In the previous chapter, evaluating the pizza machine’s price involved looking at its future cash flows and discounting them to the present value, then adding them up for a total NPV. We also contemplated how the company’s stock might be priced with an estimation of its future cash flows.
We need to consider what type of cash flow we are discussing here and how we can predict the future flow of money for a business.
– The Free Cash Flow (FCF)
When conducting a DCF Analysis, the cash flow, known as the “Free Cash flow (FCF)” must be taken into account. This is the money left over after capital expenditures have been factored in – like buying land, constructing buildings and purchasing machinery. This extra operating income is what shareholders benefit from and is essential to determining whether a business is in good health or not.
Consequently, the company’s free cash is what remains after deductions for investments and other outgoings.
The financial health of a business is often gauged by its free cash flow. Investors seeking undervalued stocks where the share price hasn’t reflected the increased free cash flow, will invest in these businesses with an expectation that in time the share prices will rise.
Thus, the Free cash flow reveals if the company has produced earnings in the given year or not. Therefore, to assess the firm’s genuine financial situation, investors should consider both Free cash flow and earnings.
FCF can be easily determined by referring to the cash flow statement. The equation is
Cash from Operating Activities – Capital Expenditures = FCF
We can work out ARBL’s free cash flow for the past three years.
In this ARBL’s FY14 annual report, you can use the figures to arrive at the free cash flow.
Please take note that the Net cash from operating activities is computed after taking income tax into consideration. The Net cash from operating activities is shown in green, whilst capital expenditure is highlighted in red.
When the goal is to calculate future free cash flow, it may be perplexing as to why we are looking at historical free cash flow. The answer is quite simple–we use the DCF model, and when utilising this model, it is necessary to forecast future free cash flow estimates. To do so, we assess the average historical free cash flow and then gradually increase it by a determined rate. This practice is an industry standard.
We should ask ourselves how much we expect to grow. It’s best to make this estimate as conservatively as possible. I personally like to calculate the free cash flow for a period of at least 10 years. Initially, I raise the cash flow for the first five years at a certain rate, followed by applying a lower speed for the subsequent five. If you’re feeling uncertain, I recommend going through this process step-by-step in order to gain better understanding.
Step 1 – We need to calculate the average free cash flow.
To start, I will gauge the average cash flow for ARBL over the last 3 years.
= 209.7 + 262.99 + (51.6) / 3
To ensure an accurate representation of ARBL’s cash flow, it is recommended to take the average free cash flow figures over the past 3 years. This eliminates any extreme outliers caused by cyclical events and provides a more reliable basis for analysis. As an example, the latest year’s cash flow was negative at Rs.51.6 Crs., which doesn’t accurately represent the business’ performance.
Step 2 – Identify the growth rate
Choose a rate which you think is sensible. This is the speed of growth for future cash flow. I normally opt for two periods of growth. The initial five years, and the ending five years. Regarding ARBL, I’ll go with 18% in the first stage and 10% in the latter. When considering a fully grown business that has reached a notable size (as in large-cap companies) I would lean towards 15% and 10%. You have to be careful in this.
Step 3 – Estimate the future cash flows.
The average cash flow for 2013-14 was Rs.140.26 Crs and with 18% growth the figure for 2014-15 is estimated to be higher.
= 140.36 * (1+18%)
= Rs. 165.62 Crs.
It is projected that the free cash flow for the fiscal year 2015 – 2016 will be…
165.62 * (1 + 18%)
= Rs. 195.43 Crs.
So on and so forth. You can check the detailed calculation here:
An estimate of future cash flow –
We now have a good understanding of the potential free cash flow. Naturally, you may question its accuracy as it involves predicting sales, expenses and other business aspects. The number is just that: an estimate. To ensure accuracy, we have been as conservative as possible when establishing the growth rate of 18% and 10%. These figures are reasonably conservative for a well managed growing business.
– The Terminal Value
We have attempted to forecast the future free cash flow for up to a decade. However, it’s highly unlikely that the company would no longer exist in the 11th year. It is expected for a business to be an ongoing concern that persists for an indefinite period. This also implies that as long as the company is in existence, some level of free cash will be produced. On the other hand, as companies become more established, the rate at which free cash is generated tends to fall.
The Terminal Growth Rate beyond 10 years (2024 onwards) is commonly assumed to be less than 5%. My personal preference lies between 3-4%, never exceeding that boundary.
The “Terminal Value” is the sum of all future free cash flow after the 10th year, also known as the terminal year. To compute this value, take the cash flow of the 10th year and expand it according to the terminal growth rate. Nevertheless, a different formula is used since we are estimating its worth indefinitely.
Terminal Value = FCF * (1 + Terminal Growth Rate) / (Discount Rate – Terminal growth rate)
Take note that the FCF for the 10th year should be used for the terminal value calculation for ARBL. We’ll use a discount rate of 9% and a terminal growth rate of 3.5%. Now let’s figure out this company’s terminal value.
= 517.12 *(1+ 3.5%) / (9% – 3.5%) = Rs.9731.25 Crs