Alternative to Discounted Cash Flow Method

What do you use if you don't want to or can't use the discounted cash flow (DCF) method of valuing a stock?  

There are other methods for valuing a stock (not valuing the company).  The most popular alternative uses various multiples to compare the price of one stock to a comparable stock.

The price earnings ratio (P/E) is the most popular multiple for these comparisons.

You can use the P/E formula to find the price based on comparable stocks.

For example, three stocks in a particular industry had an average P/E of say 18.5.  If another stock ABC in the same industry had earnings of $2.50 per share, you could calculate a stock price of $46.25 per share (= 2.5 x 18.5).  This is just an approximation, but it should put stock ABC on a comparable basis with the other three stocks in the same industry.



This strategy has several flaws.

1.  The P/E is not always the most reliable of value gauges.
2.  The process depends on the three comparables being priced correctly and there is no guarantee of that.
3.   Its biggest flaw is that the process tells you nothing of the future value of the company or the stock.

If you use this method, and many investors do, you will need to watch the stock more closely and continually measure it against comparables.  However, it does not require you to estimate anything or consider multiple variables, which is why it is so popular.

This method is best used for a quick decision on whether the stock is under-priced or over-priced.
Although you can arrive at a stock price based on the P/E formula, it is not nearly as accurate as the DCF method.



You can also use other key ratios in valuation.

These include the followings:
1.  Price/Book - Value market places on book value.
2.  Price/Sales - Value market places on sales.
3.  Price/Cash Flow - Value market places on cash flow.
4.  Dividend Yield - Shareholder yield from dividends.



So, which method should you use - DCF or multiples?

In the end, you will have to decide which method is for you.

There is no rule against using both.

Whether you calculate your own DCFs or use the estimates from others, reputable websites or analysts estimates, make sure you have the best guess available on the variables the formula needs.

Either way, make a conscious decision to buy a stock based on the valuation method of your choice and not a "feeling" for the stock.

Free cash flow to the firm (FCFF)

What It Is:

Free cash flow to the firm (FCFF) is the cash available to pay investors after a company pays its costs of doing business, invests in short-term assets like inventory, and invests in long-term assets like property, plants and equipment.

The firm's investors include both bondholders and stockholders.

How It Works/Example:

Cash flows into a business when the company sells its product (revenues, aka sales). Cash flows out to pay the costs of doing business: salaries, rent, taxes, etc. Once expenses are paid, whatever is left over can be used to reinvest in the business.

A company must continually invest in itself in order to keep operating. Short-term assets like inventoryand receivables (called working capital) get used up and need to be replenished.  Long-term assets like buildings, plants and equipment need to be expanded, repaired and replaced as they get older or as the business grows.

Once the company has paid its bills and reinvested in itself, hopefully it has some money left over. This is the free cash flow to the firm (FCFF), called such because it's available (free) to pay out to the firm's investors.

To calculate free Cash flow to the firm, you can use one of four different formulas. The main differences among them pertain to which income measure you start from and what you then add and subtract to the income measure to end up with FCFF:

FCFF = NI + NCC + Int * ( 1 – T ) – Inv LT – Inv WC

FCFF = CFO + Int * ( 1 – T ) – Inv LT

FCFF = [EBIT * ( 1 – T )] + Dep – Inv LT – Inv WC

FCFF = [EBITDA * ( 1 – T )] + ( Dep * T ) – Inv LT – Inv WC

NI = net income
NCC = non-cash charges
Int = net interest
T = tax rate
Inv LT = investment in long-term assets
Inv WC = investment in working capital
CFO = Cash flow from operations
Dep = depreciation

All of these inputs can be found in the company's financial statements.

Why It Matters:

Free cash flow is one of the most important, if not the most important, concepts in valuing a stock. As you may already know, the price of a stock today is simply a sum of its future cash flows when those cash flows are put in today's dollars.

Technical analysts aside, most investors buy a stock because you they believe the company will pay them back in the future via dividend payments or stock repurchases. A company can only pay you back if it generates more cash than it spends. Hence the importance of calculating free cash flows.

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/free-cash-flow-firm-fcff-1149

Free Cash Flow Return on Invested Capital

Free Cash Flow Analysis of NetFlix 

Mar 10, 2010

The following is a free cash flow analysis of NetFlix’s(NFLX) using FROIC and Price to Free Cash Flow.

FROIC for those who don’t know is = Free Cash Flow Return on Invested Capital.

Over the years I have tested out various ratios and have found very few that can compete with FROIC, in getting down to the real cash that a company is generating on Main Street .

Basically FROIC tells the investor how much free cash flow is actually generated as a percentage of the total capital that the company employs. To put it more simply, “How much free cash flow is generated for every $1 of capital that a company employs”

How does one calculate FROIC?

FROIC = Free Cash Flow/Total Capital

The way to determine Free Cash Flow is by taking a company's “Cash from Operations” and subtracting its “Capital expenditures” from it.

So in Netflix’s case its 2009 “Cash from Operations” was $325.1 million while its capital expenditures were only $45.9 million. Thus when we subtract $45.1 from $325.1 we get $280 million in free cash flow. We next take the company's $280 in free cash flow and divide it by its 58.416 million diluted shares outstanding and we get $4.79 a share in free cash flow.

If we then divide that number into the closing price of March 9, 2010 of $69.94, ($69.94/$4.79) we get a price to free cash flow of 14.6.

A price to free cash flow result of 14.6 is very attractive and I proved that in doing a backtest on price to free cash flow in the investment process”, using the DJIA 30 stocks from 1950-2007, and found that by only buying stocks that were selling for 15 times their price to free cash flow or less one would have substantially beat the DJIA 30 by a very large margin compared to buying the entire Index.

Now that we have seen what the free cash flow is for Netflix, let us now go and determine what its total capital employed is.

Basically Total Capital = Long Term Debt + Shareholders Equity

Taking just basic Total Capital is too easy in my view and I prefer is make it a little more difficult for a company to pass this test and add “other long term debt” to the equation. So for NetFlix we have the following for the year 2009.

Long Term Debt = $200 million

Other Long Term Debt = $54.2 million

Shareholders Equity = $199 million

When you add all those together you get $453.20 million for total capital employed.

Having done that we can now calculate FROIC as $280/$453.2 million or 61.78%.

What does this 61.78% mean?

For every $1 of total capital employed, NetFlix generates 62 cents in free cash flow.

I welcome everyone to go and try out FROIC on your own. In the end you will find that there are very few companies whose stock price trades for less than 15 times their free cash flow and generates 61.785 cents in free cash flow for every dollar of capital employed.


http://seekingalpha.com/instablog/498843-peter-mycroft-psaras/58154-free-cash-flow-analysis-of-netflix

POS Malaysia generates strong Free Cash Flow.

Have taken a brief look at POS.

1.  Cash rich company.  Cash RM 398.033 m, little debt.

2.  Net CFO is strong .. RM 198.451m

3.  Its FCF is strong ... net CFO 198.451 - capex 64.898 = RM 133.553m

4.  Market cap = RM 1670.2 m @ share price of RM 3.11 each.

5.  FCF/Market cap = 8% (very good).

6.  Dividend paid 50.346 m  DY = 50.346/1670.2 = 3%


It is no wonder that so many suitors are lining to acquire this stock from Khazanah.

Latest valuation based on closing price of 7.4.2011

Outstanding shares of POS = 537.03 million.

At the closing price of  MR 3.74 per share on 7.4.2011, its market cap = MR 2,008.5 million.

The FCF generated by POS in the last FY was MR 133.553 million.

Its FCF/Market Cap on 7.4.2011 = 6.65%.

Its Market Cap/FCF = 15 x

The successful company that acquire POS would have bought a company that is generating good net CFO and strong FCF.  

It is on the basis of this FCF that makes the valuation of POS seems reasonable for the moment.

Reviewing the rise in KLCI from March 09 to now

The market turned in March 09.  Those who continued to hold their stocks during the downturn would have seen substantial rebound in the prices of their stocks.  Remarkably many good stocks have risen above their previous highs.

The initial rise in the prices of these stocks was due to the steep bargain offered by the knocked-down prices created during the severe downturn.  Soon this steep bargain was eroded and most of the stocks were trading close to their fair price.  The market has the tendency to over-react on the downside and the upside.  As was mentioned before, this has something to do with the inexact science of finding the intrinsic value of a particular stock.  Moreover, there are many participants in the market who felt this is not important, driven mainly in their "trade" or "investing" by studying the sentiment driving the buying and selling of a particular stock.

What can we recollect from March 09 to now in KLSE?  The initial price rise from March 09 was broad base.  Almost all counters went up.  Few were laggards.  Soon the initial rise flattened.  The blue chips however continued to performed well.  The index linked counters continued their steady rise over the last few months, probably supported by huge institutional investors initially.  The financial counters moved steadily and swiftly, followed by others blue chips and KLCI component stocks.  The other stocks did not move much, though there were much excitement in some individual stocks like Mamee, Daibochi, HaiO and others. 

As usual, the retail investors were slow to enter the market missing the steepest part of the market rise.  It should be of interest to know the percentage of previous retail investors who are now permanently out of the stock market following the calamity in the market in 2008.  But the market is always a huge magnet.  When the market rises, new players (and also suckers) are attracted in.  The market has paused on a few occasions over the last 9 months.  The correction was not painful, the worst was a 6 percentage dip in the index over a brief period so far. 

As to whether the market price presently reflects the fundamentals, there are as many who argue either ways.  Is the market undervalued at present price?  Is the market overvalued at present price levels?  Is the market reflecting the fundamentals of the economy?  Is the market price ahead of the economy, not supported by the underlying fundamentals?  One way to get out of this confusion is to realise that in investing, you are investing into stocks and not into the market.  Therefore, for those stock pickers, the importance is in understanding the business of the company, the quality of its management and being able to place a value on the price of the business of this company. 

Since the start of market trading this new year, the market has risen upwards extremely fast indeed.  Many would have seen significant gains in their portfolio.  Many stocks have reached their 52 weeks high and there are also many that reach their all time high prices.  The prices of various stocks climbed not by mini-steps but by giant steps. Interestingly, a piece of good news can push up a stock price by a large amount. The present play is in the glove counters. This sector has proven to be resilient and growing.  Can one truly believe that the business fundamentals of a stock has increased 2 or 3 folds over this short period as would have to be accounted for by such rising prices in the stock?  As with all things too good to be true, be prepared now for when the music stops.  This is particularly most relevant for those who are late or recent comers to this wonderful bull party in the stock market.

Among my favourite stock picking matrix:  Search for those companies with 5 or 10 years consistent records of :

• high ROE of  >15% and
• generating large FCF (FCF/Sales >5%, high FCF/TOCE of >10%) 

This matrix has turned up many big winners with long sustainable economic moats for long term investing consistently.  Keep track of these companies and buy them when they are offered at fair or bargain prices. 

At bargain prices,

• the EYs (EPS/Price) and DYs are at the higher of their usual historical ranges,.and
• the FCF/EV yields  are attractive multiples of the risk free interest rates offered by fixed deposits.

[where,
FCF = Free Cash Flow = Cash Flow from Operation - Cash Flow from Investing = (CFO - CFI)
TOCE = Total Capital Employed = (Equity + LT Debt)
EV = Enterprise Value = (Market Cap + ST Debt + LTL Debt - Cash)]


http://www.investopedia.com/articles/stocks/05/cashcow.asp

Using Yield-based measures to value stocks: Say Yes to Yield

Say Yes to Yield

1.  Earnings yield

Earnings yield
= Earnings/Price

The nice thing about yields , as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment. (The difference is that earnings generally grow over time, whereas bond payments are fixed.)

For example:
In late-2003:
Risk-free return from 10-year treasury bond: 4.5%
Earnings yield of Stock with P/E of 20 = 5% (This is a bit better than treasuries, but not much considering the additional risk taken.)
Earnings yield of stock with P/E of 12 = 1/12 = 8.3% (This is much better than the treasury bond. The investor might be induced to take the additional risk.)

2.  Cash return

Cash return
= Free Cash Flow/Enterprise Value
= FCF/(Market capitalization + long term debt – cash)

However the best yield-based valuation measure is a relatively little-known metric called cash return. In many ways, it’s actually a more useful tool than the P/E.

To calculate a cash return, divide free cash flow (FCF) by enterprise value. (Enterprise value is simply a stock’s market capitalization plus its long-term debt minus its cash.)

The goal of the cash return is to measure how efficiently the business is using its capital – both equity and debt – to generate free cash flow.

Essentially, cash return tells you how much free cash flow a company generates as a percentage of how much it would cost an investor to buy the whole company, including the debt burden. An investor buying the whole company would not only need to buy all the shares at market value, but also would be taking on the burden of any debt (net of cash) the company has.


An example of how to use cash return to find reasonably valued investments:
Company A’s
In late 2003,
Market cap = $9.8 billion
Long-term debt = $495 million
Cash in balance sheet = $172 million
Enterprise value = $9,800 + $495 - $172 = $10,100 million or $10.1 billion.

Review its FCF over the past decade
In 2003, FCF = about $600 million

Therefore,
Cash return of Company A = $600/$10,100 = 5.9%

In late 2003:
Yield of 10-year treasuries = 4.5%
Yield on corporate bonds = 4.9% (This is higher but still relatively paltry.)
Cash return of Company A = 5.9% (Looks pretty good. Moreover, this FCF is likely to grow over time, whereas those bond payments are fixed. Thus, Company A starts to look like a pretty solid value.)

Cash return is a great first step to finding cash cows trading at reasonable prices, but don’t use cash return for financials or foreign stocks.
• Cash flow isn’t terribly meaningful for banks and other firms that earn money via their balance sheets.
• A foreign stock that looks cheap based on its cash return may simply be defining cash flow more liberally, as the definitions of cash flow can vary widely in other countries.


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Free Cashflow to Capital

FCF/Capital
=FCF/ Total Capital Employed
= FCF/TOCE
= FCF / (Total shareholders equity + Debt)

The Stock Performance Guide published by Dynaquest Sdn. Bhd. gives data on Free Cashflow (FCF) to Capital.  FCF is the amount of nett cashflow left after paying for re-investment in fixed and current assets. FCF measures the ability of a firm to pay out dividend.

FCF/Capital compares the FCF of a firm with the total capital employed (defined as total shareholders equity & debt). The higher is this ratio, the more efficiently is the firm using its capital.

Cash cows are those companies with FCF/Capital of > 10%.

FCF/Capital is not the same as Cash Return discussed above.