Apple Inc. (NASDAQ:AAPL) generated net income of nearly $42 billion in fiscal 2012, yet paid out only $2.5 billion (or 6%) of that in dividends. In that same year, Johnson & Johnson (NYSE:JNJ) paid out $6.6 billion (or 61%) in dividends on $10.8 billion in net income.
Since Johnson & Johnson paid out a high proportion of its earnings as dividends, it can be analyzed using the dividend discount model. But what are we to do about a company that pays out a very low proportion of its net income as dividends?
Free cash flow models
Authors Stephen Horan, Robert R. Johnson and Thomas Robinson set out address that issue in chapter eight of their book, "Strategic Value Investing: Practical Techniques of Leading Value Investors." They wrote, "The focus of this chapter is on free cash flow models, and it illustrates how to arrive at an estimate of value based on a firm's sustainable cash-generating capability. The models presented in this chapter are applicable to valuing a wide variety of companies: those that pay dividends and those that don't."
Because these models are more complex and require more calculations than the "much simpler" dividend discount models, they planned to offer a "flavor" of free cash flow models only.
Free cash flow is not formally defined, nor is it a recognized accounting concept. However, there is a basic definition: Free cash flow equals the operating cash flow remaining after capital expenditures are deducted. Operating cash flow is defined as the funds that arise out of cash from operations, and capital expenditures can be used for either future growth or replacement of existing assets:
There are two distinct models of free cash flow used in the valuation of companies:
- FCFF: free cash flow to the firm.
- FCFE: free cash flow to equity.
Both models will be analyzed in greater detail later, but at this point, the authors wanted to distinguish between the two.
Free cash flow to the firm refers to "the cash flow available to a firm's suppliers of capital, after all operating expenses (including taxes) have been paid and all necessary investments in working capital (think inventory) and fixed capital (think plant and equipment) have been made." Suppliers of capital include holders of common shares, preferred stockholders and bondholders.
It is what's left after all expenses have been paid and cash has been set aside for future growth. This is the formula:
In some cases, investors doing analysis will want to distinguish between the cash flow available to all suppliers of capital and the cash flow available just to the equity contributors (shareholders, both common and preferred, but not bondholders, who are lenders). In that case, they use free cash flow to equity model.
While capital supplied by bondholders is no longer in the broad capital pool, the amount of debt they hold does come back into the formula in the last expression.
Read more here:
- Strategic Value Investing:The Discount Rate
- Strategic Value Investing: Estimates of Cash Flows
- Strategic Value Investing: Dividend Discount Models
Walmart case study
With overviews of the FCFF and FCFE models complete, the authors presented a case study. It was based on the statement of cash flows for Walmart (NYSE:WMT) for the year ending Jan. 31, 2011. This was the cash flow statement, with all amounts in millions:
In addition, they learned from the supplemental disclosures that Walmart paid $2,163 million in interest to debt holders and its average tax rate was 32%.
Next, they calculated free cash flow to the firm:
The authors added, "Note that we are including as capital expenditures investments in businesses as well as net investments in property and equipment (sales net of payments). This is appropriate when computing past FCFF, but when we are forecasting future FCFF we typically just forecast net investments in property and equipment and consider potential acquisitions, if any, separately."
And, this shows the calculation to compute free cash flow to equity:
The difference in outcome values is striking and illustrates the effect of removing lenders from the pool of capital contributors.
A couple of notes were appended to the FCFE calculation by the authors. First, they wrote, "Note that in computing FCFE from a historical perspective, we are including borrowings from debt holders. This may seem odd, as it implies that borrowing could increase FCFE and somehow increase the value of the firm, as well."
"We do not use historical FCFE for valuation--we want to forecast future average FCFE, which includes borrowing to the extent that it pays for some portion of capital expenditures. This means it does not have to be paid for by the equity holders. The repayment of borrowing in subsequent years will reduce FCFE."
In the opening section of chapter eight, the authors introduced readers to free cash flow models as an alternative to dividend discount models.
There are two important approaches within the boundaries of free cash flow models. First, there is the free cash flow to the firm model, which takes in all contributors of capital: common stockholders, preferred stockholders and bondholders.
Second, the free cash flow to equity model gets more specific by taking bondholders out of the mix, leaving just common and preferred stockholders.
Finally, as the authors offered this big-picture perspective:
"Free cash models provide a way to estimate intrinsic value when dividends are low or nonexistent or when they are unreliable. They represent a helpful discipline for the strategic value investor, as well, because they require the analyst to consider carefully the factors that will impact sales, margins, capital expenditure, and growth in the future. These models are therefore well-structured mechanisms to learn the company."
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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