We have a whole series of articles on valuation metrics – you can read them here – General article – PE – PEG – Significance of Comparing Enterprise Value to EBITDA and Looking at price to book value.
There are various reasons why analysis based on free cash flow might be preferred by value investors. The accounting profit, for all its merits, is a figure that is dependent on accounting policies within the company. Although accounting standards have made an important contribution to standardizing measures of profit there are still plenty of areas where business judgment has to be exercised in establishing income or expenses for accounting purposes, examples being tangible fixed assets, finance and operating leases, treatment and valuation of intangible assets, depreciation, inventory and measurement of work in progress on long term contracts.
Value investors may therefore turn to free cash flow as an alternative that is not so dependent on human judgment and is more difficult to manipulate. There is an immediate problem however, arising from the fact that computation of cash flow is not subject to the same type of regulation as the accounting profit. The investor has to define free cash flow and ensure that the measurement is performed in the same way when applied to different companies.
How Warren Buffett Uses Discount Rates To Value Stocks
Warren Buffett has never detailed the process he uses to value the businesses he acquires for Berkshire Hathaway. However, over the years, he has provided some limited insight into his methods. Q3 2020 hedge fund letters, conferences and more Based on these comments, it is widely assumed that Buffett uses a discount cash flow model Read More
The calculation of free cash flow begins by looking at the operating cash flow, normally computed by looking at the statement of cash flow in the financial statements. The operating cash flow can also be approximately calculated by taking earnings before interest and tax, adding back depreciation and then deducting taxation. After arriving at the operating cash flow, free cash flow is then found by subtracting the expenditure required to maintain the fixed assets in good working order and replace them where necessary.
The value investor can use free cash flow in a number of different ways to look for value investments. The growth in free cash flow within a company from one year to the next may give an indication of how well a company is doing. The investor may also calculate free cash flow per share, to look at what cash is available to reward investors. This metric may be used to compare different companies in the same industry or companies in different industries.
The value investor is always concerned with the question of how the current market value of the company compares to the intrinsic value. The discounted free cash flow over the life of the company can be used as a measure of the intrinsic value. This measure is however subject to all the inherent problems of forecasting the future including the difficulty of estimating future cash flows, especially those that will be required in respect of capital expenditure. The rate at which to discount the future cash flows also presents a problem.
The figure for future capital expenditure may have two components. Firstly there is the amount required to keep the assets at the current operating level, allowing for necessary repairs and renewals. Then there is the additional capital expenditure that will be required as the company grows and expands its operations. These calculations will depend on the current state of the company and any expected future expansion and will therefore be subject to the judgment of the person performing the calculation. This is not a big problem for the value investor who knows that judgment must always be exercised in analyzing corporate performance.
Estimation of the future capital expenditure is not straightforward because the capital expenditure will not occur smoothly from year to year in a straight line or upward curve but will be uneven. In any particular year a new item of machinery may be acquired to replace an old one or some additional items of plant may be added to expand the business. In other years capital expenditure may be lower. Any future free cash flow computation must assume an even development even though in practice this will not take place.
One obvious point to note from these uses of free cash flow is that the calculations depend to a large extent on making estimates, and the significance of the result is a matter of judgment. Looking at operating cash flow can help to compare the performance of different companies and can help to arrive at an approximation to intrinsic value. The value of the analysis and any further action required to back it up is a decision for the value investor who would normally use some different metrics to check out any conclusions reached.
If the intrinsic value appears to be well above the current market value, the value investor should be sure that there is an adequate margin of safety before taking action and acquiring shares. The result of the calculation is, after all, only as accurate as the information that goes into it. Any conclusions reached about the shares should be backed up by confidence in the management of the company and in the future of the industry in which the company is operating.