Five Chinese Brothers

There are five key cash flow measures that are important in estimating the free cash flow to the firm that is used in the DCF approach. Those five cash flow measures, which we have called 'The Five Chinese Brothers' (named after a famous folk tale) are: the revenue growth rate, the net operating profit margin, the company's income tax rate, net fixed capital investment rate, and incremental working capital investment rate.

The revenue growth rate is equal to your estimate of the firm's revenue growth rate in percent over the Excess Return Period. Finance Internet sites like Zack's, First Call, and IBES project revenue growth rates over differing periods.  Yahoo Finance and America Online also have growth rates. Warning: Academic studies have shown that analyst's forecasted growth rates have been upwardly biased.

Net operating profit margin is equal to a firm's operating profits divided by its revenues.  A firm's income tax rate is equal to the provision for income taxes divided by the firm's operating income before provision for taxes. The information necessary to compute NOPM and income tax rate can be found on the firm's income statement as part of its annual or quarterly reports.

Net fixed investment rate is equal to the company's new investment in plant, property and equipment (PP&E) minus depreciation charges taken. To calculate this ratio, you need to know the company's investment rate, equal to the firm's yearly investment in PP&E divided by revenues, and the company's depreciation rate, equal to the firm's depreciation charges divided by revenues.  The firm's investment in PP&L and depreciation charges can be found on its cash flow statement in its annual report.

Incremental working capital investment rate is equal to the change in working capital divided by the change in revenue.  Working capital is equal to [( Accounts Receivable + Inventory) Accounts Payable].  The firm's accounts payable, inventories, and accounts receivable can be found on its annual balance sheet in its annual report.