What is a Forward outlook, and How Can It Contribute to the Growth Rate In DCF Model?

 

The growth rate is often thought of as the historical growth rate. That is, at what rate was the company grow in the past? When evaluating a company - the future growth rate should be considered.

This article will show how the future growth rate can be estimated simply using the Forward outlook method.

 

Forward outlook is a crucial business health factor one must consider when valuing a business and assessing its sustainability of earnings. The forward outlook – in terms of internal and external factors – can significantly impact business earnings and, hence, business value.

 

 

According to the Forward outlook, one should examine two operations of the firm - the firm's customer acquisition and production processes. 

 

The Firm's Customer Acquisition Process

The firm's customer acquisition process is not the process in which a person interested in the company's products becomes the company's customer.

In this process, the company's potential customers are usually divided into three groups:

1. Interested

2. Pipeline transactions

3. Signed contracts

 

Interested Parties

Interested parties include potential customers considering using the firm's services or purchasing the products the firm manufactures. Most interested parties will not become customers at the end of the day, but the higher the number of interested parties, the greater the company's ability to generate revenue.

 

 Pipeline Transactions

 Pipeline Transactions include interactions with potential customers who asked to receive a quote from the firm. Some offers will become signed contracts, and some will not. 

Similar to interested parties, the higher the number of pipeline transactions, the greater the ability of the firm to generate revenue, which will affect the future growth rate of the firm.

 

Signed Contracts

 Signed contracts include contracts signed with customers. The signed agreements are the ones that will generate revenue for the firm at the end of the day.

 

 

The Firm's Production Process

The revenue generation process is when the firm fulfills its contracts with its customers. In this process, the firm produces the products or services ordered from it. The process is the one that makes the cash flow for the firm since, during the performance of the contract, the firm will collect the money and record the income.

 

This process includes only signed contracts. Therefore - there is a practice of dividing the firm's signed contracts into three main groups:

Works that have not yet started:

1. Contracts Not Yet Started
2. Work in Progress
3. Ended Contracts

 

Contracts Not Yet Started

Contracts that have yet to start include signed contracts, which the firm has yet to begin to fulfill. The production of the products and services has yet to start.

 

Work In Progress

Work in progress includes work contracts for which work has begun but has yet to be completed.

 

Ended Contracts

This group includes works for which the firm has finished performing the work. At this stage, the firm hands over the work to the client and collects the debt balance from the customer.  

 

 

 

How Can The Firm's Customer Acquisition and Production Processes Help Estimating the Growth Rate?

The firm's customer acquisition and production processes can help estimate two aspects of the growth rate: the forecast period's duration and growth rate.

 

 

The Forecast Period's Duration 

When evaluating a value according to the DCF method - the valuer needs to estimate the growth rate during the forecast period.

According to this approach, the forecast period can be divided into two sub-periods. The first sub-period includes a period equal to the duration of the two processes. The second subperiod is similar to the subsequent time.

 

An Example of a Real Estate Company

The length of a real estate company's customer acquisition and production processes is years. It begins with a land purchase; then, it plans the structure to be erected on the ground. In the next stage, the company should ask for permission from the appropriate authorities and execute the plan only then. The project's time, from the decision to build to its completion, can take many years, sometimes even a decade. 

Given this period, it will be relatively easy for the appraiser to assess the firm's state in each phase. i.e., how many projects the firm is involved in and the stage of each project.

 

An Example of a Software Company

A software company, on the other hand, usually has short-term projects. Sometimes the project can take days. Due to the short period, analyzing the processes will make it possible to estimate the growth rate for a short period only.

 

 

To conclude this section, the longer the firm's customer acquisition and production processes, the ability to estimate the growth for a more extended period.

 

The Forecast Growth Rate 

To estimate the future growth rate, one should examine the number of transactions in each stage and the value of the transactions it includes.

We will demonstrate it using two examples.

 

Example 1:

Let's assume that the firm had to make a million dollars the previous year.

Let's also assume that the customers' purchase process lasts two years. The company signs the contract in the first year, and in the second year, it performs the work.

Let's also assume that the process is as described in the following table:

	Interested Parties	Pipeline transactions	Signed contracts	work in progress	Delivery of the work
Duration (months)	0		12		24
% conversion	30%	50%
value (million $)	10	8	1.5	0.5	0.5

 

 

 

 

In this case, the firm is expected to grow.

Last year she delivered work worth 1 million dollars.

It has expected receipts in the coming year of 2.5 million dollars, which include:

Completed work (delivery of work) worth 0.5 million, work in progress worth 0.5 million, and signed contracts worth 1.5 million.

The following year the firm is expected to grow to 5 million dollars:

It has interested parties with deals worth 10 million. The firm manages to convert 30% of those interested, i.e. issue them a quote. Therefore, it is expected to give bids worth 3 million dollars.

The firm manages to convert 50% of pipeline transactions into signed circulars.

Given that she has bid $8 million, 50% will become customers - i.e., $4 million.

In addition, 50% of those interested who receive offers (worth 3 million dollars) will sign with the company - i.e., 1.5 million dollars.

Therefore, the firm is expected to sign deals worth 5.5 million dollars in the coming year. These are the revenues that the firm will have in the year after the current year.

 

The firm is expected to grow from 1 million to 5.5 million dollars within two years.

 

Example 2:

Let's assume that the firm had to make a million dollars the previous year.

 Let's also assume that the customers' purchase process lasts two years. The company signs the contract in the first year, and in the second year, it performs the work.

Let's also assume that the process is as described in the following table:

 

Interested Parties	Pipeline transactions	Signed contracts	work in progress	Delivery of the work
Duration (months)	0		12		24
% conversion	30%	50%
value (million $)	1.8	1	0.1	0.3	0.4

 

 

 

In this case, the firm is not expected to grow.

Last year she delivered work worth 1 million dollars.

It has expected receipts in the coming year of 0.8 million dollars, which include:

Completed work (delivery of work) worth 0.4 million, work in progress worth 0.3 million, and signed contracts worth 0.1 million.

In the following year, the firm's revenues are expected to decrease to 0.77 million dollars:

It has transactions equivalent to 1.8 million. The firm manages to convert 30% of those interested, i.e., issue them a quote. Therefore, it is expected to give bids worth $0.54 million.

The firm manages to convert 25% of pipeline transactions into signed circulars.

Given that she offered $1 million worth of offers, 50% will become customers - i.e., $0.5 million.

In addition, 50% of those interested who will receive offers (worth $0.54 million) will sign with the company - i.e., $0.27 million.

Therefore, the firm is expected to sign deals worth 0.77 million dollars in the coming year. These are the revenues that the firm will have in the year after the current year.

 

The firm is expected to decrease from 1 million to 0.77 million dollars within two years.

Conclusion

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