Qualiport

It's really only part 8 -- DCF continued

We're nearly there, Fools. Check out the archives for the earlier articles in this marathon series.

A company is ultimately worth the sum of all the cash it can generate over its lifetime. If I were to say that Frederick's Folly PLC will be in existence for 10 years, and in that time it will generate free cash flow of £1m, how much would you be prepared to pay for that company now?

There are a number of important variables that very much determine any valuation a discounted cash flow model spits out. The first is the free cash flows of £1m.

Frederick's Folly's cash flow statement in year one could look like this:

Net profit... 407
Depreciation... 100
Increase in Debtors... (200)
Increase in Stock... (300)
Increase in Creditors... 450
Capital spend... (400)
Increase in cash... 57
(all figures in £000's)

As we have seen previously, £57k is the free cash flow a company has at its disposal. It can choose to distribute it to shareholders as a dividend, it can keep some to invest back in the business or it can use it to buy back its own shares in an attempt to enhance shareholder value. This is the amount that Warren Buffett calls owner earnings.

Let's say that we reckon Frederick's Folly can grow its free cash flow by 10% compounding per annum for the next 10 years. Starting with year 1, free cash flow is £62.7k, and following that through to year 10, free cash flow in that year is £147.8m. Adding up all the free cash flow amounts for each of the 10 years, we get a total amount generated of £1,000k or £1m (rounded up).

Does that mean the company is worth £1m? The answer is no, because we haven't taken into account the time value of money. We are also making an assumption that at the end of year 10, the company will cease to exist, which in the case of most publicly quoted companies is not the case.

This is where we introduce the discount factor. It is the amount by which you are prepared to discount each year's free cash flows to calculate their present value. If you were investing your money into something as safe as a 100% government-guaranteed bond, you would use a discount factor equivalent to the current rate of return on that bond, which for argument's sake is roughly 6%. Using that discount rate, the £62.7k free cash flow generated in year one is discounted back to a present value of £59.2k.

   
Discount factor  =   1
                 -----------
                   (1+6%)
    
DF =   1
    -------
      1.06

DF = 0.9434
 
£62.7k * 0.9434 = £59.2k

In year 2, the present value of the free cash flow would be £61.4k, and so on out to year 10, where the sum of the discounted free cash flows equals £702.8k. Using a 6% discount factor, and assuming Frederick's Folly can grow its free cash flow at 10% for 10 years (at which stage the company is liquidated), you would say the fair value of the company right now would be £702.8m. You go ahead and offer Frederick £500k, he accepts, and you're off to the races.

The discount factor very much effects the valuation of a company using a discounted cash flow model. If I was to raise the rate to 12%, the value of the company now becomes £516.9k -- quite a difference. As you can see, the use of the discount factor can substantially affect an investor's perception of a company's valuation.

When looking at publicly quoted companies, an appropriate discount factor would often be higher than the 6% I've used in the above example. Like any of the valuation models we've looked at in this series, it works best when used on a company with a predictable earnings stream. Investors can still calculate a valuation on companies with less-than-predictable earnings, but they would need to be conservative in their growth rate percentages, or their discount factor, or both.

When using the discounted cash flow model, I would suggest investors take into account that buying a share in a company is more risky than investing in a government backed bond. There is a chance your company could go broke and not deliver you any return into the future at all. There is a chance that your company will not be able to execute its business plan as well as you may have thought, and there's a chance that your company's prospects could be adversely affected because of increased competition. Although over a 10 year period various studies have shown that it is less risky to invest your money in shares than bonds, those studies are referring to the general stock market, not individual companies on their own.

The bond rate varies depending on the underlying rate and direction of interest rates. A higher discount factor is appropriate when interest rates are higher. At the moment we are seeing interest rates at relatively low levels, but this may not be the case in the future. Investors, therefore, will need to vary the discount rate accordingly.

One other complication to bear in mind is the residual value of the company. In the Frederick's Folly example, we assumed that the company would cease to exist after year 10. As we said earlier, this never happens in real life, and long-term investors will want to focus on companies that have good economics over an extended period of time, ideally 100 years or more (only joking... not quite that long, maybe only 50 years)

To give a valuation to the rest of the company after year 10, it is appropriate to work out a long-term growth rate for the company. I know that it is virtually impossible to accurately predict the rate of growth a company will achieve from 2008 to 2108, but again it boils down to the predictability of a company's earnings. If I said that 5% growth rate was appropriate for most companies, which is not far away from the rate of inflation, you'd see that I was again being conservative but realistic.

Some analysts say it is appropriate to capitalise the 10 year free cash flow by the difference between the discount factor and the long term growth rate. For example, if you said the discount factor was 12% and your long term growth rate was 5%, the capitalisation rate would be 7%.

The discount factor in year 10 using a 12% rate is 0.322. If the future free cash flow is £155.2k, capitalising that at a rate of 7% would give a residual worth of £2,217.6k (£155.2/7%). Discount that back to present using 0.322, and it gives you a present value of that residual of £714k. This is then added to the discounted value for the first 10 years, in the same method we looked at earlier, and voila -- you have a total discounted cash flow valuation for your company.

Totally confused by now? Yep, I thought so. These things work much better when we look at an example, and we will do that next Wednesday to tie up this series. Also, once you've got a template set up in a spreadsheet, it is much easier to tinker around with the numbers. If you'd like a copy of one I've set up, please email me.

Have a great looooong weekend, Fools, but don't forget the message boards. See you next week.

Bruce Jackson (TMF Googly)

Qualiport Numbers

Today's Numbers       Date    28/08/98


                 Day     Month    Year       History
Qualiport       (2.04%)  (6.58%)  30.54%      33.48% 
FTSE 100        (2.22%) (10.07%)   2.22%       4.57% 
FTSE All Shares (2.26%) (10.75%)   1.24%       3.37% 


Qualiport Stocks

Last Rec'd  Total #  Security  In At    Current    Change
 04/17/98    337       EMAP   £11.998   £10.250  (14.57%)
 05/11/98    736       MKS     £5.604    £5.120   (8.63%)
 12/19/98   1565       RTO     £2.582    £3.570   38.27% 
 07/17/98    595       ULVR    £6.804    £5.540  (18.58%)


Last Rec'd   Total #  Security    In At     Value    Change
 04/17/98    337        EMAP    £4043.37  £3454.25 (£589.12)
 05/11/98    736        MKS     £4124.37  £3768.32 (£356.05)
 12/19/98   1565        RTO     £4040.63  £5587.05 £1546.42 
 07/17/98    595        ULVR    £4048.38  £3296.30 (£752.08)


Cash:               £67.82
Current Total:  £16,173.74