My Valuation Methodology: It Answers 'Why'

by: Ian Croci
Summary

I have not widely seen Free Cash Flow Total Return used.

Through a constant questioning of "Why" a business will provide an investor returns, FCFTR is perfect at answering this question.

By using FCFTR, we can understand the relationship between a stock price and the market's expectations.

If one's expectations of a company are higher than the market has priced, and those expectations are proven accurate, alpha will inevitably follow.

I have spent the better part of the last year trying to determine how best to arrive at a fair value estimate for a company. DCF models seemed flawed, and overly complicated to me. It seemed as though they are highly susceptible to being upset by rapidly changing quarterly expectations. I wanted to find a way to value a company that doesn't change on a quarterly basis, except with drastically changing long-term prospects of a company. By doing this, it then becomes possible to identify when the market is overvaluing a company, and to sell high, and to identify when the market is undervaluing a company, and to buy low.

Understanding Dividend Growth Investing

I started as a dividend growth investor, looking for businesses themselves to pay me directly through the only method available, dividends. If I own a company, and reinvest all dividends, I can grow my income not only through dividend hikes, but also based on how many additional shares per year I can purchase with these dividends, the yield. The dividend growth rate comes from two primary sources: buybacks, and organic growth.

If a company generates an average of $60 billion dollars per year in free cash flow "FCF", and currently trades with a market cap of $725B (AAPL), the company is trading at a FCF yield of 8.3%. With a current dividend yield of 1.9%, the company has 6.4% of its market cap available for share repurchases each year. By buying up 6% of outstanding shares, the company reduces its dividend commitment by 6% per year - or, it can put the savings directly back into its commitments, resulting in roughly a 6% increase in the dividend. This is the first, simplest way to increase the dividend on an annual basis. It's directly related to the current valuation of the company - a company trading at a FCF yield of 12% can buy back, or pay out through a dividend, twice as much as a company trading at a FCF yield of 6%.

Second, is the growth of this FCF figure. Because capital expenditures may be staggered on a year-to-year basis, I find it's actually more useful to follow net income here. Hypothetically, if a company is reinvesting its earnings to grow, it should be generating a higher return on its investment than by simply repurchasing stock, so anything spent on this effort is often worth more than FCF. This is worth looking into on a company-specific basis. Further, it's important to look into any differences between net income and FCF other than capital expenditures - for instance, if receivables are growing, and inflating net income, but never seem to make it onto the company's cash flow statement, this is a significant problem. Again, all of these things are worth looking into on a company-specific basis. By observing the historical rate of earnings growth, against how much reinvestment of net income it required to generate this growth, we can come to a growth rate.

A company, thus with a net income growth rate of 10% on average over the last five years, with an average FCF yield of 8%, of which 1/3 is used for a dividend yielding 2% on average, could have bought back an average of 6% of outstanding shares per year without affecting the balance sheet, and increased the dividend by 16% per year. If this net income growth can be maintained forever, the company would indefinitely be able to achieve this, and should provide investors with 18% returns per year forever, or until the price of the company rises to decrease the FCF yield, which would directly limit the ability of the company itself to reward investors.

However, if the company's future net income growth prospects were to taper off, more to the tune of 5% per year, the current FCF yield of 8% would only give the ability for the company to raise its dividend by 11% per year, on a 2% yield. For investors reinvesting their dividends, they would see their income growing at "only" 13% per year. If the market decides this is not good enough, the price on the company may drop, leading to a higher FCF yield, potentially in the vein of 12%, so that future return expectations of 17% are more in line with historical returns of 18%. But, to someone who had already identified that 13% was a reasonable estimate for future returns, and thought it was acceptable, the significant decline in price (a 50% higher FCF yield would require a 33% drop in price) is simply an opportunity for both the company to buy back more shares, the shareholder to get more shares through reinvestment, and for the shareholder to allocate a larger percentage of their portfolio to this investment that now appears to carry a total return of 30% more than originally identified and deemed acceptable.

Free Cash Flow Total Return

By identifying the two core things that drive a dividend, and its growth rate, I identified the most important drivers of a company's long term total return picture. The dividends, at this point, are in a way, irrelevant, once we've identified what drives it. Free Cash Flow Total Return is an uncommon methodology, but describes these drivers perfectly. Everything comes back to Free Cash Flow Total Return, which can be understood as Average FCF Yield + Long Term Average Growth Rate.

In tandem with understanding the FCFTR, I've decided on a concrete target return, 10%, to go along with it. This is the value I designate as "fair value". The thought process is that 10% per year generally exceeds the market's average total returns, and, indeed, is often the maximum target for any "retirement calculator" one can find on the internet. If 10% is the maximum target, one can hold a stock at an expected 10% annual return and do fairly well, relatively speaking.

The catch with this target return of 10%, is that any company with a high single digit, or double digit, growth rate leads to very low (or negative) FCF yields being filled into the formula. The workaround for this problem, is to estimate a future in which the growth rate reaches its terminal status. One can, using this, estimate a fair value for the company, and also discount this fair value according to any risk it may take for the company to realize this estimated future.

In a recent Netflix(NFLX) article, the author provided a path to a future FCF of ~$15 billion, in an estimated 10 years. At this future point, the growth going into the last year was 6%. By reducing this to 5% for the time going forward, because growth was still slowing, we can fit it into the formula.

5% Growth + x% FCF Yield = 10% Target

Solving for x, we expect a 5% FCF yield, or for the stock to trade at 20x FCF. This would have the company trading at $300B in 10 years, plus any cash they've accumulated over this time, which using his example, was $360B. Theoretically this net cash could be used for buybacks, or dividends, but without estimating future share price, I believe it's best to simply add it on the top. By dividing out a 10% capital appreciation per year from this $360B figure, (360/(1.1^10) we would arrive to a fair value of $138.8B for today. However, this same 10% target return is likely to be attainable from far less risky investments, and I would suggest that one shouldn't be willing to pay fair value against a future that may not come to pass. Instead, we should use a higher target return to reach this future target fair value, to discount the significant execution risk. Personally, I like 20% in this case. This is where Netflix fails, in a very big way, to justify my investment today. By dividing out the discounted 20% rate (which is still much less than Netflix shareholders have come to expect over the last many years), I come to a risk-adjusted fair value of $58.1B. Against today's $140.4B market cap, I can only conclude that, while Netflix may be fairly valued if it reaches the lofty goals set for it, it is tremendously overvalued on a risk-adjusted basis, to the tune of 141%.

When using this formula, I thus think it's best to use in two different ways. One, in valuing a mature company that can be expected to grow no more than at a 6% average over the foreseeable future, leading to a valuation at a FCF yield of 4% or greater. This also works for companies in a slow, drawn-out decline. A company declining at 2% per year can easily trade at a FCF yield of 12%, or about 8x FCF, and continue to return 10% per year indefinitely. Second, as in the Netflix example, of estimating a company's future. For companies with significant execution risk, like Netflix, the discount rate should be 20%, or perhaps even higher, for any potential of future success. For companies already generating good FCF, a lower discount rate is certainly acceptable. If a company is trading at a 3% FCF yield, for instance, it's already creating a reasonable amount of profits, and might only deserve an 11-12% discount rate to its estimated terminal peak, because there's far less risk of catastrophic failure.

How To Optimize Your Use of FCFTR

Once you understand a company's future growth prospects, FCFTR allows you to input your target returns (which may be higher than my target 10%), and derive a FCF yield from it. Buying at any FCF yield higher than this, so long as you are accurate in your assessment of future growth, is a guarantee that your purchase will eventually work out. Of course, an accurate understanding of the company's future is never a sure thing, so this is the risk that must be considered. The better one's understanding, the less risk is entailed. No matter what the share price does, you will always have a clear direction of what to do. If the FCF yield is higher than FCFTR requires for a given growth rate, it's a buy. If it gets higher, it's a "buy more".

However, if the FCF yield drops below the FCFTR target, it's a sell recommendation, unless you can find new information to justify either a higher long-term growth rate, or a larger terminal size. The stock price may do whatever it does - if one wishes to capitalize on this, it may be intelligent to begin staggering one's sales over the next 3 months to a year. However, if you've accurately assessed the company, it will be completely and totally unable to meet your target returns over the long term from this price point, an an exit strategy should be considered. There is no reason to hold it, and certainly not if you've got any other options available that FCFTR is showing as better buys.

FCFTR requires an accurate assessment of any company you buy. Without this accurate assessment, your results will be just as inaccurate. It pays to gain as much understanding as possible, in this respect. Further, by setting a target return of 10% (which I, in general, think the market is willing to accept as a fair value as well), and being willing to sell, it is possible to successfully close out trades with high rates of capital gains. By buying at FCFTR of 14% (8% FCF yield, 6% growth rate), one can hold the stock until it rises 100% (to a 4% FCF yield), and sell it at fair value. This is in addition to as many years of 14% returns as the company naturally returns due to its valuation. If this process takes 2 years, one would see a natural gain of 30%, and then see a 100% due to a correction of valuation, leading to a total of 160% total returns in 2 years. Because the company is at fair value, there is no further alpha to be generated here, and it's best to move on.

Share Price

$50 $75 $80 $40 $100

Average FCF

$3 $6 $8 $4.80 $15

Yield of Average FCF

6% 8% 10% 12% 15%
Long Term Average Growth Rate 3% 4% 1 -4% -1%
FCFTR 9% 12% 11% 8% 14%
Fair Value $42.86 $100 $88.89 $34.29 $136.36
Change to Fair Value -14.3% +33.3% +11% -14.3% +36.4%

By buying when FCFTR is highest, it is possible for an investor to gain the benefit of these target returns indefinitely. Because the future growth rate is targeted as the average of all future years, (this is important when you fill the variable in), the investment must eventually average the target return. If the price drops further in the meantime, it will lead to a temporarily-higher FCF yield, and plausibly more shares bought back during this time. This will amplify long-term returns, and as such, any further decline in valuation is not only an opportunity for the shareholder to buy more shares, but an opportunity for the company itself to amplify its shareholders' returns. It's thus not required to buy dips, as the company will aid you in this. By buying the dips yourself, however, you're extracting maximum advantage.

Conclusion

Buying a selection of companies all offering exceptionally high readings reduces the risk of being wrong about any single one. In limiting your portfolio purely to high FCFTR readings, you will optimize your returns greatly. In selling high-growth stocks when they reach low FCFTR readings, you will additionally reduce risk considerably. Once again, as a final mention, a deep understanding of any company on a big picture level is the most critical piece of the puzzle to making FCFTR work for you. Accuracy is absolutely critical, and so one should work to identify any issues that my impair the expected success of the company, and discount the potential for these issues against the expected growth rate of the company accordingly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.