Forecasting Cash Flows

There are three components to forecasting cash flows:

LENGTH OF EXTRAORDINARY GROWTH PERIOD

Increased value comes from firms having a return on capital that is in excess of the cost of capital (or a return on equity that exceeds the cost of equity)
When we assume that a firm will experience high growth for the nest 5 or 10 years, you are also implicitly assuming that it will earn excess returns during that period
Factors to look for when considering how long a firm will be able to maintain high growth:

DETAILED CASH FLOW FORECASTS

Revenue growth tends to be more persistent and predictable than earnings growth
The mean relative absolute error, which measures the absolute difference between the actual earnings and the forecast for the next quarter, in percentage terms, is smaller for analyst forecasts than it is for forecasts based on historical data
The analyst forecasts outperform the time series model for one-quarter-ahead and two-quarter-ahead forecasts, do as well as the time series model for three-quarters-ahead forecasts, and do worse than the time series model for four-quarters-ahead forecasts
In general, the growth rate in operating income should be lower than the growth rate in EPS
While using analyst forecasts, you will have to adjust EPS down to reflect the need to forecast operating income growth

Growth in Net Income

To derive the relationship between net income growth and fundamentals, we need a measure of investment that goes beyond retained earnings
One way to obtain such a measure is to estimate directly how much equity the firm reinvests back into its business in the form of net capital expenditures and investments in working capital

Equity reinvested = (Capital expenditures - Depreciation) + Change in working capital - (New debt issued - Debt repaid)

Thus,

Equity reinvestment rate = Equity reinvested/Net income

and,

Expected growth in net income = (Equity reinvestment rate) * (Return on equity)

It is usually much more realistic to look at the average reinvestment rate over three or five years, rather than just the current year

Determinants of Return on Equity

In the broadest terms, increasing leverage will lead to a higher return on equity if the pre-interest, after-tax return on capital exceeds the after-tax interest rate paid on debt

ROE = ROC + D/E [(ROC - i (1 - t)]

where, ROC = EBIT (1 - t)/(BV of debt + BV of equity)

D/E = BV of debt/BV of equity

i = Interest expense on debt/BV of debt

t = Tax rate on ordinary income

this leads us to the growth rate,

g = retention rate * ROE

Average and Marginal Returns

In valuation, it is the returns that firms are making on their newer investments that convey the most information about the quality of a firm's projects
To measure these returns,

Effects of Changing Return on Equity