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Strategies & Market Trends : Gorilla and King Portfolio Candidates -- Ignore unavailable to you. Want to Upgrade?

To: Pirah Naman who wrote (39495)	2/19/2001 6:56:05 PM
From: Pirah Naman	Read Replies (1) \| Respond to of 54805

Free Cash Flow Part IV Some simple ways to apply the principles laid out in parts 1-3. The fundamentals of the methodology I covered in some previous posts: Message 13520970 Message 13522633 Message 13526190 and so I will not be repeating any of that material. In this section I will go over the major inputs needed for a basic estimate of intrinsic value, and try to give some ideas on how to choose those inputs. The four basic, important variables are the current free cash flow, the anticipated growth rate, the required return, and the terminal growth rate. A review of the above posts, especially the second, should reduce the number of questions that this part might raise. Current Free Cash Flow There are several ways to get this. In order of accuracy, they are: 1) Calculate from 10K reports. This takes the most effort, but also gives you the most information, as in going over the company's financial statements, you learn more about the business. At its most basic, this method requires that you get the net cash flow from operating activities and the capital expenditures (often listed as investments in properties, plants, and equipment) from the statement of cash flows. Some folks will dig in deeper and adjust those figures based upon other items found in the statement of cash flows. 2) Rely on an independent source. Both Value Line and Standard and Poor's give historical cash flows and capital expenditures as part of their reports. In addition, Value Line offers projections for both cash flows and capital expenditures. This level of depth is a good one because it allows you to quickly review long term performance, and to fairly quickly get the data for several companies. 3) Substitute accrual earnings for free cash flow. As discussed in parts 1-3, this can lead to lots of errors. In general, this will result in overestimating the value of semiconductor companies and underestimating the value of software companies. The Anticipated Growth Rate There are several ways to get this also. Being as these are forecasts on the future, thinking in terms of accuracy is misguided. But perhaps there are levels of thought which go into this: 1) Develop your own model of the companies future, using industry projections and any other information you may have. This is best if you can do it; not because it is most accurate, but because you will learn so much about the business while building your model. 2) Use the independent sources numbers. In the case of Value Line, projections are made, so this is pretty easy. With either Value Line or Standard and Poor's sheets, you can calculate a compounded growth rate of free cash flow for the past three, five, or however many years, and then assume that rate going forward - or increase or decrease it if you have reasons. 3) Use analyst's consensus projected earnings growth rates, assuming that free cash flow grows in lock-step. The Required Return This one causes people a lot of problems. When estimating intrinsic value, the required return is the return given to you as an owner by the future free cash flows which would accrue to you. It is incorrect to use your desired stock return in this equation. This is by definition; your stock return is not a stream of "coupons." Further, it would result in everything looking to be priced sky high. The required return can be the long term bond yield, or it can be that yield plus an equity premium. You can be very simple in selecting your equity premium, e.g. choosing an equity premium of say 2%. What this means is that you expect the stream of cash flows accruing to you as owner to be 2% more than you could get with a 30 year bond. If you wanted to be more sophisticated about it, you could calculate an equity premium which reflects the firms weighted average cost of capital. What is really more important than the method you choose, is that you be consistent in applying that method. The Terminal Growth Rate This is the growth rate that the company would have when it grows at the market's long term average. You can get historical data on this from various sources. Depending on source and period of survey, the growth rate will be 5% to 6.5%. This number isn't worth a lot of thought. Use 5.5% or 6.0% and spend your time elsewhere.