Value Investing Ideas

Of all the investing literature I have read (and I’m talking Greenblatt, Graham, et. al), it seems that this topic gets very short shrift. However, to my mind (based largely on tracking down everything Bruce Berkowitz has ever said or written publically), it is perhaps the most important topic for a value investor. I can almost understand why this is so. Free cash flow (FCF) is not easy to calculate, and you will not find it in most financial statements nor on online sources. However, to my mind, it is absolutely critical to understand and compute.

Okay, what is FCF? Forget the formal definition for a moment - I assume most could reel it off. Free cash flow is simply the money that is left after you have paid for everything - labor, expenses, research, periodic replacement of equipment, lawsuits, etc. That may sound like earnings - sometimes it is, sometimes it isn’t. Take your personal finances for a moment - you get paid, say, twice a month, and pay your bills. At the end, you (hopefully) have cash left over. However, unexpected things come up - medical bills, an unplanned vacation, gifts to the grandchildren, replacing the roof, whatever. Only after all of that can you really say I have X leftover. That amount is your free cash flow.

Its extremely important to know FCF for a company because this tells you what money actually flows to you, the owner. The money can be used in many ways. It could be used to grow the company, buy back shares, pay for dividends, or just build up in a bank account, reducing the enterprise value to you. It’s a measure of a healthy company, one that can pay for business with cash, not debt.

So, what price to pay for FCF? You will often see multiples bandied about: XYZ is trading at 8x trailing FCF. These multiples are compared to peers, announced as attractive or not, but why? What’s a good price to pay?

As always, we need to perform a discounted cash flow. And, as always, we shy away because who wants to pull out Excel?

Well, you don’t need Excel. There’s a trivial formula that allows you to do it in your head. It’s merely the first year’s FCF multiplied by 1/d, where d is the discount rate. The typical discount rate is 10%, so 1/d = 10. So, multiply the FCF by 10. Easy peasy. Done. If this year’s FCF is $23.8MM, you would be willing to pay $238MM for the company (Enterprise value, of course).

“But wait!” you say, XYZ is supposed to grow, which means FCF will grow. That formula is worthless.

Not so. Just subtract the growth rate from the discount rate. So, if you are going to grow FCF at 3%, then you would have $23.8MM * 1/(10%-3%) = $340MM. If they are going to shrink, add the shrinkage: $23.8MM * 1/(10%+4%) gives the value if FCF reduces by 4% a year.

This may appear counterintuitive: what if the growth rate is 10%? The formula tries to divide by zero, implying the security is worth infinite money. Well, it is. Assume I give you $1 dollar today, $1.1 next year, $1.21 next year, $1.33 the next, etc, 10% more each year. Well, our discount rate is 10%, so next year’s $1.1 is worth $1 today. The $1.21 I’ll get in 2 years is worth $1 today. We have an infinite series of $1 bills.

“But Grape grows at 40% a year, you say. Why isn’t their stock priced in the billions per share? ” Well, first of all, Grape probably doesn’t grow FCF at 40%, but some other measure. But secondly, this kind of growth is never sustained. In 20 years at that pace the company would be worth more than the entire United States. So calculations for these big growth stocks use another formula, one that assumes say 10 years of high growth, 10 years of modest growth, and then a plateau. Ben Graham gives a formula for this, if you are inclined. I avoid this stuff, because you will soon see how wildly the value changes based on just a 1-2% growth change. My crystal ball is not that finely tuned. As an aside, I see “Grape” stock valued at absurd values, assuming this kind of infinite growth. If you do this kind of calculation, look at the actual end value of the company. If you are calculating that it will be selling $250B of i-matches in 20 years, think again. Ain’t no market can absorb that many of anything.

Okay, so there you are. If you want to buy Coke, and your discount rate is 10%, multiply FCF by 10. If it is 15%, multiply by 6.7. I seem to remember some famous investor in Coke who can value companies in his head in about 15 seconds. What was his name? Buffer? Buffy? Something like that…. everyone wonders what his secret is. It’s just simple math.

Edit: I left out an important point. If your DCF says the FCF is worth $300MM, that means you should be indifferent about getting $300MM today, or the cash flows for the forseeable future. In the real world, that is madness, because who can perfectly predict the future? You need to be compensated for the risk you are taking. So, we look for a discount to the FCF. If the DCF value is $300MM, and the enterprise value is $280MM I’d probably pass. If the enterprise value was more in the $150MM-200MM range, and all other factors looked good (good management, solid balance sheet, etc), then I would snap it up.

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