Malcolm:
I've never understood the concept of discounted cash flow as it applies to a company that lives a long time.
The residual value is higher the farther out you go. But having said that, you don't need to go that far out. You can work with a residual value at year 3 or year 5 or year 10 if you like. The idea is not to get the right number, because you can't. The idea is to have a consistent yardstick to apply. If you find a company that is attractively priced using the conservative (pessimistic, if you prefer) input, then certainly if its business performance exceeds that conservative input you will do very well.
Your suggestion about free cash flow for 4-5 years out and comparing with the S&P 4-5 years out sounds attractive also.
I'm sorry; I must have done a bad job explaining it. I'm most definitely not suggesting any comparison to the S&P. I am saying that using a residual value (with growth rate slowed to average of S&P) starting in 4 or 5 years out, one still ends up with Gs and the like appearing attractively priced at times. e.g., if gorilla X has been growing free cash flow at 30% per year, and you assume that to continue for 5 years and then fall to the long run S&P average of about 6% starting in year 6, you still end up, sometimes, with that gorilla being priced below your estimate of its value.
But the free cash can be used for acquisitions and then we have to wonder if the acquisition was needed for future growth and in that case is it really free cash?
There are two issues here. One is how rational management is. This is where you need to do the qualitative work, really before doing any valuation and maybe again as a check after doing valuation. Two is that yes, free cash flow can be used for acquisitions, and that does not change it from being free cash flow. That is merely one of many things a company can do with their free cash flow.
Capital expenditures, on the other hand, are not discretionary, but are requisite to keep existing facilities productive. Free cash flow refers only to money after such expenses.
reiterate that if we have to assume a noticeable decay of the growth rate over the ten year period, then hardly any of our favorite gorillas is worth buying even at last Tuesday's bargain prices .
I disagree. There are several of them which to me (based upon my calcs) appear attractively priced on the basis of free cash flow. My personal experience and observation is that companies priced attractively on this basis offer superior returns, even those companies which are slow growers.
- Pirah |
