The Eagerly Anticipated Tutorial on Calculating Free Cash Flow, Part 2
I hope that those interested in learning about this did the exercise in Part 1. I also hope that looking at the Statement of Cash Flows stimulated your curiosity about the dynamics of the company's business. But that is off topic.
Now for the good news. Despite all you may have heard or read about his kind of analysis being difficult, you don't have to estimate intrinsic value. You can, if you choose, use free cash flow in place of earnings in any valuation method that you already use. The advantage is that you will be using a measure of profit which is more meaningful than reported earnings. If you do a search on the web for "free cash flow" you will find any number of sites which will describe all sorts of distortions and deceptions which may be present in reported earnings. (Many of them will also provide very complicated looking math for determining intrinsic value - don't be distracted, you need not use it.)
Some people object that since others are using earnings, they should stick to earnings as well. I would argue that to get better returns than the masses, more knowledge is key. Determining free cash flow (and understanding how your company achieves that free cash flow) will give you a better understanding of the business than using reported earnings ever will. If you understand a company's FCF, you are better able to identify a bargain or an overpriced stock.
And now to explain the estimation of intrinsic value.
Using Free Cash Flow to Determine Intrinsic Value
It would probably help if I first explained what is meant by intrinsic value. Intrinsic value is the present value of all future free cash flows (that is, all cash that could be taken out of the business over its lifetime). I will try to explain this by analogy. Imagine that I offered you a box, telling you that in one year, it would spit out a dollar, and every year thereafter, it would spit out another dollar. What would you pay me for that box? Well, it would depend upon your choice of discount rate. If you put a $1 in an investment and expect to be able to get $1.25 out in a year, then what you are saying is that $1.25 next year is worth $1 to you now. The discount rate you choose can be the return you require (that is the "official" definition, or it can be any reasonable number you would like to use. For example, some use the long bond yield, or the long bond yield plus an equity premium. Some calculate the cost of capital for each company (that's a whole other subject) and use that. But if you keep it simple, and use the same number across the board, you can compare values easily.
What is that box worth? To make this easy, I will use a discount rate of 10%. Here is how the calculation goes:
The present value of the dollar you would get in one year = $1.00/ (1 + 0.10) = $0.91
The present value of the dollar you would get in two years = $1.00/ (1 + 0.10)^2 = $0.83
The present value of the dollar you would get in three years = $1.00/ (1 + 0.10)^3 = $0.75
and so on. In other words, if you choose 10% as your discount rate (required rate of return), than a dollar next year is worth $0.91 to you today, a dollar two years from today is worth $0.83 to you today, and a dollar three years from today is worth $0.75 to you today. If you were to keep doing this calculation, and add up what each future dollar is worth today, you would get the intrinsic value of the box. BTW, the box is worth $10. I will show you a short cut to getting this value, but first there are a couple of points of interest. One, even though there is no growth here, the box has a value. Two, if I gave you the opportunity to buy this box for only $5.00, you would buy it. But if I offered it to you for $15.00, you would not buy it (unless you were confident that some other person would be even crazier than you and would buy it for an even higher price). Note that the former approach guarantees you excess returns - for $5 you would get $10. If a company has rational management and the stock is priced below intrinsic value, you are not guaranteed excess returns, but you can be pretty sure of it. For you to make excess returns with the latter approach depends entirely upon the irrational behavior of somebody else.
Now I will tell you the short cut. The intrinsic value of a stream of free cash flow growing at a constant rate
RV = FCFn+1 / (k-g)
where RV is the residual (intrinsic) value, FCFn+1 is the FCF for next year, k is the discount rate, and g is the growth rate. The box has a free cash flow for next year of $1.00, the discount rate is 10% (0.10) and the growth rate is zero. Plug in the numbers, and you will see that it works.
Now the companies we are interested in are growing, so how do we value them? Actually, it works the same way. Imagine a company growing its free cash flow at 20% per year. If it just earned a dollar of free cash flow, then next year, it would earn $1.20. The year after, $1.44. Three years out, $1.73. If we use a 10% discount rate again, the first three years would be:
The present value of the money you would get in one year = $1.20/ (1 + 0.10) = $1.09
The present value of the dollar you would get in two years = $1.44/ (1 + 0.10)^2 = $1.19
The present value of the dollar you would get in three years = $1.73/ (1 + 0.10)^3 = $1.30
and so on. You can easily set up to do this in a spreadsheet and go out as far as you like.
But of course even gorillas do not grow forever. At some time in the future even gorillas become slow growers. At that point you would need to calculate a residual value. Let's say that the hypothetical company I just described will grow its FCF at 20 per year for the next three years, but after that will only grow as fast as the average for the S&P 500, or about 6% per year (historical average). Its residual value (see the equation above) at the end of three years would be
$1.73 x 1.06 / (0.10-0.06) = $45.85
Now that is what that residual value will be worth after the third year - you still have to figure out what $45.85 is worth to you today. $45.85/(1+0.10)^4 = $31.32
So the intrinsic value of this company is $1.09 + $1.19 + $1.30 + $31.32 = $34.90.
(Note that even though this hypothetical company is going to grow at 20% for only three years, its intrinsic value is over 30 times its FCF for the next year.
Try taking the company you used for calculating free cash flow in Part 1, and make some assumptions on growth rate, choose your own discount rate, and calculate its intrinsic value. Do it on paper, or do in in a spreadsheet, and you will find it is really quite easy. You can have it grow at a high rate for a few years, a reduced rate for a few years, and then stop growing; you can adjust the number of years of high growth - go ahead, play with it. Of course you will never be able to know the "true" intrinsic value. But you can use this as a way of determining which company you are considering buying is the best value, and you can develop a feel for what stocks are truly priced too high even using optimist assumptions. It can be a good reality check.
I will stop here, not knowing whether any of this was even readable, much less useful, or just thread bloat.
- Pirah
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