Question on DCF

Hi Experts,

Was doing some in-depth analysis and decided to do some DCF Valuations. I have a couple of what is probably basic accounting questions, but would really appreciate it if I could get some help.


1) I understand that Free Cash Flow = EBIT + Depreciation/Amortization - Changes in Working Capital - CAPEX

Do I also need to add back other items such as goodwill impairment? Since these are similar to depreciation in that they are just paper expenses?

2) Change in Working Capital
I was under the impression that Change in Working Capital is just Current Assets - Current Liabilities.

However, it seems that in the AR's Cash Flow statement, the "movement in working capital section" isn't so simple. What items in the Statement of Finance Current Assets/Current Liabilities tie back to the Cash Flow?

I hope my questions are clear. If not I can elaborate.

Hi vader1671,

(04-01-2015, 03:51 AM)vader1671 Wrote: 1) I understand that Free Cash Flow = EBIT + Depreciation/Amortization - Changes in Working Capital - CAPEX

Do I also need to add back other items such as goodwill impairment? Since these are similar to depreciation in that they are just paper expenses?

Yes, these are paper expenses that should be add back. Usually, these non-cash items are already added back in the Cash Flow Statement. Since most companies use the Indirect Format to present the Cash Flow Statement, you should be able to trace the add back of goodwill impairment or other non-cash items somewhere between the line "net income" to "changes in working capital".

Further do note that other items that might not be non-cash are added back in the Cash Flow from Operating Activities because these items belong to the Cash Flow from Financing or Cash Flow from Investing section. So basically, these items are reclassified from Operating to Investing or Financing.

The formula you use for Free Cash Flow is for creditors and investors. If you are looking at how much the business is worth to a shareholder, you'll need to consider the Free Cash Flow after paying out the principal and interest expenses on the liabilities. This would be cash flow that belong strictly to shareholders only.

To adjust Free Cash Flow for shareholders only, you'll need to read the section on capital management in the Annual Report or talk to the management on their plans on capital management/financing.

(04-01-2015, 03:51 AM)vader1671 Wrote: 2) Change in Working Capital
I was under the impression that Change in Working Capital is just Current Assets - Current Liabilities.

However, it seems that in the AR's Cash Flow statement, the "movement in working capital section" isn't so simple. What items in the Statement of Finance Current Assets/Current Liabilities tie back to the Cash Flow?

I hope my questions are clear. If not I can elaborate.

When doing a Discounted Cash Flow analysis, there is a need to identify the "sustainable" part of the Free Cash Flow that would likely repeat in the future so that you may project the Free Cash Flow with a high degree of reliability into the future. In the "movement in working capital section", some companies include one-off and non-recurring changes to working capital. These items need to be taken out. One suggestion is to start looking carefully at any line items that include the key word "other". For example, "other receivables" and "other payables". If you think that the item would not repeat in the future, you may want to exclude it from your calculations for Free Cash Flow.

To better illustrate the point, consider the case of a retail business which bought a piece of land for development. The Cash Flow Statement might include a line item in changes to working capital: Other payable SGD1mil for land to be paid within the 12 months and thus the land payable is included under current liabilities. One might want to exclude this line item to ensure that the Free Cash Flow calculations include cash from the retail business only.

Also, if the retail business is growing, the working capital should increase as the business put in more money into inventories at new shops. However, if the retail business is not growing, but decides to raise prices, the inventories would increase for 1 to 2 quarters because at higher prices it takes longer for customers to buy. In this case the changes in working capital is unlikely to repeat and thus should also be excluded once a stable working capital base is established.

I've also seen some companies who use extra cash to buy unit trusts, and reports the changes in unit trusts in the changes in working capital section of Cash Flow from Operating Activities. Similarly, I think these are not recurring for the purpose of the core business(the core business is not buying unit trusts) so I excluded it from the cash flow analysis.

You can read more from this book "Creative Cash Flow Accounting" by Eugene E Comiskey and Charles W. Mulford. It is long winded and not to the point but it has the basic concepts I discussed above.

Which company AR are you looking at?

(04-01-2015, 10:54 AM)HyperionTree Wrote: Hi vader1671,

(04-01-2015, 03:51 AM)vader1671 Wrote: 1) I understand that Free Cash Flow = EBIT + Depreciation/Amortization - Changes in Working Capital - CAPEX

Do I also need to add back other items such as goodwill impairment? Since these are similar to depreciation in that they are just paper expenses?

Yes, these are paper expenses that should be add back. Usually, these non-cash items are already added back in the Cash Flow Statement. Since most companies use the Indirect Format to present the Cash Flow Statement, you should be able to trace the add back of goodwill impairment or other non-cash items somewhere between the line "net income" to "changes in working capital".

Further do note that other items that might not be non-cash are added back in the Cash Flow from Operating Activities because these items belong to the Cash Flow from Financing or Cash Flow from Investing section. So basically, these items are reclassified from Operating to Investing or Financing.

The formula you use for Free Cash Flow is for creditors and investors. If you are looking at how much the business is worth to a shareholder, you'll need to consider the Free Cash Flow after paying out the principal and interest expenses on the liabilities. This would be cash flow that belong strictly to shareholders only.

To adjust Free Cash Flow for shareholders only, you'll need to read the section on capital management in the Annual Report or talk to the management on their plans on capital management/financing.

(04-01-2015, 03:51 AM)vader1671 Wrote: 2) Change in Working Capital
I was under the impression that Change in Working Capital is just Current Assets - Current Liabilities.

However, it seems that in the AR's Cash Flow statement, the "movement in working capital section" isn't so simple. What items in the Statement of Finance Current Assets/Current Liabilities tie back to the Cash Flow?

I hope my questions are clear. If not I can elaborate.

When doing a Discounted Cash Flow analysis, there is a need to identify the "sustainable" part of the Free Cash Flow that would likely repeat in the future so that you may project the Free Cash Flow with a high degree of reliability into the future. In the "movement in working capital section", some companies include one-off and non-recurring changes to working capital. These items need to be taken out. One suggestion is to start looking carefully at any line items that include the key word "other". For example, "other receivables" and "other payables". If you think that the item would not repeat in the future, you may want to exclude it from your calculations for Free Cash Flow.

To better illustrate the point, consider the case of a retail business which bought a piece of land for development. The Cash Flow Statement might include a line item in changes to working capital: Other payable SGD1mil for land to be paid within the 12 months and thus the land payable is included under current liabilities. One might want to exclude this line item to ensure that the Free Cash Flow calculations include cash from the retail business only.

Also, if the retail business is growing, the working capital should increase as the business put in more money into inventories at new shops. However, if the retail business is not growing, but decides to raise prices, the inventories would increase for 1 to 2 quarters because at higher prices it takes longer for customers to buy. In this case the changes in working capital is unlikely to repeat and thus should also be excluded once a stable working capital base is established.

I've also seen some companies who use extra cash to buy unit trusts, and reports the changes in unit trusts in the changes in working capital section of Cash Flow from Operating Activities. Similarly, I think these are not recurring for the purpose of the core business(the core business is not buying unit trusts) so I excluded it from the cash flow analysis.

You can read more from this book "Creative Cash Flow Accounting" by Eugene E Comiskey and Charles W. Mulford. It is long winded and not to the point but it has the basic concepts I discussed above.

Which company AR are you looking at?

That's a good question, and that's a great reply as well.
For a simplified way to calculate FCF, I usually just take the "Net cash used in/from operating activities" - capex (eg purchase of PPE etc)
Can some pro advise if this is fairly accurate?
I figured the "net cash used in/from operating activities" already includes the EBIT and depreciation etc.
Am I missing out anything leading to inaccuracies?

Also, I found that most companies that are listed in SGX have fairly unstable FCF varying from year to year. Even if they are growing, the FCF can jump and fall drastically when comparing annual figures, so I generally just take a 5 year average and compute a minimal growth rate of about 5-10% (if there's some sign of growth)
The discount factor I take is usually about 2-3% above the long term bond yields. (so I take it as approximately 6% now)

Any pros got any comments? Thanks

Hi GFG,

Hyperion and Tree here.

(04-01-2015, 12:49 PM)GFG Wrote: For a simplified way to calculate FCF, I usually just take the "Net cash used in/from operating activities" - capex (eg purchase of PPE etc)
Can some pro advise if this is fairly accurate?

Bruce Greenwald would recommend you to differentiate between maintenance capital expenditure and growth capital expenditure to obtain an estimate of the "sustainable" free cash flow generated by the business. So Free Cash Flow for shareholders = Net Cash Used In/From Operating Activities - "Maintenance" Capital Expenditure - debt repayment - cash interest expense - preference share compulsory dividends - cash redemption of preference share.

For example, let's say Hyperion owns a retail business called Hyper Retail Shops, and he spends SGD 1mil to open 10 shops last year, it would appear under purchase of PPE. But this amount is to be excluded in estimating sustainable free cash flow because Hyperion is not expected to keep opening 10 shops for next 20 years every year and thus SGD 1mil is only during periods of growth. This amount SGD 1mil is referred to as growth capital expenditure.

A common problem is that companies do not report separately the amount of capital expenditure spend to grow the business, so sometimes you need to read the Chairman's discussion on the year's business performance to get the amount of capital spent to grow the business or read the announcement or read the news. For example, let's say Hyperion, the Chairman of Hyper Retail Shops says, I spend SGD1mil to open 10 new retail shops this year in the management discussion section. You can thus exclude SGD1mil from capital expenditure and thus your free cash flow actually increases. Good news is recent changes in International Financial Reporting Standards is encouraging companies to separate maintenance and growth capital expenditure for analyst to estimate free cash flow better.

Other methods include assuming that current year depreciation of PPE would be equal to the maintenance capital expenditure and thus use depreciation in the free cash flow calculations. However, further adjustments to account for inflation, investment cycle and accounting policy for depreciation is required. For example, let's say Hyperion obtained a concession to run a port business in Singapore called Hyper Monopoly Port for 20 years, and every year he says he depreciate the property by SGD2mil based on historical cost of PPE. He renovated the port just recently and has 20 years more to run it. Currently his maintenance capital expenditure is SGD1mil. Hyperion would recommend you start with SGD1mil every year for maintenance capital expenditure and apply the construction material or construction cost inflation index(if such a statistic is available) like say at 8% every year and project the capital expenditure to increase 8% until the final 20th year. This is because in the beginning after an investing cycle(renovation), usually capital expenditure is less than depreciation. Think about it this way, you just bought a computer, so each year you just change the hard disk drive or some spoiled part, so the expenditure its less than the depreciation. Eventually, due to inflation, capital expenditure will increase such that in the final year(year 20) you actually spend SGD4.66mil at 8% inflation which is significantly more than the 20 year historical cost of depreciation at SGD2mil!

This is assuming you trust Hyperion depreciates his PPE according to the useful life of the PPE. Let's say cheeky Tree wants to mess with you. So Tree depreciate the PPE on the assumption that it will only last 10 years, instead of 20 years. This means the depreciation would increase significantly and would not be a good estimate for maintenance capital expenditure. Fortunately, Hyperion can figure out Tree's little trick. Hyperion recommends you read the section on PPE depreciation policy, PPE remaining life left, and the note to PPE because you can find clues that Tree is making fun of you. For example, you will see that PPE useful life under the depreciation would only be 10 years and when compared to another port business is significantly short. Further, auditors might make Tree disclose in the note to PPE that he has SGD20mil of PPE that has been depreciated but still in use. This would raise the red flag that the PPE depreciation policy might be aggressive.

One real life example is ThaiBev. Looking at the PPE note, Tree told Hyperion that ThaiBev disclosed in two short lines that it is still using PPE that has been fully depreciated. This means, it would be difficult to estimate ThaiBev's actual maintenance capital expenditure based on just historical depreciation.

(04-01-2015, 12:49 PM)GFG Wrote: I figured the "net cash used in/from operating activities" already includes the EBIT and depreciation etc.
Am I missing out anything leading to inaccuracies?

Hyperion recommends you to go through line item by line item in the P&L and compare to the section Cash Flow from Operating Activities to ensure that all non-cash or non-operating cash has been excluded. This is because different business have different specific line items that might mess up your calculations.

Tree recommends you consider pension liabilities that need to be settled in cash in future which sometimes do not appear on balance sheet or costs of share-based compensation after you finish discounting your cash flow. This is particularly difficult especially for companies like OCBC which have a strong share-based compensation plan. As to how to adjust for share-based compensations, it is for another day when Tree feels like it. Hyperion can't help you on this.

(04-01-2015, 12:49 PM)GFG Wrote: Also, I found that most companies that are listed in SGX have fairly unstable FCF varying from year to year. Even if they are growing, the FCF can jump and fall drastically when comparing annual figures, so I generally just take a 5 year average and compute a minimal growth rate of about 5-10% (if there's some sign of growth)
The discount factor I take is usually about 2-3% above the long term bond yields. (so I take it as approximately 6% now)

Any pros got any comments? Thanks

Which company you refer to which have unstable FCF? Hyperion would like to know and he may be able to make Tree check out those companies for you.

If FCF jumps, you would like to trace whether it is due to revenue or cost. Either way it is not a good sign because it means that there is no certainty in the revenue or cost and thus FCF cannot be reliably predicted. Averaging does not help. In this case, Hyperion suggests you use net tangible assets which excludes goodwill or intangibles to value the company.

Hyperion notes that the discount rate becomes very aggressive once growth of 5% is used. A discount rate of 6%, and growth rate of 5% actually means you discounting at 1%, which is like the risk free rate. As of 22 December, the Edge reports that the 5 year Singapore Government Securities(SGS) yields are 1.5% which means you are discounting even lower than the SGS assuming the business can last 5 years. This is why it is tricky to value how much growth is worth.

Hyperion likes to highlight that unlike other countries, the Singapore Government Securities market is small and a bit more illiquid and thus might not be able to reflect the true risks free rate in Singapore. You may have to use an average of various triple A rated corporate bonds of blue chip companies like Singtel etc.

Tree said according to the famous journalist Teh Hooi Ling's article in Business Times on 20 Nov 2010, the average spread between equity returns versus 5 year SGS rates is 5.2% since 1998. Equity returns exclude dividends. This means Equity Returns - 5yr SGS = 5.2% on average. So you may consider using 5.2% above 5yr SGS bond yields which is currently around the 6% figure you had used.

Tree also said that you might want to be cautious when it comes to a company with many different business segments. Different business have different cash flows and different risks and thus doing free cash flow analysis on an overall basis would get you into trouble because you may be discounting a very risky cash flow at too low a discount rate.

Since this is a long reply, Tree likes to give you a potato.

(04-01-2015, 02:19 PM)HyperionTree Wrote: Hi GFG,

Hyperion and Tree here.

(04-01-2015, 12:49 PM)GFG Wrote: For a simplified way to calculate FCF, I usually just take the "Net cash used in/from operating activities" - capex (eg purchase of PPE etc)
Can some pro advise if this is fairly accurate?

Bruce Greenwald would recommend you to differentiate between maintenance capital expenditure and growth capital expenditure to obtain an estimate of the "sustainable" free cash flow generated by the business. So Free Cash Flow for shareholders = Net Cash Used In/From Operating Activities - "Maintenance" Capital Expenditure - debt repayment - cash interest expense - preference share compulsory dividends - cash redemption of preference share.

For example, let's say Hyperion owns a retail business called Hyper Retail Shops, and he spends SGD 1mil to open 10 shops last year, it would appear under purchase of PPE. But this amount is to be excluded in estimating sustainable free cash flow because Hyperion is not expected to keep opening 10 shops for next 20 years every year and thus SGD 1mil is only during periods of growth. This amount SGD 1mil is referred to as growth capital expenditure.

A common problem is that companies do not report separately the amount of capital expenditure spend to grow the business, so sometimes you need to read the Chairman's discussion on the year's business performance to get the amount of capital spent to grow the business or read the announcement or read the news. For example, let's say Hyperion, the Chairman of Hyper Retail Shops says, I spend SGD1mil to open 10 new retail shops this year in the management discussion section. You can thus exclude SGD1mil from capital expenditure and thus your free cash flow actually increases. Good news is recent changes in International Financial Reporting Standards is encouraging companies to separate maintenance and growth capital expenditure for analyst to estimate free cash flow better.

Other methods include assuming that current year depreciation of PPE would be equal to the maintenance capital expenditure and thus use depreciation in the free cash flow calculations. However, further adjustments to account for inflation, investment cycle and accounting policy for depreciation is required. For example, let's say Hyperion obtained a concession to run a port business in Singapore called Hyper Monopoly Port for 20 years, and every year he says he depreciate the property by SGD2mil based on historical cost of PPE. He renovated the port just recently and has 20 years more to run it. Currently his maintenance capital expenditure is SGD1mil. Hyperion would recommend you start with SGD1mil every year for maintenance capital expenditure and apply the construction material or construction cost inflation index(if such a statistic is available) like say at 8% every year and project the capital expenditure to increase 8% until the final 20th year. This is because in the beginning after an investing cycle(renovation), usually capital expenditure is less than depreciation. Think about it this way, you just bought a computer, so each year you just change the hard disk drive or some spoiled part, so the expenditure its less than the depreciation. Eventually, due to inflation, capital expenditure will increase such that in the final year(year 20) you actually spend SGD4.66mil at 8% inflation which is significantly more than the 20 year historical cost of depreciation at SGD2mil!

This is assuming you trust Hyperion depreciates his PPE according to the useful life of the PPE. Let's say cheeky Tree wants to mess with you. So Tree depreciate the PPE on the assumption that it will only last 10 years, instead of 20 years. This means the depreciation would increase significantly and would not be a good estimate for maintenance capital expenditure. Fortunately, Hyperion can figure out Tree's little trick. Hyperion recommends you read the section on PPE depreciation policy, PPE remaining life left, and the note to PPE because you can find clues that Tree is making fun of you. For example, you will see that PPE useful life under the depreciation would only be 10 years and when compared to another port business is significantly short. Further, auditors might make Tree disclose in the note to PPE that he has SGD20mil of PPE that has been depreciated but still in use. This would raise the red flag that the PPE depreciation policy might be aggressive.

One real life example is ThaiBev. Looking at the PPE note, Tree told Hyperion that ThaiBev disclosed in two short lines that it is still using PPE that has been fully depreciated. This means, it would be difficult to estimate ThaiBev's actual maintenance capital expenditure based on just historical depreciation.

(04-01-2015, 12:49 PM)GFG Wrote: I figured the "net cash used in/from operating activities" already includes the EBIT and depreciation etc.
Am I missing out anything leading to inaccuracies?

Hyperion recommends you to go through line item by line item in the P&L and compare to the section Cash Flow from Operating Activities to ensure that all non-cash or non-operating cash has been excluded. This is because different business have different specific line items that might mess up your calculations.

Tree recommends you consider pension liabilities that need to be settled in cash in future which sometimes do not appear on balance sheet or costs of share-based compensation after you finish discounting your cash flow. This is particularly difficult especially for companies like OCBC which have a strong share-based compensation plan. As to how to adjust for share-based compensations, it is for another day when Tree feels like it. Hyperion can't help you on this.

(04-01-2015, 12:49 PM)GFG Wrote: Also, I found that most companies that are listed in SGX have fairly unstable FCF varying from year to year. Even if they are growing, the FCF can jump and fall drastically when comparing annual figures, so I generally just take a 5 year average and compute a minimal growth rate of about 5-10% (if there's some sign of growth)
The discount factor I take is usually about 2-3% above the long term bond yields. (so I take it as approximately 6% now)

Any pros got any comments? Thanks

Which company you refer to which have unstable FCF? Hyperion would like to know and he may be able to make Tree check out those companies for you.

If FCF jumps, you would like to trace whether it is due to revenue or cost. Either way it is not a good sign because it means that there is no certainty in the revenue or cost and thus FCF cannot be reliably predicted. Averaging does not help. In this case, Hyperion suggests you use net tangible assets which excludes goodwill or intangibles to value the company.

Hyperion note that the discount rate becomes very aggressive once growth of 5% is used. A discount rate of 6%, and growth rate of 5% actually means you discounting at 1%, which is like the risk free rate. As of 22 December, the Edge reports that the 5 year Singapore Government Securities(SGS) yields are 1.5% which means you are discounting even lower than the SGS assuming the business can last 5 years. This is why it is tricky to value how much growth is worth.

Hyperion like to highlight that unlike other countries, the Singapore Government Securities market is small and a bit more illiquid and thus might not be able to reflect the true risks free rate in Singapore. You may have to use an average of various triple A rated corporate bonds of blue chip companies like Singtel etc.

Tree said according to the famous journalist Teh Hooi Ling's article in Business Times on 20 Nov 2010, the average spread between equity returns versus 5 year SGS rates is 5.2% since 1998. Equity returns exclude dividends. This means Equity Returns - 5yr SGS = 5.2% on average. So you may consider using 5.2% above 5yr SGS bond yields which is currently around the 6% figure you had used.

Tree also said that you might want to be cautious when it comes to a company with many different business segments. Different business have different cash flows and different risks and thus doing free cash flow analysis on an overall basis would get you into trouble because you may be discounting a very risky cash flow at too low a discount rate.

Since this is a long reply, Tree likes to give you a potato.

Yeah that's a very long and very good reply.
Can I ask why you'd use the 5yr SGS bond yields instead of using longer term bonds like 10 yr or 20yr? Since the DCF usually stretches over a longer period than just 5yrs. (I usually take 20yrs into account when using DCF)
"Hyperion note that the discount rate becomes very aggressive once growth of 5% is used."
By "aggressive", do you mean it is too optimistic a rate because it's actually (6% - 5%) = 1% discount rate in reality?
So would you suggest NOT incorporating any growth rate in FCF (which is not accurate over a 20 yr period either), or using a lower growth rate? Or do you mean that in such instances when the FCF is unstable, then DCF cannot be used at all?

Here are some of the companies and the respective FCF (FCF simply calculated using cashflow from operating activities minus CAPEX)
1) Boustead ('000)
2008 2009 2010 2011 2012 2013 2014
68,824 29,306 48,220 48,761 81,885 43,637 97,734

2) Hock Lian Seng
FY10 FY11 FY12 FY13
32,125 30,892 -187,402 15,733

3) BBR Holdings
FY09 FY10 FY11 FY12 FY13
30,537 4,573 -54,419 53,690 -977

4) Metro Holdings
FY10 FY11 FY12 FY13 FY14
-13,873 -18,560 130,992 -197,807 21,294

5) Asia enterprises holdings
FY07 FY08 FY09 FY10 FY11 FY12 FY13
1,301 12,066 14,549 11,866 5,589 2,402 10,673

2), 3) and 4) have their bulk of their earnings in property development, so I understand that perhaps because of the "lumpy" nature of their cashflow (high capex at the start of the project, with high CF at the end after TOP), DCF may not be suitable.
1) also has substantial property related earnings, and has several parts and it may not be suitable to study the consolidated earnings of the various parts.
So I included 5)
5) is a simple steel trading business, easy to understand, they pretty much do the same thing every yr. Buy and resell steel. nothing fancy, not expanding into anything new etc.
Even then you can see their long term cashflow can vary from 1.3mil to 14.5mil. So which FCF figures would you use if averaging would not help?

Thanks

(04-01-2015, 02:35 PM)GFG Wrote: Yeah that's a very long and very good reply.
Can I ask why you'd use the 5yr SGS bond yields instead of using longer term bonds like 10 yr or 20yr? Since the DCF usually stretches over a longer period than just 5yrs. (I usually take 20yrs into account when using DCF)
"Hyperion note that the discount rate becomes very aggressive once growth of 5% is used."
By "aggressive", do you mean it is too optimistic a rate because it's actually (6% - 5%) = 1% discount rate in reality?
So would you suggest NOT incorporating any growth rate in FCF (which is not accurate over a 20 yr period either), or using a lower growth rate? Or do you mean that in such instances when the FCF is unstable, then DCF cannot be used at all?

Since you like the reply, would you be Hyperion and Tree's friend? Hahaha

Referring to Teh Hooi Ling's article in Business Times dated 20 November 2010, she note the following average equity returns above of the various Singapore Government Securities since 1998:

5yr t-bonds, 7yr t-bonds, 10yr t-bonds
Average 5.2%, 6.4%, -0.1%
Median 4.2%, 6.7%, -1.2%

So once you enter the 10 year zone, it becomes hard to understand why it is negative. That's the reason why Tree only talks about 5yr rates.

Tree says that there are few bonds in the 20 year zone which are liquid enough for you to reliably estimate the risk free rate or the AAA corporate bond yield. Most long dated bonds are bought by insurance companies to matched their life insurance long term liabilities and they rarely sell. But Tree maybe wrong because this is outside of Tree's circle of competence. Tree would give you a banana if you can find out whether there are any good liquid 20 year bonds that can be use to estimate risk free rate.

Tree likes to challenge you to think, if there are no good risk free rate benchmarks, how should you value a company from a discounted cash flow basis? Hyperion gives you a hint: be very conservative.

Hyperion notes that it is hard to estimate cash flow for next 20 years for business that are too competitive or cyclical or uncertain. Competitive businesses like Food and Bevarage constantly face cash flow shocks in terms of drop in demand or need to upgrade to new technology like new cashier or new kitchen equipment which eats up capital expenditure. Without market power to raise prices, it is hard to be confident about the cash flows of such business. Cyclical business are like property development where the risks of oversupply is real. Uncertain businesses are like palm oil where the prices are uncertain and thus pose a significant uncertainty in your cash flow analysis.

Yes. Hyperion meant that you'll be just discounting at 1% effectively if you assume 5% growth. If FCF is unstable, you run a high risks if you rely on your averaged out FCF which is why it is better to just pass and look for another company with better information for you to value or within your circle of competence.

Hyperion has bad experiences incorporating growth rates in FCF because he cannot estimate reliably how long the growth will last, and how high the growth will be. After all, most business don't grow without increasing capital expenditure and business that grow tend to have unstable FCF. But this does not mean you should give up because you may find a better way than Hyperion to be successful in estimating growth.

Tree recommends you to look at the competition and study something call "Industrial Organisation" which is full of hardcore math but Tree finds it fun. This allows you to decide how stable is a FCF. Tree is a great fan of a person call Jean Tirole, the recent economic Nobel Price winner. Tree would be happy if you spar with him on Industrial Organisation. Again, that would be for another day since Tree is stuck with playing SC2 while Hyperion is finding a job to increase his market value among females.

Hyperion and Tree will look up the Asia Enterprise Holdings and see why the FCF is like a yoyo swing up and swing down.

DCF is one of the methods of valuing companies which gives you a very precise answer but which is subject to numerous assumptions which may be either flawed or too sensitive (i.e. putting too much weight on the Terminal Value).

I agree with Hyperion that cash flows are inherently too unstable to project more than a few years into the future, and even then it may still be wildly off the mark. Notice how brokerage reports consistently project FCF in a "straight" ascending line? That's actually a very optimistic scenario; in reality most businesses see fluctuation profits and cash flows which are subject to economic cycles and industrial competitive forces.

DCF may arguably be suitable only for businesses with extremely predictable cash flows - utilities and a few other "bond-like" businesses with natural monopolies and a ton of regulation (note that utilities are not always a good bet either as they are usually monopolies which are subject to strict regulation).

The idea, I guess, is to be ultra-conservative and to quantify your downside, rather than to appraise your (potential) upside. Given that businesses are inherently unpredictable, perhaps it is better to be able to understand how and why you may have over-paid than to understand that you've (always) got a bargain. My opinion is there aren't many great businesses out there in the first place with i) a competitive moat which can endure and which can ii) compound shareholders' funds at high rates of return over many years.

(04-01-2015, 06:54 PM)Musicwhiz Wrote: DCF is one of the methods of valuing companies which gives you a very precise answer but which is subject to numerous assumptions which may be either flawed or too sensitive (i.e. putting too much weight on the Terminal Value).

I agree with Hyperion that cash flows are inherently too unstable to project more than a few years into the future, and even then it may still be wildly off the mark. Notice how brokerage reports consistently project FCF in a "straight" ascending line? That's actually a very optimistic scenario; in reality most businesses see fluctuation profits and cash flows which are subject to economic cycles and industrial competitive forces.

DCF may arguably be suitable only for businesses with extremely predictable cash flows - utilities and a few other "bond-like" businesses with natural monopolies and a ton of regulation (note that utilities are not always a good bet either as they are usually monopolies which are subject to strict regulation).

The idea, I guess, is to be ultra-conservative and to quantify your downside, rather than to appraise your (potential) upside. Given that businesses are inherently unpredictable, perhaps it is better to be able to understand how and why you may have over-paid than to understand that you've (always) got a bargain. My opinion is there aren't many great businesses out there in the first place with i) a competitive moat which can endure and which can ii) compound shareholders' funds at high rates of return over many years.

Hi Musicwhiz,

Hyperion has always been a fan of your posts!

Tree asks if you heard of "Industrial Organisation"? It is related to competitive moats.

(04-01-2015, 07:06 PM)HyperionTree Wrote: Hi Musicwhiz,

Hyperion has always been a fan of your posts!

Tree asks if you heard of "Industrial Organisation"? It is related to competitive moats.

Hi Hyperion,

Thanks, good to know I still have people reading haha.

I haven't though - is that a Company or a new concept? I've read up extensively on moats (mainly through Pat Dorsey) but am always ready to add on to my knowledge. Thanks.