Geoff Gannon January 30, 2006

On the Free Cash Flow Margin Method

There are several ways to value a business. Investors often disagree on which to use.

I’ve already mentioned using a DFCF analysis based on a free cash flow margin estimate and a sales estimate for a series of years. I used this method explicitly with (OSTK) and implicitly with Lexmark (LXK). Before reading further, you may wish to review those two examples: “On Overstock” and “On Lexmark”.

The free cash flow margin method has several important benefits:

The analyst needs to focus on only two things: revenue growth and the free cash flow margin. The estimate of the free cash flow margin can be based on quantitative data such as the company’s historical FCF margin, the industry’s historical FCF margin, or gross margins within the business. It can also be based on qualitative data like the variability in those margins, the ability of the business to raise prices in a period of inflation, the nature of competition within the industry, and the company’s competitive position. In cases in which the FCF margin has been consistently and extraordinarily wide or narrow, the quantitative and qualitative data will likely agree.

The analyst is forced to make his assumptions explicit. By using exact projections of sales and the free cash flow margin for each year, the analyst is forced to see just how reasonable or unreasonable his assumptions are. Static multiples and simple equations based on a company’s growth factor let the analyst arrive at a valuation without necessarily knowing what his projects for any given year are.

When projecting growth rates into the future, it is very easy to overlook the cruel realities that mitigate the continuance of any trend. Both static multiples and DFCF calculations based on returns on capital and growth rates will often lead to projections of unachievable sales numbers. You may think you are being very conservative in your growth projections for Google (GOOG); however, when you look at the actual revenue needed to support your valuation, you may find you are assuming far more than you thought. That is why I went over the resulting revenue numbers in the Overstock analysis. I wanted to demonstrate that the revenue growth assumptions were not unreasonable, even going out thirty years.

The factors that determine a business’ free cash flow margin are the keys to understanding, and properly valuing, that business. In coming up with an estimated free cash flow margin, the analyst must ask questions about the nature of competition in the industry, the relation of tangible assets to intangible assets, the profitability of the business, the capital spending required to maintain that level of profitability, the stickiness of a business’ customers, the differentiation of its products, and the business’ ability to raise prices. These are important questions. They need to be asked regardless of the method of valuation used. So, why not use a method of valuation that is inherently focused on these crucial questions?

The free cash flow margin method automatically breaks out what portion of the intrinsic value of a business is derived from each year. Again, this is an advantage over a compact equation. You can still use a terminal value in the free cash flow margin method. Whether you should or not will really depend on the business you’re analyzing. You should for Coke (KO). You shouldn’t for Journal Register (JRC).

Other valuation methods can be adjusted to provide many of the same benefits I’ve described. I will discuss several different valuation methods in my next post. For now, I just wanted to introduce you to the method I used in the Overstock post.

For the Overstock post, I used a model requiring ten pieces of information: discount rate, sales, four free cash flow margins, and four sales growth rates.

I broke the analysis down into four future periods: 1 – 5 years, 6 – 10 years, 11 – 15 years, 15+ years. Then, I estimated a free cash flow margin and sales growth rate for each period (these were my four assumptions).

I set the discount rate at 8%. A lot of people will say that’s too low. For several years now, all my DFCF calculations have used a discount rate of 8%. I don’t believe in adjusting the discount rate for risk.

Risk is the most important factor in any investment decision. It is accounted for at every step along the way: in the qualitative assessments, in the use of conservative estimates, in the solvency analysis, in the margin of safety, etc.

Adjusting the discount rate for risk destroys the utility of the DFCF calculation as an analytical tool. I want the DFCF calculation to tell me what the business is worth given my assumptions. Whether I actually buy the business or not I can decide for myself. Therefore, an 8% discount rate is appropriate.

The free cash flow margin method is just one of many ways to value a business. My next post will look at a few of the others.

Further Reading:

Free Cash Flow Margin

Discounted Future Cash Flow

Growth Factor

Return on Capital

On Overstock

On Lexmark