Cash_Flow_Valuation_Models

Cash flow valuation models, Part 2 Microsoft, the world’s largest software company in the world, founded in 1975, by Bill Gates and Paul Allen had during the year of 2009, amazing revenue of approximately US$ 58.5 billion. The following pages will analyze Microsoft’s ability to turn assets into profit. Forecast Model Assumptions for Sales According to Soffer & Soffer (2003) forecasting free cash flows requires an analysis of historical results as well as knowledge of the businesses and the industry’s expectations and the ability to interpret the information gathered. Cash Flow Models The forecasting process is completed in four steps. First it is necessary to develop the equations that will be used, known as modeling the cash flows. In order to be consistent the process for calculating future assumptions should be done in exactly the same manner as the calculations of historical ratios. The chosen ratios in this example are the revenue growth rate, the gross margin percentage, operating margin percentage, and the effective tax rate, and the asset turnover rate. Model Assumptions & Computations The next step is to calculate the ratios for the historical amounts and, using assumptions about likely future events, calculate future ratios using the same methods as the historical ratios. The assumptions used to forecast results in this report are explained here. One of the most important ratios to consider when forecasting future results is the sales growth because revenues from the company’s primary, or core, activities are the foundations of its free cash flows. The calculations completed in the accompanying Excel spread sheet are based on information from Microsoft Corporation’s 10-K filing, retrieved from the Security & Exchange Commission’s website (Securities & Exchange Commission, 2010). The figures show that Microsoft’s sales revenue grew 15% in 2007, according to Datamonitor (2010), 18% in 2008 but shrunk by 3% in 2009 in comparison to the industry standard reported by Datamonitor (2010) of + 11.5%, +5.7% and -4.7% respectively. According to Datamonitor’s analysis, sales growth for the software industry had declined significantly beginning in 2008. However, the projection is for growth to begin again in 2010 with a compound annual growth rate of 8.4% expected over the next five years. Since Microsoft typically outperforms the industry, according to Datamonitor (2010), a measure of 8.4% should be conservative and sustainable. The cost of goods sold [COGS] is a measure of the direct expenses in materials and labor required to produce salable goods. A forecast of future revenues should include the costs to produce those goods as this reduces free cash flow. Microsoft’s cost of goods sold [COGS] has remained consistent between 79 to 81% for the past three years, so it seems appropriate to use a median of 80% to predict anticipated expenses. In addition to the cost of goods sold, the indirect expenses of providing salable goods, such as research and development, sales and marketing, etc. are a reduction to free cash flows. Like the direct costs, the operating margin has remained consistent for three years between 35 to 37% so a forecast of 36% would seem appropriate. Most municipalities levy some amount of income tax on net earnings. Taxes reduce free cash flows and are calculated as a percent of the net earnings. Since these rates vary by location, an average of 29% is used because it represents the average of Microsoft’s effective tax rate for the last three years. Refining the Forecast Model The next step is to refine the model. Should the data be broken down further because there are multiple products at different stages of maturity or because of anticipated fluctuations in some of the factors of production' For instance, according to Datamonitor (2010) the software application industry relies heavily on highly skilled workers. Because the demand for these workers may exceed the supply, competition among employers can be fierce, resulting in high compensation and benefit packages, in order to entice and retain the most talented employees. Therefore employee costs are a significant portion of the costs of revenues. Additionally, R & D is one of the most important aspects of software manufacturers’ costs of production. Datamonitor (2010) explains that this is a highly competitive industry where the ability to bring new or improved products to market, faster than the competition, is a key factor in a company’s success. Therefore Microsoft’s R & D expenses will be a significant portion of their costs. It may be appropriate to calculate the costs of skilled labor, or R & D as separate line items since they could fluctuate more or less than other factors of production. Sensitivity Analysis The final step is to conduct a sensitivity analysis to confirm that the assumptions are valid. For instance, according to Datamonitor (2010) the production of marketable software requires very specific and exacting equipment and supplies and there is some level of differentiation between supplier products. Once a supplier has been chosen, the cost of switching to another supplier can be overwhelming. Since, there are constantly more products being developed, the costs of switching to alternative suppliers increases over time. This results in high supplier power with little room for the software manufacturer to negotiate price, although volume customers, such as Microsoft, have more power than smaller customers. If Microsoft is forced to switch suppliers or if they are able to commit to very large purchases, how might this affect the costs of production' If costs of production rise can those increase be passed along to customers, and if so, is this likely to cause a reduction in sales. If Microsoft’s sales increase quickly and they need to fund operating expenses or R & D efforts with debt financing, the cost of the debt service can affect the effective income tax rate. A sensitivity analysis, according to Soffer & Soffer (2003), allows the analyst to determine a range of possibilities that may affect the valuation. Total Asset Turnover Total asset turnover per definition, is creating a relationship between everything that a company owns and how much money is being produced to create revenue based on those assets (Total Asset Turnover). The same is calculated by dividing the net sales for a specific period of time by the net assets of the company being studied. Total Asset Turnover=Sales / (Net Total Assets) The calculation for Microsoft would go as follows based on the numbers (in millions): Sales = US$58,437 Assets = US$77,888 Total Asset Turnover = 58,437/ 77,437 Total Asset Turnover = 0.75 Conclusion Projections of future results rely on good knowledge of the industry, regulations, technology advances, and an accurate assessment of consumer market and economic trends. However, the starting place for these projections is found in the company’s historical results, so it is necessary to understand how to calculate those results in a manner that can support future estimates. References: Datamonitor. (March, 2010). Industry profile: Global application software. Retrieved June 23, 2010, from Business Source Premier database. Securities and Exchange Commission [SEC]. (2010). Company filings: Microsoft 10-K. Retrieved June 24, 2010, from http://www.sec.gov/Archives/edgar/data/789019/000119312509158735/d10k.htm Soffer, L. & Soffer, R. (2003). Financial statement analysis: A valuation approach. Upper Saddle River, NJ. Prentice Hall. Total Asset Turnover. (n.d.). Retrieved June 25, 2010, from Investopedia: http://www.investorwords.com/5005/total_asset_turnover.html