Expected cash flows

What Is Expected Cash Flows?

Expected cash flows represent the projected future inflows and outflows of cash for a business, project, or investment. These projections are fundamental in financial analysis, particularly within the realm of valuation. Unlike historical financial data, expected cash flows are forward-looking estimates that attempt to predict the monetary movements an entity will experience over a specific period. This concept is central to determining the intrinsic value of an asset, as an asset's worth is largely derived from the cash it is anticipated to generate. Analysts rely on expected cash flows to make informed investment decisions, assess financial viability, and conduct various types of financial modeling.

History and Origin

The concept of valuing an asset based on its future income streams has roots dating back centuries, with forms of discounted cash flow calculations used as early as the 1700s in specific industries like coal mining in the UK. However, the formal articulation and widespread adoption of using expected cash flows for valuation in modern finance began in the early 20th century. Economist Irving Fisher is often credited with first suggesting that an asset's value is equivalent to the present value of its future income in his 1907 work, The Rate of Interest. Later, in 1938, John Burr Williams expanded on this in The Theory of Investment Value, proposing that a common stock's true worth could be calculated by discounting its future dividends. The term "discounted cash flow" itself is often attributed to Joel Dean, who in the early 1950s advocated for evaluating capital projects by projecting future cash flows, discounting them, and comparing them to investment costs. This methodology gained significant traction in the 1980s and 1990s, becoming a cornerstone for financial analysts, investment bankers, and consultants worldwide.⁷

Key Takeaways

• Expected cash flows are forward-looking estimates of money anticipated to be received (inflows) or paid out (outflows) over time.
• They are crucial for valuing assets, businesses, and projects, forming the basis of discounted cash flow (DCF) analysis.
• Accurate forecasting of expected cash flows is vital but inherently challenging due to reliance on assumptions and future uncertainties.
• Businesses use expected cash flows for strategic planning, capital budgeting, and managing liquidity.
• The reliability of expected cash flows impacts financial reporting and compliance, especially for publicly traded companies.

Formula and Calculation

Expected cash flows themselves are not a single formula but rather the inputs into various valuation models, most notably Discounted Cash Flow (DCF) analysis. The core idea is to sum the present values of these anticipated cash flows.

The general formula for calculating the present value of a series of expected cash flows is:

$PV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t} + \frac{TV}{(1 + r)^n}$

Where:

• ( PV ) = Present Value
• ( CF_t ) = Expected cash flow in period ( t )
• ( r ) = Discount rate (representing the cost of capital or required rate of return)
• ( t ) = Time period
• ( n ) = Number of discrete forecast periods
• ( TV ) = Terminal value (the value of cash flows beyond the discrete forecast period)

For corporate valuation, two common types of expected cash flows used are Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). The CFA Institute notes that Free Cash Flow models are widely used, with FCFF calculated as:

$FCFF = EBIT(1 - \text{Tax rate}) + \text{Depreciation} - \text{Capital Expenditures} - \text{Change in Working Capital}$

Or, alternatively, starting from Cash Flow from Operations (CFO):

$FCFF = CFO + \text{Interest Expense}(1 - \text{Tax rate}) - \text{Capital Expenditures}$

Where:

• ( EBIT ) = Earnings Before Interest and Taxes
• ( CFO ) = Cash Flow from Operations
• ( Depreciation ) = Non-cash expense reflecting asset wear and tear
• ( Capital Expenditures ) = Investments in property, plant, and equipment
• ( \text{Change in Working Capital} ) = Change in current assets minus current liabilities (excluding cash)

The chosen discount rate for FCFF is typically the weighted average cost of capital (WACC), which reflects the average rate of return a company expects to pay to its investors.⁶

Interpreting the Expected Cash Flows

Interpreting expected cash flows involves more than just looking at the projected numbers; it requires understanding the assumptions behind them and their implications for an entity's financial health and future prospects. A positive trend in expected cash flows generally indicates a growing and financially sound entity, capable of generating sufficient cash to cover its obligations, fund growth, and potentially distribute to shareholders. Conversely, declining or negative expected cash flows can signal financial distress, liquidity issues, or fundamental problems with the underlying business model.

When evaluating expected cash flows, it is crucial to consider the time horizon of the projections. Short-term forecasts (e.g., 1-2 years) are generally more precise and focus on immediate operational liquidity and working capital needs. Longer-term forecasts (e.g., 5-10 years or more) are inherently less certain, relying on broader economic assumptions and industry trends. The chosen discount rate also significantly influences the interpretation, as a higher rate implies greater risk or a higher opportunity cost, leading to a lower present value of future cash flows. Analysts must also critically assess the consistency of expected cash flows with the company's historical performance, strategic initiatives, and overall market conditions.

Hypothetical Example

Consider "GreenTech Innovations," a startup developing renewable energy solutions. The company is seeking investment to scale its operations. An investor performing due diligence needs to estimate GreenTech's expected cash flows over the next five years.

Year 1:

• Expected Revenue: $1,000,000
• Expected Operating Expenses (excluding depreciation): $700,000
• Expected Capital Expenditures: $100,000
• Depreciation: $50,000
• Change in Non-Cash Working Capital: -$20,000 (an increase in current assets, using cash)
• Tax Rate: 25%

Calculation for Year 1 FCFF:

1. EBIT: Revenue - Operating Expenses = $1,000,000 - $700,000 = $300,000
2. EBIT (1 - Tax rate): $300,000 * (1 - 0.25) = $225,000
3. Add back Depreciation: $225,000 + $50,000 = $275,000
4. Subtract Capital Expenditures: $275,000 - $100,000 = $175,000
5. Subtract Change in Non-Cash Working Capital: $175,000 - (-$20,000) = $195,000

Therefore, the expected Free Cash Flow to the Firm (FCFF) for GreenTech Innovations in Year 1 is $195,000.

The investor would repeat this process for subsequent years, factoring in anticipated growth rates, changes in expenses, and future capital needs. They would also estimate a terminal value for cash flows beyond Year 5. All these projected cash flows would then be discounted back to the present using an appropriate weighted average cost of capital (WACC) to arrive at a present value for GreenTech Innovations, aiding the investor's decision.

Practical Applications

Expected cash flows are a cornerstone in various financial disciplines and practical scenarios:

• Corporate Finance: Companies use expected cash flows extensively for capital budgeting decisions, evaluating potential projects, mergers, and acquisitions. They help determine the viability of long-term investments by comparing the present value of future cash inflows to initial costs.
• Investment Analysis: Investors and analysts rely on expected cash flows to value stocks, bonds, and other securities. The discounted cash flow (DCF) method is a primary tool for assessing the intrinsic value of a company, comparing it to the market price to identify potential investment opportunities. The CFA Institute highlights that a significant percentage of analysts use discounted free cash flow models for equity valuation.⁵
• Business Planning and Operations: For businesses, forecasting expected cash flows is critical for liquidity management, ensuring sufficient cash to meet short-term obligations and operational needs. It informs decisions related to financing, budgeting, and strategic resource allocation.
• Regulatory Compliance: Publicly traded companies are required to present statements of cash flows as part of their financial statements. While this typically reflects historical cash flows, the Securities and Exchange Commission (SEC) emphasizes the importance of accurate classification and presentation to provide useful information for investors.⁴ The SEC also urges companies to meticulously review the relationships within their cash flow statement presentations to ensure compliance and data integrity.³
• Lending and Credit Analysis: Lenders assess a borrower's ability to repay debt by analyzing their projected cash-generating capacity. Strong expected cash flows indicate a lower risk of default.

Limitations and Criticisms

Despite their widespread use, expected cash flows come with inherent limitations and criticisms, primarily stemming from their forward-looking nature:

• Reliance on Assumptions: Expected cash flows are inherently based on forecasts and assumptions about future economic conditions, market trends, operational efficiency, and management strategies. Any inaccuracies in these underlying assumptions can lead to significant deviations between projected and actual outcomes.
• Sensitivity to Discount Rate: The valuation derived from expected cash flows is highly sensitive to the chosen discount rate. A small change in the discount rate can lead to a substantial change in the calculated present value, potentially altering investment conclusions.
• Difficulty in Forecasting Long-Term Flows: Projecting expected cash flows accurately becomes increasingly challenging over longer time horizons. Unforeseen market shifts, technological disruptions, competitive pressures, or regulatory changes can render long-term forecasts unreliable. This difficulty is a common challenge in cash flow forecasting.²
• Subjectivity: The process of estimating future cash flows can involve a degree of subjectivity, particularly for companies with irregular earnings patterns, those in nascent industries, or those undergoing significant transformation. This subjectivity can lead to manipulation or overly optimistic projections.
• Data Quality and Communication: Inaccurate data inputs and a lack of clear communication across departments within an organization are significant contributors to poor cash flow forecasting accuracy. As much as 90% of treasurers at large companies surveyed rate their cash flow forecasting accuracy as "unsatisfactory," often due to poor resources and communication.¹
• Exclusion of Non-Cash Factors: While focusing on cash is vital for liquidity, expected cash flow models may not fully capture the impact of important non-cash items, such as the value of patents, brand reputation, or employee morale, which can nonetheless influence long-term value.

Expected Cash Flows vs. Actual Cash Flows

Expected cash flows and actual cash flows are two distinct but related concepts in finance, serving different purposes.

While expected cash flows represent what an entity hopes or predicts will happen, actual cash flows tell the story of what did happen. Analyzing discrepancies between expected and actual cash flows is a critical exercise for businesses and investors to refine their forecasting methodologies and improve future predictions.

FAQs

What is the primary use of expected cash flows?

The primary use of expected cash flows is in valuation, particularly in discounted cash flow (DCF) analysis. This method helps determine the intrinsic value of a business, project, or asset by calculating the present value of its anticipated future cash generation.

How are expected cash flows different from revenue or profit?

Revenue is the total income generated from sales, and profit (or net income) is what remains after all expenses are deducted from revenue. Expected cash flows, on the other hand, focus specifically on the movement of cash, considering non-cash expenses like depreciation and capital expenditures, as well as changes in working capital. They represent the actual cash available to the business, which can differ significantly from accounting profit.

Why is forecasting expected cash flows challenging?

Forecasting expected cash flows is challenging because it relies heavily on predicting future events, economic conditions, and business performance. Factors like market volatility, unexpected expenses, changes in customer behavior, or competitive actions can make projections inaccurate. The further into the future the forecast extends, the greater the uncertainty.

Can expected cash flows be negative?

Yes, expected cash flows can be negative, particularly for rapidly growing companies, startups, or businesses making significant new investments. Negative expected cash flows in the short term might be acceptable if the company is investing heavily for future growth and expects substantial positive cash flows later. However, consistently negative expected cash flows over a long period would indicate financial instability.

What is a "free cash flow" and how does it relate to expected cash flows?

Free cash flow (FCF) is a specific type of expected cash flow that represents the cash a company generates after accounting for cash outflows to support its operations and maintain its capital assets. It is the cash available to all investors (shareholders and debt holders) or just equity holders after all expenses and necessary investments are covered. Analysts often use expected free cash flows as the primary input in valuation models to determine a company's worth.