QUALIPORT
Valuation Lessons From The Corner Shop

By Maynard Paton (TMFMayn)
June 20, 2002

There are countless ways to value a company. Price to earnings, price to book, price to sales and so on. However, the Qualiport uses the free cash flow yield. This article will recap on the theory behind this particular valuation measure.

Corner shop

Let's go back to basics. Why do people buy businesses? Ultimately, it all boils down to cash. The purchaser envisages that the amount of cash the business will generate will -- over time -- exceed that from other investment alternatives.

Imagine you've got £500,000 to spare. Which option would produce the best financial outcome for your savings? Putting it all in the building society for 5% interest, or using it all to buy the local corner shop?

To answer that question, you'd need to know the financial details of the corner shop. Let's say you discover the shop's present owner has been regularly paying himself £20,000 a year, while the rest of the shop's profits were all spent on refurbishments.

If you'd put the £500,000 into the building society, 5% interest would give you £25,000 a year. Compared with the £20,000 being a shopkeeper, the building society appears to be the better bet.

Of course, if you did buy the shop, you could reduce the refurbishment spend or raise your prices to try and improve your income. However, those changes could backfire and you may lose custom instead. And of course, running a corner shop involves a certain degree of external risks too. A supermarket may open up next door or trade could deteriorate because of local job losses.

Overall, there's a lot more certainty with the building society account than there is with owning a shop (or any other company). It therefore makes sense to build in a margin of safety when making a 'business' purchase to cope with the unexpected.

If you were to buy the imaginary local shop then, you'd want to receive an income 'premium' over and above the investment alternatives. For instance, if you wanted an income yield of 7% (2% higher than the building society), the resulting £20,000 salary would mean a corner shop price tag of £285,000. At this price, your salary could drop to £14,250 following various unforeseen events, yet you'd still be better off than if you'd put the £285,000 in the building society. On the other hand, if there were no slip-ups and you get £20,000 a year, then all well and good.

Real world

Let's translate part of that example...

 "the shop's present owner has been regularly paying himself £20,000"

...into the real world of share investing:

The key points here are regularly and £20,000.

First off, you need to find listed companies that are regular generators of cash. Steady, proven and predictable are the watchwords here. Supported by experienced management, industry-leading products and few competitors, you're looking for companies that are quasi gilts, whose annual profits can almost be deemed as reliable as coupon payments by the Government.

Cash that a company produces over and above what's required to sustain its present competitive position is deemed 'free cash'. It funds such discretionary corporate activities as the payment of dividends and acquisitions. In the corner shop example, free cash of £20,000 was generated (effectively a dividend paid to the owner), since the remaining profits were all spent on refurbishments.

It's important to note that there is no single definition of free cash flow. Its calculation can differ and the Qualiport's own formula can be found here. From the Qualiport's point of view, the major difference between free cash and reported earnings concerns capital expenditure and depreciation. Calculating the free cash flow yield is simply a matter of dividing the company free cash flow per share (either prospective or historic) by its share price.

So just how much of a free cash flow yield should investors demand? The figure should be initially based on risk-free alternatives, the least risky being gilts. At the moment, gilts yield around 5%. Then it's up to each individual investor as to exactly how much 'premium' they should add. The Qualiport presently uses a premium of 2.5%, equating to a free cash flow yield of 7.5%. Should the yield on gilts change significantly, the free cash flow yield demanded by the portfolio will alter accordingly.

Of course, a company's free cash flow is rarely dished out to investors in full via a dividend. Part of it will remain in the company for reinvestment purposes. However, the greater the dividend portion, the more scope there is to reduce your free cash flow yield requirements. Unlike retained profits, dividends go straight into your bank account and there's no doubting their 'free cash' status.

In summary, a business with a free cash flow yield well above the risk-free rate of return, combined with a proven ability to reinvest its retained profits at superior levels, should generate much more cash for shareholders than other investment alternatives. Although shareholders will not know exactly how much cash they'll receive in the future, there's an extremely good chance their investment will prove rewarding over time.