“Every investment is the present value of all future free cash flow.” Everything Money
Cash flow refers to the net amount of cash and cash equivalents that comes in and goes out of a company. Businesses take in money from sales as revenues and spend money on expenses. Cash received represents inflows, while money spent represents outflows.
“Intrinsic value can be defined simply as the discounted value of cash that can be taken out of a business during its remaining lifetime. “ ~ Warren Buffett
A company’s ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows or, more specifically, to maximize long-term free cash flow (FCF). FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Intrinsic value is defined as the discounted present value of all future cash flow of a business.
The only reason to lay out money for an investment now is to get more money later. When you invest in a bond, its very easy to see the future cash flow and the terminal value of a bond, its printed on the certificate.
When you invest in a stock,
Investing in any financial asset involves laying out cash now in order to get cash later out of the investment. And investing in a business, can the business deliver enough cash to you (the owner) soon enough that it makes sense to buy it as its current market value?
How much am I willing to pay for a business, considering it makes $24B in cash flow per year, and is growing at 10% annually.
Once we determine the business intrinsic value, we compare that number to the business’ current market capitalization. Market cap is the product of the total shares outstanding and the current market stock price.
- Market cap is higher than intrinsic value = overvalued
- Market cap is lower than intrinsic value = undervalued
Discounted Free Cash Flow since one dollar today is worth more thant $1 in five years due to opportunity costs and lost of purchasing power of that dollar.
- Step 1: Find the current free cash flow – Free cash flow is the amount of money left over for the owners of the business, after factoring in cash outflows that support its operations and maintain its capital assets. The ideal FCF for valuation would equal Operating Cash Flow minu Maintenance CapEx
- Step 2: Grow the current free cash flow out 10 years in the future – the growth rate used will have a big impact on the final intrinsic value calculation. Check historical growth rate for cash flow and industry growth rate for cash flow. Or, look at trend and future capital investments.
- Step 3: Add a terminal value – what you can sell the business for in 10 years. Use FCF multiple.
- Step 4: Discount all future cash flows to present value at a rate of 12% to 15%
- Step 5: Add together all future cash flows to find intrinsic value
- Step 6: Add a margin of safety (of 20% to 30%)
In the current market environment, most companies will be trading above the intrinsic value.
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