I'm a huge proponent of value investing. I think anyone that knows a thing or two about the investment world knows what Value investing is. For those who do not here are a couple quoted definitions.
A brief definition from Benjamin Grahams book Security Analysis (Wikipedia)...
involves buying securities whose shares appear underpriced by some form(s) of fundamental analysis.[1] As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.
A brief definition by Warren Buffett (Wikipedia)...
the essence of value investing is buying stocks at less than their intrinsic value.[2] The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". The intrinsic value is the discounted value of all future distributions.
There are some differences between Graham, the teacher, and Buffett, the student. Mr. Buffett has taken the idea one step further in the last 50+ years. Adding his own prerequisites to potential securities. He subjectively determines if its an outstanding company. If they are leaders or will be leaders in the market they are in. And finally forecasting their future earning and cash flow potential.
What was the reason Mr. Buffett evolved his teachers methods? Valuing a business and determining if it was under priced became very difficult once businesses themselves started to evolve. Goodwill, technology and other types of intangible assets/liabilities made it very difficult to determine a companies worth. For instance, look up the goodwill of Wal-Mart or McDonalds, it's outrageous. Or how does one even begin to dissect Goldman Sachs balance sheet?
In this post, I will only cover the basics of theory and some math that goes into value investing. It is only the beginning! Do not consider this the end all be all post on this topic. Do not go out looking for profitable companies by analyzing their free cash flow numbers from what you see here. We need to establish a set of ground rules once we understand the theory involved.
Now, the technical aspect of value investing is projecting future cash flows and discounting them to the present. This method gives one an excellent idea of what the worth of a business is. So how does it work and why is it so beneficial? Let me go over the basic mathematics of DCF method. (Discount Cash Flow).
- Our ultimate goal is to calculate what the free cash flow has been for every year, individually, dating back 7 to 10 years.
- We will use these numbers to come up with what the average increase, in percentage terms, has been over those 7 to 10 years.
- With the confidence of knowing what the average increase in free cash flow has been, we can try to predict how much that cash flow will increase 5-10 years into the future.
- We will discount all the future values back to the present day, discounting all future cash flows. Hence the term DCF!
- This is the value of the company today. It has taken into account how the company has performed, is currently performing and will perform in the future.
- Now to turn this number into a per share value we just divide it by the number of stocks currently out there in the public.
Here I have calculated the free cash flows for each year. I will explain HOW to obtain all these numbers separately. This is just for a general understanding of the theory right now.
Here I have taken the various years of cash flow and determined multi-year averages (Table: Multi-Year Performance). Looking at the averages from various points of views. Then I have taken the sum of all averages from multi-year timescales and determined my final free cash flow average in a percentage term. I have then taken this number and determined how much the the cash flow from the current year will increase for the next 5 to 10 years. (Table: Project of Future Cash Flow)
From there I use the Discounted Cash Flow equation to determine the Total Value (Table: Company Valuation). The equation I use takes all the future cash flows and discounts them to the present day value. In technical terms this is the DPV formula. Here is the equation:
wikipedia.org
And if we require to use multiple years such as my example:
wikipedia.org
Where- DPV is the discounted present value of the future cash flow (FV), or FV adjusted for the delay in receipt;
- FV is the nominal value of a cash flow amount in a future period;
- i is the interest rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full;
- d is the discount rate, which is i/(1+i), ie the interest rate expressed as a deduction at the beginning of the year instead of an addition at the end of the year;
- n is the time in years before the future cash flow occurs.
Link: Calculating Free Cash Flow
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