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Strategies & Market Trends : Free Cash Flow as Value Criterion -- Ignore unavailable to you. Want to Upgrade?

To: Andrew who wrote (62)	10/31/1997 12:16:00 PM
From: Pirah Naman	Read Replies (1) \| Respond to of 253

Andrew: I'm going to respond to you "out of order" to make this kind of flow. > I have not heard of his quick test you describe. It does sound like > an absolute valuation. Could you describe the math for me? Sure. By the way, one of the very first examples in the Hagstrom book illustrates this. Take the FCF (can't recall whether he used previous year or coming year) and divide by the current long bond yield to get the intrinsic value. If the price of the stock is below that figure then on this criterion the stock is a buy. In math terms: If Price < FCF/LBY, then buy, or alternatively: If 100*FCF/Price > LBY, then buy. Note that this puts the FCF in terms of a yield for direct comparison to a bond. Again, the idea is that since the company's FCF "coupon" will grow, whereas a bond's remains constant, then if the company is giving a bigger coupon than the bond now, it will for the forseeable future. > I am sure that when you decided (if you did) to buy Compaq, you made > some implicit assumptions about minimum growth. Not really. My assumption was that the VL analyst, after working with the people at CPQ, had as good a handle as any on CPQ's prospects for the next year or few. At the time the LBY was around 6.6%. Based on VL projections, CPQ would have a 1997 FCF "yield" of 7.8%. Over the next 3-5 years, it would have a FCF "yield" of 8.7%. OK? Absolute value. Now to clarify the philosophical differences in our approaches. My view is that if I buy a company which meets or exceeds an absolute value test like this over a short time frame, then I have a greater margin of error than one which exceeds an absolute value test over a longer time frame. Simply put, the longer the time frame you use in your calculations, keeping all other factors constant (like growth rate), the better any company will appear from a valuation perspective. This has nothing to do with stock market gyrations, a bear market in 3 years doesn't affect my process any more than it does yours. Everything other than the time frame given to demonstate value is the same - expected success of great company, etc. Read your own post, and everything you write applies to both methods, except the time frame. > Also, you mentioned earlier that the S&P Buffett program divides the > 5-year-out FCF estimate by the long bond rate to get the target > price. If I'm not mistaken, that is the present value of an infinite > series of equal cash flows. In that light, do you like > that method (or were you just describing it for my benefit)? I was just describing it to illustrate different approaches. However, it is most emphatically NOT the present value of an infinite series of equal cash flows. It would be the value of an infinite series of equal cash flows five years out, which is what I think you meant. I don't think it is a bad way to do things, given the imprecise nature of this ballgame. What I appreicate is that they have all the other screens in there as well - who wants to crank through the math to check if each stock has increased its capitalization more than its retained earnings over five years? ;-) Pirah