Merchant Portfolio Valuation: Understanding Discounted Cash Flow Analysis (Part II)
PART II: Cash Flow Projection
In the first part of this blog series focusing on the application of Discounted Cash Flow (DCF) analysis to merchant processing portfolio and residual valuation, we discussed the theoretical underpinning of the DCF method: The Time Value of Money (TVM). We applied this notion to determine how much a residual stream, received over a certain period of time in the future, would be worth in today’s dollars. But how do we determine the particular dollar amount of that residual stream (cash flow) received over those future years? It’s this concept, known as future Cash Flow (CF) projection, that we will examine in Part II of this blog series.
First, we must decide on a specific time period over which to project these CFs. Typically in merchant portfolio valuations, the time period ranges from 3 to 10 years depending on the size of the portfolio. The duration of the projections is heavily dependent upon portfolio’s size and historical attrition.
1.) Statistically, a larger population size begets more meaningful and accurate projections, thus forecast reliability is improved. This improved, and more accurate, forecast reliability equates to lower risk, and therefore, a longer period of return for the buyer (i.e. the buyer does not need to recoup his initial investment as quickly as he would have with a riskier portfolio acquisition).
2.) With higher levels of attrition, increasing the duration of the projections becomes less meaningful. If a portfolio has a 30% attrition rate annually, after 10 years only 3% of the original portfolio remains on the books. After factoring in TVM, as discussed earlier, the additional projection periods stop being meaningful to the valuation model.
Once we determine our time period, we begin the CF projection by calculating the current year’s revenue, or “Year 0 CF.” This is done by taking the average of the most recent 3 months of net processing revenues and multiplying that number by 12 (months).
NOTE 1: Seasonal discrepancies in revenue may need to be accounted for by excluding certain months. For example, if the most current month’s data begins in January 2021, revenue from December 2020 might be excluded to account for the higher holiday transaction volume associated with that time of year. Therefore, we would add together the net revenues from January 2021, November 2020, and October 2020, and divide by 3 to arrive at our monthly average.
To estimate the cash flows for the remaining years in our time frame, we would need to apply an attrition rate to the Year 0 CF, and subsequently, an attrition schedule to the remaining year’s cash flows. The attrition rate is a function of the merchant portfolio’s historical attrition rate and an acceleration rate based on current market data.
NOTE 2: The attrition rate is critical component of portfolio DCF analysis and it’s calculation will be covered in a separate blog post.
It’s important to point out that CF projection via an attrition rate and schedule is a method specific to merchant portfolio and residual stream valuations, and is very different than estimating CFs for an entire business (e.g. an ISO platform) that is expecting future growth. When valuing a portfolio or residual stream, we treat it as a depleting asset; we assume no future growth in the number of merchant accounts, and that the portfolio’s revenue will eventually attrit to 0. The attrition schedule is then applied to the Year 0 CF to find the following years’ CFs (Year 1, Year 2, and so on).
Example:CF projection for a small portfolio with a time period of 3 years
Monthly Net Revenues: February 2014: $1000, March 2014: $1100, April 2014: $900
Average Monthly Revenue = ($1000 + $1100 + $900)/3 = $1000
Year 0 CF = $1000/month x 12 months = $12,000/year
Historical Attrition Rate of Portfolio = 10% per year
Attrition Rate Acceleration (based on current market conditions) = 5% per year
Year 1 Attrition Rate= 10% x 1.05 = 10.5%
Year 1 CF = $12000 x (1-.105) = $10740
Year 2 Attrition Rate = 10.15% x 1.05 = 11.025%
Year 2 CF = $10740 x (1-.11025) = $9555.92
Year 3 Attrition Rate = 11.025% x 1.05 = 11.576%
Year 2 CF = $9555.92 x (1-.11576) = $8449.70