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The Discounted Free Cash Flow Screener focuses on Free Cash Flow (FCF) and Total Equity. These measures can be used to determine an intrinsic value estimate for a company. This article discusses the importance of free cash flow and total equity and describes how GuruFocus arrives at an intrinsic value estimate.

To understand the importance of free cash flow, please read the following from the 1992 Berkshire Hathaway Chairman’s Letter in which Warren Buffett wrote the following:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows — discounted at an appropriate interest rate — that can be expected to occur during the remaining life of the asset. -1992 letter _{(all letters )}

Free Cash Flow is the money generated in a year which can be used to grow the business and pay dividends. Free cash flows can be thought of as being similar to the payout of a CD or bond. While CDs and Bonds reward the holder with cash, not all of the free cash flows are handed back to the investor as dividends. In some cases, no dividends are paid and all of the free cash flows are reinvested by the company on behalf of the owner.

With a company, the free cash flows are what is left for reinvestment. With CDs and bonds, the dividends can be used for reinvestment. In this manner, free cash flows can be thought of as being equivalent to the return of CDs and bonds. Free cash flow is what a business owner is interested in creating.

THE FORMULA

Based on the 6 year free cash flow average, total equity and free cash flow growth assumptions, the following formula is applied

Value = (Growth Multiple)*FCF_{(6 year avg)} + 0.8*Total Equity_{(most recent)}

The free cash flow growth assumptions translate into the Growth multiple in the above formula. In the case of negative total equity, the following formula is used (see the Total Equity section for the reason):

Value = (Growth Multiple)*FCF_{(6 year avg)} + Total Equity_{(most recent)} /0.8

The Growth Multiple, 6 year average of FCF and Total Equity are discussed in the sections that follow.

6 YEAR FCF AVERAGE

The screener uses a 6 year average of Free Cash Flow. The reason for this is to smooth the peaks and valleys that can occur in any single year of reported data. This average acts as a way to normalize the FCF data.

In addition to the past 6 years of annual FCF data, recent quarterly data is also included. So, this 6 year average is technically the average FCF over the past 6 to 6.75 years. The reason for the inclusion of quarterly data is simple. GuruFocus believes that the most recent data should be included in order to give the best results possible. For purposes of discussion, the term “6 year FCF average” is used, even though this is actually anywhere from 6 to 6.75 years.

There is still one small issue. The 6 year free cash flow average is currently treated as a trailing average. The 6 year free cash flow average is really an average centered around a date from 3 years prior. So, the 6 year FCF average needs to be adjusted forward by 3 years. For this purpose, we assume that inflation is 3.3% per annum This creates a multiple of 1.1023 (1.03 3 ) that is used to adjust the 6 year average slightly.

So, if free cash flow for ABC Corp were $1, $2, $3, $4, $5 and $6 million over the past 6 years the average would be $3.5 million. However, this average is multiplied by 1.1023 to give an adjusted average of $3.858 million. This $3.858 million is the 6 year average that is used by the screener.

This 6 year FCF average is the basis for the “cash inflows and outflows” that Buffett refers to. By making assumptions about future free cash flows and discounting those free cash flows “at an appropriate discount rate”, the value of the future free cash flows in today’s dollars can be determined.

The next section discusses the discounting of future free cash flows using the 6 year FCF average as a basis.

GROWTH MULTIPLE

The growth multiple is a multiple that is based on a growth assumption. GuruFocus uses various historical growth numbers (EBITDA growth, revenue growth, etc) to come up with an assumption of future growth. This growth assumption is determined and then restricted to a range of 4.5% to 11%. This growth assumption is then translated into a proper growth multiple which is in the range of 8.63 to 13.48. Multiplying the 6 year FCF average and the growth multiple together provides an approximation of the sum of all futures estimated free cash flows in today’s dollars.

The following explains how the growth multiples were determined based on the various growth rates. To determine a formula, growth multiples for growth rates ranging from 4% to 15% were determined. Based on the samples, a best fit curve formula was created. The formula is as follows:

Growth Multiple = 8.3459 * 1.07 (Growth Assumption -4)

To learn how this formula was created, read on. To gain a grasp of what discounting free cash flows really is, it is highly recommended that this section be read and understood. Otherwise, skip to the Total Equity section.

The growth multiple is determined by projecting 20 years of free cash flows and discounting them to today’s dollars. There are many discount rates that could be used. Historical average of inflation, historical average stock market returns, 75th percentile inflation. The list goes on and is open to personal preference and opinion. Choosing a discount rate is more art than science. Over the past 60 years, inflation was greater than 9% just 5 times (less than 10% of the time). Therefore, theDiscounted Free Cash Flow Screener uses a discount rate of 9%. That is, the projected future free cash flows are discounted by 9% per annum to arrive at the value of projected free cash flows in today’s dollars.

To determine the projections for free cash flow over 20 years, the growth assumption is used to determine the first 10 years of free cash flows. For the purposes of the screener, this first 10 years of growth are limited to a range of 4.5% to 11%. The last 10 years are always assumed to grow at 4%. To understand what this all means, consider the following table which walks through a 10% growth assumption: