements.
• State law may define benefits for litigation, while market multiples may define them for transactions.
• Earnings, in some cases, is defined by the method used in estimating the business's value
• Net income of the company is used with the Price Earnings Ratio Method or the Dividend Paying Capacity Method.
• Earnings could be net cash flow to equity, net income before tax, or net income after-tax when using Capitalization of Earnings or Excess Earnings Return on Assets, but capitalization rate should be consistent.
• The Discounted Economic Income Method utilizes Net Cash Flow to Equity or Net Cash Flow to Invested Capital.
• Net Income Before Tax or Net Income After-tax is usually the earnings used with the Excess Earnings Return on Assets (Treasury Method) as long as the rate of return on assets is based on the same type of earnings

Net Cash Flows vs. GAAP Earnings

• Valuators may prefer net cash flows for measuring economic income within an income approach.
• Net cash flows are preferred because they represent the earnings investors seek and expect.
• Cost of capital from markets and empirical data represents net cash flows for measuring economic income, such as in the Ibbotson Build-up Method.
• Net cash flows include expected future balance sheet changes, considering working capital needs, capital expenditures, and long-term debt changes.
• Analysts need to analyze future trends in earnings and cash flows to determine working capital needs, expenditures, and debt.

Selecting the Type of Benefits as a Measurement of Economic Income

• It's important to distinguish and understand net cash flow to equity versus net cash flow to invested capital.
• The Direct Equity Method, or net cash flow to equity, assesses cash flows available to equity owners after debt is serviced.
• The Invested Capital Method, or net cash flow to invested capital, assesses cash flow available to service invested capital like equity and interest-bearing debt.
• Valuators generally prefer net cash flows for measuring economic income to value equity or total invested capital.

Formulas For Net Cash Flow

• Net Cash Flow to Equity = Net Income (after-tax) + Non-cash charges - Capital expenditures - Additions to net working capital + Changes in long-term debt from borrowings - Changes in long-term debt for repayments - Dividends paid to preferred shareholders = Net cash flow to common shareholders’ equity (after-tax)
• The appropriate discount rate when discounting net cash flow to equity is the cost of equity.
• Net Cash Flow to Invested Capital = Net income (after-tax) + Non-cash charges - Capital expenditures - Additions to net working capital + Interest expense net of the tax benefit = Net cash flow to invested capital (after-tax)
• The appropriate discount rate is the weighted average cost of capital (WACC) when discounting net cash flow to invested capital,.
• When calculating net cash flows, analysts must determine cash flow components necessary to support projected operations, basing them on the cash flow necessary to support the projected operations and not historical data.
• Components of net cash flow need to reflect expected operation and capital requirement levels to support the estimated future benefit stream.
• Analysts generally use net cash flow to equity as the benefit type to derive the value of an equity interest
• If a company's capital structure differs greatly from comparable companies, analysts should consider net cash flow to invested capital
• Analysts need to consider weighted cost of capital for all invested capital types, and deduct actual debt capital from total invested capital to arrive at equity capital value.

Using Historical vs. Projected Economic Income to Estimate Future Benefits

• The analyst should consider the valuation's purpose, company history, management expectations, economic and industry conditions, and factors affecting the benefit stream and historical income trend.
• The valuation’s purpose may suggest using historical vs. projected income.
• Projected income is used for litigation, ESOPs, and transactional valuations, as it better represents expected future results.
• State law or jurisdiction may dictate data use in litigation
• Key questions to consider include whether historical data represents future operations, whether the company has changed significantly, and what management expects for the future
• Industry-related factors include industry changes, consolidations, regulations, technology, and competitive pressures
• Analysts must factor in how the forecasts may affect capital expenditures, revenues, and working capital requirements as well as consider local, regional, and national economic forecasts.

Estimated Future Benefits Based on Each Approach

• Historical economic income is based on fact and more reliable than projected income, which is frequently used in tax or divorce valuations.
• Historical operations are a good proxy for the future when prior economic performance shows stability that is expected to continue with a steady and linear trend.
• Using projected economic income is most useful when historical data is unreliable
• This is because projected income may be considered more representative of the future if the economic performance of new, emerging and start-up companies for example have a non-linear trend
• A linear stream remains constant or grows/declines at a constant rate, whereas a non-linear benefit stream declines at a variable rate.
• Analysts use financial analysis, management inquiries, and industry research to decide whether historical data or projections best indicate the future benefit stream.

Methods Used to Calculate the Estimated Future Benefits

• There is no best practice when projecting future benefits, one must rely on professional judgment.
• After adjusting historical income statements and defining earnings, future benefits are estimated.
• Methods for calculating benefits depend on whether the future stream is linear or non-linear.
• Methods for estimating linear streams of income include the Unweighted Average Method and Weighted Average method

Analyzing Adequate Historical Years & Unweighted Average Method

• The number of historical years depends on the company’s business cycle, where the goal is to reflect typical operations.
• Analysts prefer five to seven years of historical data

Weighted Average Method

• It's based on the average or arithmetical mean and takes the set of values that have been multiplies by a weighting factor.
• This generally applies heavier weights to more recent years' earnings and lighter weights to earlier years.

Non-Linear Benefit Stream Assumption

• Two of the most commonly used methods to estimate future benefits based on projected economic income are projected cash flows and earnings that are used to estimate future benefits.
• Terminal value represents capitalized income and is used once the benefit stream stabilizes, remains constant, or grows or declines at a constant rate

Other Methods Used to Project Economic Earnings

• Other economic earnings methods that analysts utilize to estimate future performance and financial viability include the Trend-Line Static Method, which establishes a fixed line of best fit based on historical data; the Projected Growth Rate Method, which uses historical growth rates to forecast future earnings; and the Trend-Line Projected Method, which combines elements of both static trend analysis and growth projections. Additionally, Geometric or Logarithmic approaches can provide alternative lenses for evaluating performance trends. The Gompertz Curve is particularly useful for modeling growth processes that slow over time, while considerations of Internal Growth focus on the firm’s capacity to grow using its own resources. Careful attention should be given to handling instances of negative earnings, as these can significantly impact the interpretation of all these methods.

The Concept of Free Cash Flow

• Free cash flow (FCF) represents cash available for discretionary uses post necessary operational costs. It often includes cash allocations for growth-oriented capital expenditures, debt reduction, and shareholder payments, with limited guidance on required versus discretionary uses.

Review Checklist & General Considerations

• Reviewing the fit between selected future benefits' type and valuation purpose is one of the analyst's steps
• Review if the method represents operations, along with management's expectations, industry conditions, and forecasts.
• Review that the earnings approximate cash flows or discount rate adjustment if earnings are the benefit type and ensure debt borrowings and repayments reflect capital expenditures
• Confirm that selected benefit type matches the nature of the interest being valued which is reflected by the discount rate chosen.

Validity of Historical Data

• A key consideration is data quality and quantity, where estimation is faulty with invalid or questionable data.
• Any estimation method outputs riskier results with questionable data, and the analyst is required to comprehend and determine data quality, and withdraw if one cannot determine due to invalidity.
• Limited historical data reduces confidence in future estimates
• One must find a different means of valuation should historical economic income be lacking where one or two years exist and one must question if the data is indicative of projected operations.
• All projection approaches are more manageable using financial calculators/software and always have a clear understanding of it's methodology.

Discussion on valuing future benefits, understanding cash flows, and forecasting economic benefits. Analysts estimate value, by defining/measuring future benefit streams, historical/projected economic income, and projecting benefits to equity or total invested capital.