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Strategies & Market Trends : Free Cash Flow as Value Criterion
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To: Andrew who wrote (118)11/3/1997 8:17:00 PM
From: Pirah Naman  Read Replies (1) of 253
 
Andrew:

The dilemna you face regarding the residual value is part of why the application of the Gordon Dividend Valuation model (GDV)to FCFs is questionable in my mind. If one incorporates residual value than the result seems arbitrary in one direction; leave it out and it looks dicey in the other direction. (If you want to err on the side of conservatism, you could try using the "few years" method I've described. :-])

Any valuation I calculate would be subject to at least the same fuzziness as anybody else's valuations. And as you know, you and I are using about the same math. To veer off on a philosophical tangent, what we learn from the application of the GDV to FCFs is that for practical purposes, almost all stocks are trading at less than their intrinsic value. The reason for that is uncertainty about the future. If a stock was trading at its intrinsic value, it would return the discount rate. Rhetorical questions: who will buy a stock that guarantees them X return? What must X equal to attract sharehlders?

Recall that I had said earlier in the thread that the intrinsic value is typically calculated using the long bond yield, but that the value to an investor must be calculated using that individual's return requirement as the discount rate. Rhetorical question, Andrew: you have been using 9% in your modeling for the discount rate. That isn't the long bond yield; is that your required return over the long haul when investing in stocks?

So part of the problem lies in the treatment of the discount rate. We shouldn't lose sight of the meaning of the discount rate - a return that might be reasonably expected by a competing instrument.

As for the options - I think you are right to contemplate them simply from the aspect of trying to understand how management does business, but I would guess that in most cases this is complicating things unnecessarily. Pretty soon you'll be seeing the need to buy somebody's pricey software which will ask you for your guesses on 47 different variables. Though I trust you would calculate how much it would have to add to your ROI for you to economically benefit, and evaluate the probability of it matching that hurdle. ;-]

PIrah
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