Question

Suppose the government proposes a relief package in an urgent attempt to bail out virtually all industries across the board and offset the economic damage unleashed by the 3-month long coronavirus [COVID−19] crisis episode, and indeed, keeps its promise.

Required: By approximately what factor [in the long-run] are businesses likely to discount their negative cash flows, to work out how much is needed to level their current losses?

Answer 1

Negetive Earnings

Negative earnings or losses can be caused by temporary (short-term or medium-term) factors or permanent (long-term) difficulties.

Temporary issues can affect just one company such as a massive disruption at the main production facility or the entire sector, such as lumber companies during the U.S. housing collapse back in 2008.

Longer-term problems may have to do with fundamental shifts in demand, due to changing consumer preferences

Investors are often willing to wait for an earnings recovery in companies with temporary problems, but may be less forgiving of longer-term issues. In the former case, valuations for such companies will depend on the extent of the temporary problems and how protracted they may be. In the latter case, the rock-bottom valuation of a company with a long-term problem may reflect investors’ perception that its very survival may be at stake.

The economic impact of the 2020 coronavirus pandemic in India has been largely disruptive. India's growth in the fourth quarter of the fiscal year 2020 went down to 3.1% according to the Ministry of Statistics. The Chief Economic Adviser to the Government of India said that this drop is mainly due to the coronavirus pandemic effect on the Indian economy. Notably India had also been witnessing a pre-pandemic slowdown, and according to the World Bank, the current pandemic has "magnified pre-existing risks to India's economic outlook".

Valuation Techniques

Since price-to-earnings (P/E) ratios cannot be used to value unprofitable companies, alternative methods have to be used. These methods can be direct – such as discounted cash flow (DCF) – or relative valuation.

Discountyed Cash Flow(DCF)

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation.

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

  The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. As such, a DCF analysis is appropriate in any situation where a person is paying money in the present with expectations of receiving more money in the future.

For the management of negetive cash flow, use the following factors:

1. Look at the source

First, find out why your cash flow is negative. Determine whether you have a loss(subtract payables from your receivables) from your operations, or if your income and expenses do not match up.

Negative Cash Flow from Operations

2. Negotiate payment terms

You set invoice payment terms with your customers so they know when to pay you. And, you agree to your vendors’ payment terms so you know when to pay them. You can try to adjust either of these types of payment terms to improve cash flow.

For customer payment terms, shorten the number of days customers have to pay you. For example, if you currently give customers 45 days to pay you, shorten the number of days to 30. You should receive invoice payments faster.

Also, talk to your vendors about your payment terms. Certain types of vendors may be willing to give you a longer amount of time to pay invoices. Or, see if the vendor will give you a payment plan and split the balance due into smaller amounts.

3.Talk to lenders

To make up for low sales, you might need to turn to investments or financing. You can apply for a small business loan through your bank. The Small Business Administration also backs loans for small businesses that meet the SBA loan guidelines. Having the SBA seal of approval should make it easier to secure a loan from the bank.

You could open a business credit card to pay expenses. Check the interest rates before signing the agreement terms. Pay the credit back quickly to avoid accumulating debt.

4. Reduce operating expenses

Audit your current operating expenses to see if any can be reduced or eliminated. Make sure you’re not paying too much for the products and services you need to run your business. Shop around with other vendors to see if you can get a better deal.

5. Increase sales

Bringing in more sales will also improve cash flow. You can sell old inventory at a discounted price.

Hold sales and events that encourage consumers to buy larger quantities. You can also expand your business operations. For example, add additional offerings or open your business to online sales.

Example, assume a company has a free cash flow of $20 million in the present year. You forecast the FCF will grow 5% annually for the next five years and assign a terminal value multiple of 10 to its year five FCF of $25.52 million. At a discount rate of 10%, the present value of these cash flows (including the terminal value of $255.25 million) is $245.66 million. If the company has 50 million shares outstanding, each share would be worth $245.66 million ÷ 50 million shares = $4.91 (to keep things simple, we assume the company has no debt on its balance sheet).

Now, let’s change the terminal value multiple to 8, and the discount rate to 12%. In this case, the present value of cash flows is $198.61 million, and each share is worth $3.97. Tweaking the terminal value and the discount rate resulted in a share price that was almost a dollar or 20% lower than the initial estimate.