Karl

# New Feature Announcement: Discounted Free Cash Flow Screener

June 16, 2010

The Discounted Free Cash Flow Screener focuses on Free Cash Flow (FCF) and Total Equity. These measures can be used to determine an intrinsic value estimate for a company. This article discusses the importance of free cash flow and total equity and describes how GuruFocus arrives at an intrinsic value estimate.

Link: Discounted Free Cash Flow Screener

To understand the importance of free cash flow, please read the following from the 1992 Berkshire Hathaway Chairman's Letter in which Warren Buffett wrote the following:

"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." -1992 letter(all letters)

Free Cash Flow is the money generated in a year which can be used to grow the business and pay dividends. Free cash flows can be thought of as being similar to the payout of a CD or bond. While CDs and Bonds reward the holder with cash, not all of the free cash flows are handed back to the investor as dividends. In some cases, no dividends are paid and all of the free cash flows are reinvested by the company on behalf of the owner.

With a company, the free cash flows are what is left for reinvestment. With CDs and bonds, the dividends can be used for reinvestment. In this manner, free cash flows can be thought of as being equivalent to the return of CDs and bonds. Free cash flow is what a business owner is interested in creating.

THE FORMULA

Based on the 6 year free cash flow average, total equity and free cash flow growth assumptions, the following formula is applied

Value = (Growth Multiple)*FCF(6 year avg) + 0.8*Total Equity(most recent)

The free cash flow growth assumptions translate into the Growth multiple in the above formula. In the case of negative total equity, the following formula is used (see the Total Equity section for the reason):

Value = (Growth Multiple)*FCF(6 year avg) + Total Equity(most recent)/0.8

The Growth Multiple, 6 year average of FCF and Total Equity are discussed in the sections that follow.

6 YEAR FCF AVERAGE

The screener uses a 6 year average of Free Cash Flow. The reason for this is to smooth the peaks and valleys that can occur in any single year of reported data. This average acts as a way to normalize the FCF data.

In addition to the past 6 years of annual FCF data, recent quarterly data is also included. So, this 6 year average is technically the average FCF over the past 6 to 6.75 years. The reason for the inclusion of quarterly data is simple. GuruFocus believes that the most recent data should be included in order to give the best results possible. For purposes of discussion, the term “6 year FCF average” is used, even though this is actually anywhere from 6 to 6.75 years.

There is still one small issue. The 6 year free cash flow average is currently treated as a trailing average. The 6 year free cash flow average is really an average centered around a date from 3 years prior. So, the 6 year FCF average needs to be adjusted forward by 3 years. For this purpose, we assume that inflation is 3.3% per annum This creates a multiple of 1.1023 (1.033) that is used to adjust the 6 year average slightly.

So, if free cash flow for ABC Corp were \$1, \$2, \$3, \$4, \$5 and \$6 million over the past 6 years the average would be \$3.5 million. However, this average is multiplied by 1.1023 to give an adjusted average of \$3.858 million. This \$3.858 million is the 6 year average that is used by the screener.

This 6 year FCF average is the basis for the “cash inflows and outflows” that Buffett refers to. By making assumptions about future free cash flows and discounting those free cash flows “at an appropriate discount rate”, the value of the future free cash flows in today's dollars can be determined.

The next section discusses the discounting of future free cash flows using the 6 year FCF average as a basis.

GROWTH MULTIPLE

The growth multiple is a multiple that is based on a growth assumption. GuruFocus uses various historical growth numbers (EBITDA growth, revenue growth, etc) to come up with an assumption of future growth. This growth assumption is determined and then restricted to a range of 4.5% to 11%. This growth assumption is then translated into a proper growth multiple which is in the range of 8.63 to 13.48. Multiplying the 6 year FCF average and the growth multiple together provides an approximation of the sum of all futures estimated free cash flows in today's dollars.

The following explains how the growth multiples were determined based on the various growth rates. To determine a formula, growth multiples for growth rates ranging from 4% to 15% were determined. Based on the samples, a best fit curve formula was created. The formula is as follows:

Growth Multiple = 8.3459 * 1.07(Growth Assumption-4)

To learn how this formula was created, read on. To gain a grasp of what discounting free cash flows really is, it is highly recommended that this section be read and understood. Otherwise, skip to the Total Equity section.

The growth multiple is determined by projecting 20 years of free cash flows and discounting them to today's dollars. There are many discount rates that could be used. Historical average of inflation, historical average stock market returns, 75th percentile inflation. The list goes on and is open to personal preference and opinion. Choosing a discount rate is more art than science. Over the past 60 years, inflation was greater than 9% just 5 times (less than 10% of the time). Therefore, theDiscounted Free Cash Flow Screener uses a discount rate of 9%. That is, the projected future free cash flows are discounted by 9% per annum to arrive at the value of projected free cash flows in today's dollars.

To determine the projections for free cash flow over 20 years, the growth assumption is used to determine the first 10 years of free cash flows. For the purposes of the screener, this first 10 years of growth are limited to a range of 4.5% to 11%. The last 10 years are always assumed to grow at 4%. To understand what this all means, consider the following table which walks through a 10% growth assumption:

YearGrowthFCFdiscounted FCF (9% annually)
06 year average: \$100.00
110%\$110.00\$100.92
210%\$121.00\$101.84
310%\$133.10\$102.78
410%\$146.41\$103.72
510%\$161.05\$104.67
610%\$177.16\$105.63
710%\$194.87\$106.60
810%\$214.36\$107.58
910%\$235.79\$108.57
1010%\$259.37\$109.56
114%\$269.75\$104.54
124%\$280.54\$99.74
134%\$291.76\$95.17
144%\$303.43\$90.80
154%\$315.57\$86.64
164%\$328.19\$82.66
174%\$341.32\$78.87
184%\$354.97\$75.25
194%\$369.17\$71.80
204%\$383.94\$68.51
Discounted future free cash flows:\$1905.84
After 33% estimated taxes:\$1257.86

In the above table, 20 years of free cash flows are estimated using \$100 as the 6 year FCF average. This \$100 in annual free cash flow is assumed to grow at 10% annually for 10 years and then 4% for the next 10 years. These future free cash flow estimates are then discounted by 9% annually in the right most column. The right most column represents the future free cash flows discounted to today's dollars. In the bottom right, the discounted future free cash flows are totaled and reduced by 33% to account for taxes. In the above table, the initial \$100 of free cash flow is worth \$1257.86. This means that it is fair to pay \$1257.86 for this company since that is the value of the future free cash flows that are expected to be generated over 20 years. \$1257.86 represents a multiple of 12.57 on \$100. This multiple applies for any company that shares the assumption of 10% growth over the next 10 years. If the 6 year FCF average is \$200, all the numbers in the above table would simply double. So, \$1257.86 would double to \$2515.72. And 2515.72 divided by \$200 is still 12.57.

Using the above reasoning, growth multiples can be determined for various rates of free cash flow growth (for the first 10 years). The following table of growth assumptions to growth multiples was determined using the method described above:

Growth AssumptionGrowth Multiple
4%8.35
5%8.94
6%9.57
7%10.25
8%10.98
9%11.76
10%12.59
11%13.48
12%14.44
13%15.46
14%16.56
15%17.74

From these values, the following formula (best fit curve) was determined:

Growth Multiple = 8.3459 * 1.07 ((growth assumption)-4)

This formula correctly converts any growth assumption to the appropriate growth multiple.

TOTAL EQUITY

Total Equity is Total Assets less Total Liabilities. If all liabilities were to be paid off by assets, total equity is what would remain. In addition to the discounted future free cash flows (the 6 year FCF average multiplied by the growth multiple), the screener adds 80% of the most recently reported total equity to the intrinsic value calculation. The reasoning is that portions of companies are often bought and sold for various reasons. Because of this, it is fair to include a portion of total equity as part of the intrinsic value calculation.

The most recently reported value of Total Equity is used. The formula again is:

Value = (Growth Multiple)*FCF(6 year avg) + 0.8*Total Equity(most recent)

There is one issue that arises on occasion. Total Equity can be negative. Using the above formula, would actually provide undesirable results. For example, consider XYZ corp, having a growth multiple of 10, a 6 year FCF average of \$100 and total equity of -\$100. The following would occur:

Value = (10)*\$100 + 0.8*(-\$100) = \$1000 - \$80 = \$920

Because Total Equity is negative, it is not fully accounted for. The full value of the negative total equity should be used:

Value = (10)*\$100 + (-\$100) = \$1000 - \$100 = \$900

That is better, as the negative total equity is fully accounted for, Better yet, negative total equity should be more heavily weighted in order to represent a more pessimistic view. More than \$100 should be subtracted due to the negative equity. So, when a company has negative total equity, the following formula is instead applied:

Value = (Growth Multiple)*FCF(6 year avg) + (Total Equity(most recent))/0.8

So, in the case of XYZ corp, the following math occurs:

Value = (10)*\$100 + (-\$100)/0.8 = \$1000 - \$125 = \$875

EXAMPLE

Assume the following. FOO corp has a Growth Assumption of 8%. The 6 year average FCF of \$100 million and Total Equity is \$500 million, Value is determined by first determining the appropriate growth multiple. Applying the conversion formula:

Growth Multiple = 8.3459 * 1.07(growth assumption-4)

Growth Multiple = 8.3459 * 1.07(8-4)

Growth Multiple = 8.3459 * 1.07(4)

Growth Multiple = 8.3459 * 1.31 = 10.94

Now, applying the value formula:

Value = (Growth Multiple)*FCF(6 year avg) + 0.8*Total Equity(most recent)

Value = (10.94) * \$100 + 0.8*\$500

Value = \$1094+400 = \$1494

If there are 100 million shares of FOO corp, it's value is \$14.94/share (\$1494 million divided by 100 million shares).

ASSUMPTIONS

In creating this screener, several assumptions were made. They are discussed in the following paragraphs.

It was decided to use a 6 year FCF average. For explanatory purposes, consider 3, 6 and 9 year time frames. Supposing a 9 year average were used, companies with less than 9 years of data would be omitted. Also, the impact of more recent events would be minimized since each year has an in impact of about 11%. If 3 years of data were used, any single year which is “out of whack” could greatly impact the result since each year would have a 33% weighting. Because of these very simple reasons, a 6 year FCF average was chosen as a happy medium. With a 6 year FCF average, a valuation may be off due to one odd year of data, but it's effect would be to a much lesser degree since each year accounts for about 17% of the average. It is also thought that the 6 years of data is sufficient when normalizing most company data.

It was decided to weight total equity by 80% (multiple of 0.8). To better understand why, consider extreme cases of 0%, 100% and even 100%+ discussed in the following paragraphs.

A total equity weighting of 0% would mean that total equity has no impact. This is clearly not reasonable. As a simple example, most companies have cash and cash equivalents on the books. These items clearly hold some value. Therefore more than 0% needs to be accounted for.

A total equity weighting of 100% would have a possibly irrational impact. For example, 100% would assume that 100% of the assets are valid. For example, accounts receivable may not be collected in its entirety. The reason is simple. If a company owing money goes bankrupt, they will not necessarily repay their debts. And not paying their debts to the company being considered for investment is a possibility. 100% is the ideal case, but it is not always reasonable to account for all of the 100% since some of the assets might not turn out to be real assets.

As an odd case, a total equity weighting of more than 100% (100%+) is theoretically possible, but that would assume that a companies liabilities would not be resolved. It should always be assumed that a companies liabilities be resolved. If liabilities were not to be resolved, that would be akin to thinking the company being researched will not be able to pay it's debt and if that is the case, it is probably not worthy of investment due to more deeply rooted financial issues. Regardless, imagine total assets of \$100 million and total liabilities of \$50 million. This would result in a total equity of \$50 million (\$100m - \$50m). So, if only \$40 million in liabilities were to be accounted for, total equity would actually by \$60 million (\$100m - \$40m). A weighting greater than 100% should not normally be considered.

For the reasons in the above paragraphs, total equity weighting is more art than science and it should always be revisited in more detail when researching a company. Weightings from 0% to 100% to more than 100% are possible. 80% was chosen as a happy medium after taking the above ideas into consideration. Additionally, during the creation of the screener results were being reviewed. After reviewing the results that the screener was providing for larger well, known entities it was decided to use the 0.8 multiple (80%). As a side note, 70% was originally going to be used but it was later decided to increase that weighting slightly.

CONCLUSION

In using this screener, please remember that this is an idea generator and that further research and a more detailed valuation should be performed. The future free cash flow growth estimates and total equity weighting are not equal for all stocks. Each stock is an individual case which warrants deeper study.

NOTE: Companies that are more than 4 months delinquent with their annual reporting are not included in the results. Also, financial companies are excluded.

Link: Discounted Free Cash Flow Screener

Karl
Karl is currently a software engineer in Connecticut with a bachelors of science in electrical engineering from Clarkson University. He has been investing since 2001 and interested in value investing since 2005. Karl is continually striving to learn more about investment.

 Currently 3.36/512345 Rating: 3.4/5 (50 votes) Voters:

Gabriel Canelli - 7 years ago

Why can`t it be used for finantial companies?
The_laws - 7 years ago    Report SPAM
Could you point me to some documentation that describes the relationship of "fair value" in the DFC panel and "intrinsic value (DCF)" in the valuation box on the valuations panel. I was assuming they were the same thing, but I see hugely different values between these two values (take CAT for example). Is intrinsic value just one part of the fair value determination, or is there an inconsistency between the two panels mentioned above? Or am I just completely missing something?

Regards,

Doug

Gurufocus - 7 years ago
They are different ways of estimate the value of the companies.

DCF calculator is only applicable to Predictable Companies. The details are explained here:

Fair Value Calculator Tutorial
The_laws - 7 years ago    Report SPAM
Got it. Thanks!
Plkcma - 6 years ago    Report SPAM
The most comprehensive explanation I have seen for intrinsic value which is much talked about but seldom defined.

excellent.

Tryan112000 - 6 years ago    Report SPAM
Could you please explain why you subtract future taxes from the discounted future free cash flows? Since FCF starts with net income, which is already net of taxes.
Aldandrea - 6 years ago    Report SPAM
Now that you have segmented your subscriptions by geographic area, PLEASE PLEASE PLEASE segment your data in similar fashion too! If I subscribe to U.S. data, why would you think I want to see a list of non U.S. companies in my DCF search results? Here's a hint: I don't!

The GuruFocus site started out great, however, like so many commercial ventures today, your push for more and more revenues without the corresponding discipline to take care of the existing customer base, is nothing short of annoying and, frankly, insulting. At this point, after so many data snafus over the year, it will be difficult justifying a renewal until you get your act together.

Thank you.
Gurufocus - 6 years ago
hi Aldandrea,

by non-US companies do you mean the foreign companies traded in the US on Pink sheets?

We do have more coverages on Pink sheets, which may appear if they meet your requirements.
Et45 - 5 years ago

Dear Gurufocus --

If my vote counts, please ignore Aldandrea's suggestion. IMHO, he or she doesn't know how to appreciate a gift. Let's see, you're giving him *free* DCF analysis on companies in areas he/she is not paying for, and he/she is complaining about it? Is it really that difficult to just ignore the extra data? I wonder if he/she does the same with other gifts?

This customer says: "Thanks, and please continue to provide free DCF analysis on all the companies in your database. (And any other free info, too.) Who knows, if I see great DCF numbers coming from a market I'm not currently buying, maybe I might want to expand into it. But if you don't show me the info, then I'm blind, and I might not know when some great investments are passing me by."

Or how about this idea, Gurufocus? Maybe build a toggle into the Screener? So sensitive or touchy people can turn off data from markets they don't buy? And the rest of us can see it?

But if the toggle isn't feasible, please, don't stop giving the rest of us the extra info!

Kreshel47 - 3 years ago    Report SPAM

Tryan112000 stated, "Could you please explain why you subtract future taxes from the discounted future free cash flows? Since FCF starts with net income, which is already net of taxes."

Any cash left over to the owner, that is having already paid taxes is free - hence the name free cash flow. So why are you double taxing future cash flows? And is the double taxation truly applied to all DFCF screens? If so, we have a major error.

Eitherway, great article and you are right about "this is an idea generator and that further research and a more detailed valuation should be performed."

Keep up the great work, TeamGuru!

Open Mind Learning - 2 years ago    Report SPAM

Good article, I think by including 80% you are perahps being optimistic. Most companies do not have excess net assets ( like cash ) that come up to 80%. Some tech compnaies do but this is rare in the overall schem of things. The key is one shoul only add excess net assets , not equity becuase clearly some or all of the equity is needed to produce the cash flow, so it is like double counting. As an estimate which is all this can be, the percentage one uses shoudl be checked against the balance sheet to determine if the percentage used represents a fair approximation of the excess net assets.

Williama - 1 year ago

I want to echo Open Mind Learning's observation about adding back equity.

Most of a company's assets are needed to generate the cash flows, so it would be double counting to count both. It would be better to say, in effect, that the company would be sold for book value at the end of the 20 years. You then estimate its ending equity by growing it at the same rate as cash flows, and discounting it back at 1 plus the discount rate raised to the 20th power.

AndrewGoh55 - 1 year ago

Hi Karl,

How about if I need to do a valuation of a startup company that has been operating for several years but the cashflow is still negative for the last few years but will be positive for the coming next few years. Will I be using exactly the same method that you have described above?

Richday101 - 5 months ago    Report SPAM

GuruFocus stated above that FCF is reduced by 33% to account for taxes.

Tryan112000 and Kreshel47 pointed out the error 5 years and 3 years ago respectively and never got a reply.

Since GuruFocus did not respond, I have the following questions:

(i) Did they quietly correct the error of double deduction for taxes without acknowledging the error, or

(ii) Do they continue to use the incorrect formula "FCF minus 33%xFCF (estimated for taxes)".

I am hopeful the former is true. Hopefully we can get an answer from GuruFocus.