Why Bother Forecasting Cash Flows?
I recently read a tweet from a European investor who shared the following quote from an unnamed CEO: “If we can’t forecast it, what chance have you analysts got?”
It’s a fair question. Indeed, analysts like me who base our valuation models on estimated cash flows should recognize we have limited visibility as outside shareholders. If the company’s insiders can’t confidently forecast cash flows, our efforts may be pointless.
Exercise in futility?
Whether we’re evaluating a new company or monitoring an existing company, a key question in our confidence framework is, “To what extent is this business intrinsically forecastable?”
On one extreme, a company can have a simple, straightforward business model with steady cash flows. Only a few of our portfolio companies get a top score from us in this category. One is Mastercard, which benefits from a secular shift away from cash payments and operates as a “tollbooth” of sorts for general consumer spending. Despite recessions along the way, the trend of U.S. consumer spending has marched steadily higher with time.
It’s worth noting that our scores are relative. No company is free from uncertainty.
We aim to avoid investing in the other extreme, which is a complex business model with highly uncertain cash flows. A “complex” business may have a complicated or opaque operating structure, or there may be inaccessible key information. These factors can make cash flows relatively difficult to forecast. For any success, these companies need to catch just the right wave at just the right time.
Naturally, companies with relatively predictable cash flows tend to trade at a premium valuation to companies with more uncertain cash flows. Value opportunities are less frequent in the former category than the latter. As such, we consider this topic alongside other moat, management, and business model-based questions. Indeed, we love opportunities where the market confuses short-term and long-term uncertainty regarding a high-quality business.
Make a call
But this may be missing a more important question: “Why forecast at all?”
When you invest in a company, you are either implicitly or explicitly making assumptions about the company’s future. Even if you buy a stock because it has a low price/earnings ratio and don’t do a cash flow forecast, the market-driven multiple nevertheless contains implicit assumptions of future growth and uncertainty.
We’ve found that by explicitly estimating cash flows in our valuation models, despite recognizing that our estimates will be wrong to some degree, it naturally generates important questions.
- Are the company’s targets for revenue growth and profit margins realistic?
- Are returns on invested capital improving or deteriorating?
- Can management fund its buyback, dividend, or debt repayment plan with free cash flow?
We believe such questions are relevant to a part-owner of the business as opposed to a renter/trader of the stock.
Without uncertainty there is no opportunity. If the market had perfect knowledge of a company’s future cash flows, the stock’s return would approximate Treasuries.
As such, we need to be comfortable with uncertainty in our pursuit of higher returns. We believe that by explicitly forecasting cash flows and asking better business-focused questions, we can more fully appreciate the opportunities and risks faced by the company.
As of the date of the post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Mastercard (MA). This company represents only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.
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