Estimating the growth rate and EBIT in the case of changing margins and returns on capital:

Estimating the growth rate and EBIT in the case of changing margins and returns on capital:

If you do have an evolving or changing firm, where margins and returns on capital are expected to change over time, you have no choice but to start with revenues and work down through the rest of the cash flow statement. In making your estimates, here are the key steps. There are general trends to this.

1)    You do have to estimate revenue growth over time, looking at your company’s past growth, the size of the overall market, and potential competition. As a general rule, the expected growth rate in revenues will tend to decline as revenues get larger over time.

2)    You have to forecast the expected pretax operating margin that you expect your firm to generate each period. While you will start with the current margin, you will have to make judgements on what margin you want to target (industry average or your company’s historical average) and the pathway that you see the company taking in getting from the current to the target margin.

3)    The taxes that will come due each year will have to be computed, keeping in mind that losses can be carried forward and used to offset future profits.

4)    The reinvestment that the company has to make to generate its revenue growth will need to be worked out.

In making these estimates, you may find it useful to look at both your company’s history and the industry averages for how many dollars of sales you can expect to generate for each dollar of invested capital.

This general template works for almost all types of firm, from a young start up to a firm in decline, plotting a turnaround. For young start up, it is the high revenue growth combined with a healthy target margin that serves to turn things around, with cash flows going from large negative numbers in the early years to large positive numbers in the later periods. For declining firms, the revenues may actually be expected to decline over time (negative revenue growth) but the improvements in margins combined with divestitures (negative reinvestment) can make the difference.

Example) Estimating Operating Income and Cash Flows with Changing margins: Baidu

In 2012, Baidu reported operating income of 11,051 million CY on revenues of 22,306 million CY, an astonishingly high operating margin of 49.54%. Between 2012 and 2013, though while Baidu’s revenues increased by 28.92%, its operating income increased by only 2.25%, reflecting a reduction of margin in that year, not surprising as the company scales up and faces fresh competition from Google and other search engines.

We expect Baidu’s margins to continue on their downward trend in the future and expect margins to drop to 35% by 2023. That would still be higher than Google’s margins (22%) but reflect the protection that Baidu receives from competition, from the Chinese government, at least for its Chinese operations. Given the growth potential in the market, we do expect revenue growth to continue to be robust, forecasting growth of 20% a year in revenues, for the next five years, tapering down to a 3.5% growth rate (in CYterms) in ten years. In table below, we forecast revenues, operating margins, and after-tax operating income (assuming their prevailing effective tax rate of 16.31% holds for the next five years and then starts rising toward the Chinese marginal tax rate of 25%). Note that while revenues continue to grow, shrinking margins and rising tax rates result in a flattening out of after-tax operating income over time.

To get from earnings to cash flows, we have to forecast the reinvestment that Baidu will have to make in future periods. In 2013, Baidu generated $2.64 in revenues for each dollar of capital invested, well above the $1.40 in revenues generated per dollar of capital invested at the peer group. We will assume that Baidu will generate $2.00 in incremental revenues for each additional dollar of capital invested in future years, and use this statistics to estimate the reinvestment and free cash flow for the firm for the next ten years. As revenue growth diminishes in the second half of the growth period, the reinvestment that Baidu has to make also declines.

Year	Revenue Growth	Revenues	Operating Margin	EBIT	Tax Rate	EBIT(1-t)
2013		28756	48.72	14009.92	16.31	11724.9
2014	20%	34507	47.35	16339.16	16.31	13674.24
2015	20%	41409	45.97	19035.55	16.31	15930.85
2016	20%	49690	44.6	22161.9	16.31	18547.3
2017	20%	59628	43.23	25777.38	16.31	21573.09
2018	20%	71554	41.86	29952.56	16.31	25067.3
2019	17%	83504	40.49	33810.64	18.05	27707.82
2020	13%	94693	39.12	37043.96	19.79	29712.96
2021	10%	104257	37.74	39346.66	21.52	30879.26
2022	7%	111347	36.73	40897.63	23.26	31384.84
2023	4%	115244	35	40335.33	25	30251.5

The income statement for a firm provides a measure of the operating income of the firm in the form of the EBIT and a tax rate in the form of an effective tax rate. Because the operating income we would like to estimate is before capital and financing expenses, we have to make at least two adjustments to the accounting operating income:

1.     The first adjustment is for financing expenses that accountants treat as operating expenses. The most significant example is operating leases. Because these lease payments constitute contractual commitments into the future, they are tax-deductible, and the failure to make lease payments can result in bankruptcy, so we treat these expenses as debt commitments. The adjustment results in an increase in both the operating income and the debt outstanding at the firm.

2.     The second adjustment is to correct for the incidence of one time or irregular income and expenses. Any expense that is truly a one time expense or income should be removed from the operating income and should not be used in forecasting future operating income. Although this would seem to indicate that all extraordinary charges should be expunged from operating income, there are some extraordinary charges that seem to occur at regular intervals- say, once every four or five years. Such expenses should be viewed as irregular rather than extraordinary expenses and should be built into forecasts. The easiest way to do this is to annualize the expense. Put simply, this would mean taking one-fifth of any expense that occurs once every five years, and computing the income based on this apportioned expense.

As for the tax rate, the effective tax rates reported by most firms are much lower than the marginal tax rates. As with the operating income, we should look at the reasons for the difference and see whether these firms can maintain their lower tax rates. If they cannot, it is prudent to shift to marginal tax rates in computing future after-tax operating income.