Why investors buy stocks? Investors buy stocks to generate two types of cash flows. First, for dividend incomes, which are paid as long as the stock is held by the investor. Second, for capital appreciation, which is earned when stock is ultimately sold.
If one can focus only on dividends paid by the company, intrinsic value of companies can be easily estimated. But the problem with focusing only on dividend is that, not many company pay dividends.
So, what is the alternative?
The alternative is to consider Free Cash Flow to Equity (FCFE) instead of dividend alone.
Free cash flow to equity (FCFE) is a measure of potential dividends that a company could have paid to its shareholders.
How to calculate FCFE?
Companies report net profit (PAT) of their business each year. Net profit (PAT) is the most talked about value among investors.
Net profit is not same as free cash. Companies must utilize this fund in wisely to keep the business running for long term.
Though it is totally on discretion of the management how to use PAT, but if company do not use PAT wisely, long term growth of company will get jeopardized.
Hence all good companies use their net profit (PAT) ingeniously to fund their future growth. How?
They reinvest part of PAT back into companies business. How?
This reinvestment is done again in two ways, to fund the purchase of ‘long term assets’ and ‘short term assets’.
Long term asset purchase is done using capital expenditures (Capex). For valuation purpose, we will use net capex. Net capex = Capex – depreciation.
Short term asset purchase can be identified by looking at change in companies inventory & change in account receivables. This is called change in working capital. Increase in inventory & account receivables represents locked-funds. The locked funds do not generate income for company. [Change in working capital = (inventory for year n – inventor for year n-1) + (account receivables of year n – account receivables of year n-1)]
FCFE = Net Profit – Net Capex – Change in working capital.
Estimate intrinsic value of stocks by recording last 10 years data from companies financial reports.
Next, forecast the next 5 years free cash flow based on last 10 years data.
Free cash flow is one value which is most critical in terms of stock valuation by discounted cash flow model. For novice, net profit declared by companies in financial reports can be treated as free cash flow.
But for more accurate stock valuation, one must also consider that part of profit which has been reinvested back into business.
Hence free cash flow in this case will be slightly reduced (net profit – reinvested money).
The money that is reinvested back into business is used to purchase long term asset & short term asset. Both these type of asset purchase will generate future cash flow for the company.
It is essential for companies to keep buying long term assets and short term assets. A company which does not keep improving its asset base will find it hard to generate free cash flow in future.
All good companies invest a substantial part of its net profit in form of CAPEX. Using CAPEX, they buy long term assets.
To conclude, a company which is able to generate consistent free cash flow, with reasonable growth rate can be considered as good buy.
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