There are two types of free cash flow models that may be used for the valuation of stocks. The first is free cash flow to the firm, and the second is free cash flow to equity. The difference between the two is that FCFF takes into account both debt and equity contributions to capital, while FCFE includes only equity.
These models are described in chapter eight of "Strategic Value Investing: Practical Techniques of Leading Value Investors," written by Stephen Horan, Robert R. Johnson and Thomas Robinson. The authors noted free cash flow models are comparable with dividend growth models, the difference being the former is based on free cash flow while the latter is based on dividend growth.
The authors wrote, “A forecast of next year’s FCFE is discounted at the return desired by you as an equity investor minus the future expected growth rate of free cash flow to equity.” This is the formula, where “r” is the desired return and “g” is the expected growth rate:
They added that the intrinsic value per share can be calculated by dividing the total equity value by the number of shares outstanding.
To illustrate, the authors created a case study, showing how they applied forecasted FCFE to value Walmart (WMT, Financial) for 2014. The inputs were (at the time of writing):
- Forecast FCFE: $14.275 billion.
- Desired rate of return: 8%.
- Future growth rate: 3%.
That works out to:
If we now divide $285.5 billion by 3.34 billion shares, we arrive at an intrinsic value of $85.50 per share for Walmart. This is close to the value calculated using the single-stage FCFF model, and the authors told us that is “as it should be” if we have been using consistent assumptions.
Read more here:
- Strategic Value Investing: Free Cash Flow to the Firm Model
- Strategic Value Investing: Free Cash Flow Models
- Strategic Value Investing:The Discount Rate
As with the FCFF model, there is also a multistage FCFE model, which might be used in the case of a company that is expected to grow at one rate for the next several years, then grow at a different rate in subsequent years. This might be the case for a company that is growing fast now, but is expected to grow at a slower rate when it matures.
Which model?
These guiding principles were offered by the authors in response to the question, “Which model should I use?”
- If the capital structure is unlikely to change and borrowing likely will remain consistent, then the FCFE model would be appropriate.
- If the capital structure is expected to change, and they use the example of a leveraged buyout, FCFF will be more appropriate. The authors wrote, “In fact, we believe that FCFF can be used in most circumstances, making it a pretty safe bet. You should, however, get similar results by employing either model. The estimated margin of safety likely won’t be dramatically different from one model to the other.”
The “art” of valuation
Underlying all these models are numerous judgments by analysts, making valuation an "art” as well as a mathematical exercise. That’s because a model should never depend on just historical data, for several reasons:
- The company may have been, in your judgment, too aggressive in its reporting, for example. There are many areas in which an analyst may disagree with the company’s data or reporting. In these cases, you are expecting a change of reporting in the future.
- The external environment in which the company operates may change or is being changed as you do your analysis. Consider the economy as well as changes in the business models used by the industry and by the company.
- Consider changes in business models within companies and between companies. For example, companies like Walmart need to invest in working capital to cover inventory, receivables and so on. On the other hand, a company like Dell (DELL, Financial) uses a business model that collects payments from customers before the order is filled, and only builds after the order is received, reducing its need for big inventories.
Conclusion
As we’ve seen, the free cash flow to equity model is much like the free cash flow to the firm model, and both are useful tools for determining the intrinsic value of a company.
And, as the authors of "Strategic Value Investing: Practical Techniques of Leading Value Investors" make clear, many nuances are involved in using these models. Indeed, their use involves a great deal of “art.”
In both cases, the process of using these models help us better understand the companies we are analyzing. In the words of the authors, “These models are therefore well-structured mechanisms to learn the company.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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