December 13, 2007

Valuation Method: Discounted Free Cash Flow

Any successful investment approach contains a systematic three-part step, which is:

  • search strategy,
  • valuation technology, and
  • a structure that allows you to be patient.

In this guide I would like to describe one of the valuation technologies I use for estimating the intrinsic value of a business. Valuation is far from a science and more of an art. It requires a lot of background knowledge to determine the assumptions being fed to the tools used. And the assumptions are far more critical than the tool or valuation method.

Valuation is meaningless, if a passing familiarity of the industry is what is needed. What is required is an in depth and intimate understanding of an industry or a business. Therefore I only can value those companies in an industry that I understand and know well to ascertain to the value of future revenues, assets values, and potential threats to the business earning potential. You should also be careful not to count of valuation applets on the web and use it to derive a business value and make investment decision on that basis.

Valuation technologies are many but some work better than others and in this case I focus on one of the most used: the Discounted Free Cash flow (DFCF) method. Moreover, valuation is a very detailed subject in this guide I am giving a brief overview of the method. There are a lot of issues and intricacies in the subject that is not covered here and need to be understood.

The Discounted Free Cash Flow Valuation method is defined in Investopedia as:
A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Off course you need to substitute the CF for Free Cash Flow, or you can calculate with any variant of cash flows definition you wish.

To accomplish the business valuation, go through the following steps:

  1. Project sales 10 years into the future, either from trend analysis or using analysts growth numbers published in financial sites. Obviously the first and second year will be more or less accurate but beyond that assume conservative growth rates in sales.
  2. Prepare a common size statements for the last 5 years, where the balance and income statements accounts are divided by gross revenue for that year, and analyse the behaviour and trends of costs in relation to expanding or contracting sales, and compare to industry, if not similar investigate further. Average the 5 years ratios as you will use them in the steps below.
  3. Project expense accounts ( Cost of Goods Sold (COGS), Depreciation and Expenses) using historical relationships between expenses and revenues. Use the historical relationships derived from creating the common size statements in step 2. In this step you can adjust the ratio relationships in the future as you see fit. Industry experience and knowledge helps here.
  4. Project effective tax rate from reviewing the company's analysis of its tax liabilities. You can use 33% on average to eliminate the clever tax plans used by companies.
  5. Use all the outputs from the above to construct a proforma profit and loss statement.
  6. Project working capital. Again by relating their historical ratios to sales derived in step 2, use these ratios and multiply them by projected sales to get future accounts in working capital. You have to do this for the following accounts from the balance sheet: Accounts Receivables (AR), Inventory and Accounts Payables (AP). A simplified version of working capital is AR+inventory-AP.
  7. Project Capital expenditure using necessary expenditure for additional dollar increase for historical data and management plans to expand operations.
  8. Compute free Cash Flow for the next 10 years to Firm from the following formula: projected net income + Depreciation - Capital Expenditure - Change in working Capital yr over yr
  9. Obviously the company's value extends beyond 10 years, to account for that use the current PE multiple for the firm to compute its value at year 10 by multiplying the PE multiple by Projected net earnings. I would be careful not to use more than 10 times earnings even if current multiple is higher under any circumstance; the multiple used here can skew valuation greatly.
  10. Compute Discount Rate or Weighted Average Cost of Capital (WACC). WACC is simply the company's cost to finance its operations. WACC is very important to determine a company's value added and profitability. Obviously the lower the figure the better the returns the company achieves. WACC is the combination of the Cost of equity and the Cost of debt, for more details on the formula see here.
    1. Cost of Debt: Many companies detail the weighted average cost of debt in the notes of their financial statement. However if you need to compute it, it is very easy to compute. you need to find the interest rate for each long term debt instrument and multiply it by the weight of that instrument in relation to the company total long term debt.
    2. Cost of equity is computed as:
    3. To compute cost of equity, you need the following inputs:
    1. Risk free rate is 10 yr Treasury Bill (TB), which is currently is hovering around 4%
    2. Risk premium is the 10 yrs geometric mean of difference (stock returns (S&P)- 10 TB), which currently is estimated at 6%.
    3. Beta is the published in financial press, you can use Google Finance or Yahoo finance to get the figure. For more details on the subject see here.
    1. Now we are ready to compute the value of a business. Discount the stream of free cash flow computed using WACC to the present time then add the discounted value of company value in year 10 computed in step 9 to present time. The combination of the two figures will give the present value of the business. Obviously you can compare it to the current price and determine if the business is selling at a discount or a premium.

You can find on my blog a link where you can download templates to accomplish this valuation method.

You can download my Excel template for this valuation methodology here.


David Annis said...

Great post. I have a similar background to you (MBA, software company that I sold in 2003) and have similar interests.

I like this analysis, but I rarely use it anymore, because it's too easy to fool yourself about the projected returns 10 years out and the future contains too many surprises. I wish that the calculation contained a correction for the level of certainty in the projections.

I'll expand on this on my blog and link to you when I get a chance.

Sami said...

Thanks David.

I agree with you that the biggest threat to the model is your own assumptions about future prospect and its use is overrated. However it is one yardstick of value that I tend to confirm with other models like sum of the parts analysis, if applicable, and earning power value.

but in general valuation is such an illusive concept and overrated in its use. I look forward to your post.