Build the Forecast Before the Valuation

Type “cash grows 5%” into a spreadsheet and the forecast is finished. Harbor Coffee still has to buy beans, earn a margin and replace equipment.

Our fictional coffee business can sell more and still leave more money tied up in stockrooms and equipment. The faster-growth case earns more operating profit yet leaves less cash in the first year.

The difference is what the business must buy to grow. Before applying the present-value method, see whether Harbor's cash forecast has paid those bills.

Separate evidence from choices

A driver-based operating forecast builds cash from sales, profit margins and reinvestment. Those inputs need to fit together: selling more coffee can require more inventory and equipment.

Use three labels: R for reported figures or supplied memos, C for calculations and A for future assumptions.

Harbor's income and cash-flow statements supply these R inputs. Amounts throughout are USD millions; FY1–FY3 are historical fiscal years, with FY3 latest. D&A means depreciation and amortization; capex is spending on long-lived assets.

Sales growth was 5.00%, then 4.76%. Operating margins held at 20%. D&A stayed near 3.6% of sales and capex near 5.5%.

A historical ratio becomes an assumption the moment you carry it forward. Harbor supplies no expansion plan, price/volume split or management forecast to test that choice.

Build the first forecast year

F1 is the first forecast year after FY3, the same year called FY4 in the earnings-estimate lesson. This is our own operating forecast, separate from that EPS consensus. Choose 5% sales growth and a 20% operating margin. Keep Harbor's supplied 25% tax rate and the exact FY3 ratios: D&A at 40/1,100 of sales and capex at 60/1,100.

Noncash operating working capital is money tied up in unpaid customer bills, inventory and prepayments, minus supplier bills and other operating short-term funding. It excludes cash and interest-bearing debt, so it differs from the broader liquidity measure: current assets minus current liabilities.

Each historical $50 million sales increase tied up another $10 million in working capital: 10 ÷ 50 = 20%. Carry that forward and each extra $1 of sales needs 20 cents. Apply the rate to extra sales, not all sales.

The cash-flow statement shows that cash use as −10. Our forecast subtracts investment as a positive amount: F1 deducts 20% × (1,155 − 1,100) = 11.

The table puts history beside the forecast. Every calculated F1 result depends on the assumptions above.

The FCF-yield lesson used cash after interest. Here we forecast cash for lenders and shareholders together, before financing payments. Reinvestment still gets paid, and we tax operating profit as though Harbor had no debt.

The F1 calculation:

1. Sales: 1,100 × 1.05 = 1,155.
2. Operating profit: 1,155 × 20% = 231.
3. After-tax operating profit: 231 × 75% = 173.25, after a 57.75 tax charge.
4. D&A and capex: sales are 5% higher, so unchanged ratios give 40 × 1.05 = 42 and 60 × 1.05 = 63.
5. Cash available: 173.25 + 42 − 63 − 11 = 141.25.

D&A has already reduced operating profit but used no cash this year, so add it back. The equipment and working-capital bills still have to be paid.

Keep stock-based compensation as an operating expense. It is zero for Harbor, but paying staff in shares still costs owners.

Make three coherent cases

The base case extends history. The downside pairs slower growth with weaker margins. The upside pairs faster growth with stronger margins. Give each its own reinvestment bill.

Tax and D&A follow the base assumptions in every case. Base capex is rounded in the table; use 60/1,100 in calculations.

The downside keeps equipment spending heavy even while growth slows, and ties up more working capital per extra sales dollar. The upside pays more for expansion. These are teaching stresses around Harbor's history, with no probabilities attached.

F1 cash is $118.35 million downside, $141.25 million base and $131.09 million upside. Faster growth leaves less cash at first: the upside spends 77.22 on capex and 22 on working capital, versus base spending of 63 and 11.

Challenge the least-supported bill

Which input is hardest to defend? Try the capex ratio. Three years of spending cannot tell you how much spare capacity Harbor has. A capacity and capital-spending plan would help test whether sales can rise without a jump in equipment costs.

Add one percentage point to F1 base capex/sales, keeping everything else fixed. Extra spending is 1% × 1,155 = 11.55. Cash falls from 141.25 to 129.70. That is a sensitivity calculation: changing one input to expose its effect.

The first year checks out arithmetically. Weaker margins explain part of the downside; the missing capacity plan could change the investment bill. Look first at the bill your forecast has the least evidence for.

Optional: extend the forecast to F5

Repeat each case's drivers for F1–F5. Keep full precision between calculations and treat each year's cash as a year-end amount. The five-year horizon and constant margins are model choices.

The exact base recipe starts with FY3 sales of 1,100:

• Sales and profit: grow sales 5% a year, take 20% as operating profit and tax it at 25%.
• Equipment: add D&A at 40/1,100 of sales, then subtract capex at 60/1,100 of sales.
• Working capital: subtract 20% of that year's sales increase.

Base cash for F1–F5 rounds to 141.25, 148.31, 155.73, 163.51 and 171.69. These are the inputs for discounted cash flow.

The upside's annual cash first passes base in F4: 165.14 versus 163.51. Even at F5, its five-year cash total is $11.44 million below base. Passing the annual cash line does not recover the earlier shortfall.

Future acquisitions, financing, share issuance and buybacks sit outside this operating forecast.

The next optional step is a matching discount rate. Later, growth quality asks whether the extra growth earns enough to justify its upfront cash demands.

In short

• A historical ratio becomes a forecast assumption when you carry it forward.
• More sales can leave less cash after equipment and working capital are paid for.
• An upside case must pay for its growth, even when that puts its cash below base.
• A useful forecast names its weakest assumption and the evidence that could change it.