The Uncertainty of
Future Cash Flows
The main reason forecasts are in such demand is because
everybody is facing an unknowable future. And this includes, not only investors
but the senior manage of corporations as well. That being the case management teams face two major risks that should be considered and dealt with.
The risk that the future cash flows of the company will actually materialize and grow (competition might threaten the companies competitive position).
How much investment will be needed to keep the company going (return on capital)
To deal with these two issues the investor should examine the business model of the company.
Companies that have high recurring revenue usually exhibit lower sales volatility and greater predictability of their earnings and cash flows which helps management lessen the operational risk of running their business. It reduces the strain from growth since a company with high recurring revenue has to put forth a lot less effort to grow revenues. Companies whose customers need to buy their products or services on a consistent basis usually exhibit less earnings volatility thus lessening risk to both the company and its investors.
The purest form of recurring revenue involves periodic licensing fees that follow upfront product purchases. This license model often appears in the software industry, where customers pay an upfront installation charge and subsequently make monthly or annual payments for maintenance, support and upgrades.
Outside the software industry, the more common form of recurring revenue is the service model: when repair and maintenance revenue can be expected on products sold but whose timing and extent are more uncertain, To fend off third-party service companies, management often implements long-term service contracts with large customers who pay a fixed annual fee
Service models can be further strengthened when costly and long-lived equipment needs to be upgraded or maintained rather than being replaced. And sometimes the breakdown of equipment purchased can be so critical to a customer they can little afford a delay in their operations. This often ties the customer closer to the service contract of the company offering the service.
The risk that the future cash flows of the company will actually materialize and grow (competition might threaten the companies competitive position).
How much investment will be needed to keep the company going (return on capital)
To deal with these two issues the investor should examine the business model of the company.
Companies that have high recurring revenue usually exhibit lower sales volatility and greater predictability of their earnings and cash flows which helps management lessen the operational risk of running their business. It reduces the strain from growth since a company with high recurring revenue has to put forth a lot less effort to grow revenues. Companies whose customers need to buy their products or services on a consistent basis usually exhibit less earnings volatility thus lessening risk to both the company and its investors.
The purest form of recurring revenue involves periodic licensing fees that follow upfront product purchases. This license model often appears in the software industry, where customers pay an upfront installation charge and subsequently make monthly or annual payments for maintenance, support and upgrades.
Outside the software industry, the more common form of recurring revenue is the service model: when repair and maintenance revenue can be expected on products sold but whose timing and extent are more uncertain, To fend off third-party service companies, management often implements long-term service contracts with large customers who pay a fixed annual fee
Service models can be further strengthened when costly and long-lived equipment needs to be upgraded or maintained rather than being replaced. And sometimes the breakdown of equipment purchased can be so critical to a customer they can little afford a delay in their operations. This often ties the customer closer to the service contract of the company offering the service.
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