Let’s start with depreciation and amortization. We add them back for the reason I mentioned in the previous post: they are non-cash expenses, so the company is not actually using this cash year to year. For tax purposes, they can put it in their books and write it off as an expense, but we don’t care about that. We want to see what cash they have on hand to gauge the year-to-year changes more accurately.
The second part is more difficult. If you not the equation in the previous post, we subtractthe change in working capital. That is, if working capital goes up year over year, we subtract the amount that it went up by. To visualize this, assume that a company during the year paid down some of its bank loans, but sold more products than expected (thus increasing accounts receivable, a fancy name for what it is owed by debtors). As a result, the company’s current assets (which includes cash and accounts receivables) increased, but our current liabilities (which includes short term bank loans) decreased.
By simple math, more current assets minus fewer current liabilities means that our working capital increased. Therefore, in the free cash flow equation, this will reduce our FCF since the change in WC increased.
The final piece of the equation is the CapEx expense of the company. We subtract out these investments that year, since the company is actually using cash to buy the equipment or plant that it can depreciate over the next five or ten years.
The mechanics are more complex, so if you’re interested, check out this page on FinWebfor more background on FCF.
[For the more advanced students: I do realize this is pretty simplistic. My goal here is to help you understand in general how to value a company, because building an actual model would take many more hours.]
Now that we have this item known as free cash flow, we have to forecast this out over a period of five or ten years. As I mentioned earlier, we can use the expected growth rate of the company for that period. It might be 5% a year, but it could be higher or lower depending on the individual company. [side note: in practice, modelers might forecast the actual inputs to free cash flow, such as all your income statement items like revenue and expenses, but obviously that requires a lot more work.] Assuming 5% annual growth, we forecast all these cash flows forward and then estimate a terminal value for the company at the end of the forecast. All this means is since we can’t forecast accurately a large growth rate indefinitely (especially for a fast-growing company), we pick a more modest growth rate, such as 2 or 3%, and call this our growth into perpetuity rate. Computing a terminal value is slightly more complicated, but you can find out more here.
The final step is to take the net present value of all these cash flows and terminal value by discounting it back to the present day (i.e. today). The rate we would use is the weighted average cost of capital (WACC). The WACC is a blended rate of what it costs the company to issue both equity (stocks) and debt (bonds or notes) versus how much of the company’s capital structure is made up of equity and debt. If a company has a bank loan of $5 million and equity outstanding for $10 million, then the capital structure would be two thirds equity, and one third debt.
If the cost to the company to have this outstanding equity was 12%, and the interest rate that they paid the bank was about 6%, then we could calculate the WACC as follows:
2/3 * 12% = 8%
1/3 * 6% = 2%
Thus, we would say that the weighted average cost of capital to this company is 10%.
Whew, getting tired yet? Didn’t think this was going to be a math lesson? There is a tiny bit more. Now that we have the WACC, we need to discount this back to the present day, and this is slightly complicated as well. If you have Microsoft Excel, you can do this with the =NPV() function. Otherwise, you have to take the FCF for year 1, 2, 3, etc. and divide it by (1 + 10% = 1.1) RAISED to the power of that year (1, 2, 3…). So, the fourth year would look something like this:
NPV4 = FCF4 / (1.1)^4
I apologize for the fact that I can’t show prettier formulas, but when I get a chance I’ll try to convert them over using Word’s formula function. So, once we discount each of the years back to a present day value, we simply add all these amounts together, and that gives us our enterprise value. If we subtract out net debt (or if we add in cash and subtract the debt), this gives us the equity value of the company. If we divide this value by the number of shares outstanding, theoretically this would give us a value for the company per share.
And that is more or less what we are looking for. This per share value should be higher or lower than the current trading price of the company. This gives us an indication of whether the company is under- or over-valued, respectively. As I mentioned before, we want to scenario test this number because it is highly unlikely that we can accurately forecast interest rates and growth rates 5 or 10 years into the future. So we vary them. Our WACC can be changed to anything between 5% and 15%, and the growth into perpetuity can be anything between 0% and 6%. All of the permutations of the interest rate changes would produce a slightly different per share value. The main objective is to give yourself a comfortable margin of safety, so to speak, so that you have high confidence if a company is undervalued and you want to buy the stock.
Again, I realize that this was a fast overview of a pretty complex topic, so if you have questions, write them in the comments. If you are looking for further reading on DCFs, see here. I hope that this was helpful!