“Earnings are only a means to an end and the means should not be mistaken for the end. Therefore, we must say that a stock derives its value from its dividends, not its earnings.” -John Burr Williams

“In ‘The Theory of Investment Value’, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.” -Warren Buffett (Trades, Portfolio)

After I wrote a recent article (“Value Investing and Relativity,” August 2017), many individuals asked if I could write about the proprietary discounted free cash valuation model I used at Nintai Partners and still use at Dorfman Value Investments. The amount of content required for a sufficient explanation is enough to break this into three articles – definitions of free cash flow (FCF) and model pros and cons (Part 1), describing free cash flow and other investment tool model steps (Part 2) and a working example of the free cash flow tool in a corporate valuation (Part 3).

Some definitions and background

Free cash flow represents the cash a company is able to generate after spending the money required to run operations and spend adequately for future growth. Free cash flow is simply operating cash flow less capital expenditures. Capital expenditures are a vital step in growing many businesses and are - after all - paid in cash, so its use in corporate free cash flow valuation is essential. Free cash flow is calculated by the following formula:

EBIT + Depreciation + Amortization - Change in Net Working Capital – CapEX

Of all the numbers used to calculate valuation, free cash flow is arguably the hardest number to manipulate. Sometimes earnings are not what they appear to be, but cash is cash. When my investment partners’ hard-earned savings are at work, I look to use many tools to reduce downside risk. By basing my valuation models on cash, I believe I am using the most solid measurement available to an investment manager.

Pros and cons of DCF modeling

As with any valuation tool, a discounted free cash flow model has both its positives and negatives. Dependent on your strategy, investment style and valuation proclivities, a discounted free cash flow model can make sense or not. Let’s start with the negatives.

Discounted free cash flow can give an investor a false sense of security in the establishing a company’s intrinsic value. Getting the estimate to within a penny can often lead investors to think valuation is more a science than an art. The smallest changes in growth rates or average cost of capital can make an enormous difference in your final value. I wrote about this earlier in “Moats and Terminal Value” (October 2017). Estimates must reflect the most reasonable – and conservative - numbers available to the investor. Discounted free cash flow valuations are the least static of valuation models. They should be constantly updated as new information becomes available. I generally update mine after the release of each 10-Q. If I have done my job well, valuations rarely jump significantly, but are tweaked as necessary. Discounted cash flow models take an awful lot of time to research and get the numbers right. One should have a detailed understanding of the company, its markets and its chief competitors. Achieving valuable insights in DCF calculations means you become very comfortable with every aspect of your portfolio holdings. For me, this means keeping the total number of stocks in the portfolio down to only 15 to 20 stocks.

Not everything about DCF models are negative. I have found over time the positives far outweigh the negatives.

Free cash flow is arguably the hardest of numbers to cheat on when reporting financials. Financial reporting today means earnings might be earnings, but cash is still cash. Basing your valuation on the soundest basis will cut down on the inevitable blowups that happen every now and then on Wall Street. DCF models scrub out short-term trends and general market conditions that play little role in calculating long-term value of a potential holding. If an investor’s decision to hold is based on each quarter’s earnings report, then they are not investing. They are speculating. A good DCF model keeps an eagle eye on the long-term trends in free cash flow and guides long-term decision-making. A DCF model generally makes an investor focus on several areas critical to a company’s long-term performance. Weighted average cost of capital (WACC) and free cash flow growth rates should be supported by such numbers as return on capital, cash return and internal rate of return versus Treasury bills. All of these will begin to nail down the company’s breadth and depth of its competitive moat, its strength in the marketplace and management’s ability to allocate capital. Understanding these are essential to provide estimates on long-term value creation.

A process, not a solution

For all the benefits of a vigorous DCF valuation model, investors should be crystal clear this is a process – not a solution – in attempting to come up with a reasonable intrinsic value for their investment. Nothing in the DCF model will give an investor a definitive answer. In the parlance of Wall Street, the process should add some “color” to your knowledge base. As an investor works through their model, the process should answer some general – but vital - questions.

Are managers great allocators of capital? Do they use assets to drive future growth (hopefully highly profitable) over the long term? Does the company have the financial strength to shake off even the most severe economic or financial challenges? Does the company have the ability to earn a return on capital greater than its weighted cost of capital over a 10- to 20-year time horizon? Does the company have the ability to beat competitors over the same time horizon? Calculate whether the share price is indicative of an adequate margin of safety to purchase, hold or sell.

The DCF calculations are not the only step in answering these questions. I look to develop a better understanding of the company by other calculations. These include cash return, return on capital, gross/net margins, internal rate of return versus risk-free return (equity premium), rate of return, etc. (I will discuss these in much greater detail in Part 2). All of this data is loaded into one spreadsheet with the ability to tinker with the numbers as needed. Behind all this data is in-depth research on the markets, competitors, regulatory and other issues which drive company performance at a macro level.

Conclusions

Any valuation tool should try to scrub out information that can skew results from subjective or fuzzy thinking. Hunter Thompson once said the only objective reporting was the horse race ticker. This tool – though somewhat more subjective than the latest Pimlico results - forces me to review new data and trends as they appear, not how I want them to appear. There is much research that does not get plugged into the spreadsheet. These will be layered on top of some calculations or integrated into specific calculations. Is this process perfect? Not at all. But it forces me to use data to come up with my best shot at what I think an individual share is worth.

Part 2 of this series will cover the major components of my valuation spreadsheet functionality.

As always, I look forward to your thoughts and comments.

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