Subscriber Models

By: Robin Greenwood and Mihir A. Desai and Lucy White

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Synopsis: "Most investment projects are valued by first computing the free cash flows generated in each period, then discounting these cash flows back to the present, and finally summing these to give the net present value of the project. Typically, the cash flows used in the valuation come from forecasts of future revenues, combined with forecasts of future costs, by assuming historic margins as a percent of sales. Because forecasted cash flows rely heavily on aggregate sales and ratios relative to sales, this technique is often called the “percent-of-sales” approach to calculating cash flows.
The percent-of-sales approach can be useful in a number of settings. In particular, it may apply when unit volume growth is predictable and when the business is characterized by regular but randomly timed sales of manufactured goods. But fewer and fewer businesses can be described this way today. Service businesses, for example, are not always well suited to the percent-of-sales approach because sales are not simply the revenues from randomly timed transactions, but rather repeated interactions with known customers. Common examples in recent years include “Software as a Service”, magazine publishing, and cellular phone service. For these businesses, computing the free cash flows in each period can be difficult, complicated by the fact that customers are coming and going at all times."