[A colleague inquired about a prior post on the topic of Forecasting Cash Flows. This post is topical to my long-winded series on Measuring Value Creation and therefore I took this as a prompt to re-post this. It is, as the original title indicates, the foundation of an exceptional company.]
Predicting Cash Flows: The Foundation of an Exceptional Company (from Nov 5, 2007)
The prior post Investing versus Speculating described the difference between “investing” and “speculating”. Investing is only possible if free cash flows can be forecasted with reasonable level of accuracy whereas speculating is more akin to gambling, as future cash flows require guess-work. Warren Buffett is an investor, not a speculator, so he only makes investments in companies whose cash flows he can predict with confidence.
A corollary to this principle pertains to how companies should be run. Management should make it an extremely high priority to build a strong corporate competence around how to reliably forecast cash flows. This capability should be an integral part of their culture. It should permeate the entire employee base. The goal should be to get better and better at both the thoroughness and accuracy of cash flow forecasting.
Further, management should involve the entire organization in this quest. The financial forecasts should be communicated often and in a way that makes it easy for executives and employees alike to understand. Every month, the actual results should be compared to the forecast. Was the forecast as accurate as it should have been? How could it have been more accurate?
Each month, management should update the forecast. The update should reflect that 30 days have elapsed and more is known than a month ago. Enabled by this new information, the revised forecast should be better than the old one. Moreover, if the company is getting better at projecting cash flows, this should be reflected in bettering solidifyng the forward looking view.
I know what you are thinking: “your company already does this”. I doubt it, at least not anywhere close to the degree I believe it should. I am not talking about an annual budget process. I am not allowing for making loose approximations. If it feels like a bureaucratic waste of time, you can trust we are talking about two different things. If it is primarily an exercise for the finance organization, a warning bell should go off. If the balance sheet is excluded from the exercise, substantial pieces of cash flow are largely ignored. Finally, if the relationship between revenue, expense and capital is extremely hard to follow, know that your company is nowhere close to having a competency in this most critical area.
Buffett requires that he stay grounded in companies that he can reliably predict cash flows. Else, he is a speculator. Executives should require that their companies develop a core competency in accurately predicting cash flows. Otherwise, the executive is taking on more risk than he or she is required to. It is hard to overestimate the importance of this point. The executive cannot allow its employees to make decisions based on unnecessary speculation. The executive should not force investors to speculate on what should be knowable.
I feel so strongly about this point that I make it a centerpiece of every company I am involved with. We will be better at predicting cash flows than any company out there, whether in our industry or not. We will do this not just to be better than our competitors, as this is too low a bar in my mind. Our goal is to earn exceptional returns for our investors. Knowing everything we can know about our future cash flows is the foundation for doing this.
In subsequent blogs, I will discuss what management’s responsibility should be relative to its stock price. As a teaser, I will offer a provocative clue: the executive’s job should not be making the stock be as high as possible. [See: High Stock Price = Bad]
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