"How much is this business worth?" is a critical question that one needs to ask, after answering
- Is this a good business?
- Is there good management?
Typical techniques used to produce that answer, have been a combination of the following: Discounted Cash Flow (DCF), with varying degress of sophistication, Dividend Discount Model, Gordon Growth Model, etc. all the stuff that you find in a corporate finance textbook.
To answer the question myself, I attempted a simple exercise to value a stream of cashflows, where I know what the eventual answer should be. A company can be modeled in the simplest sense, like a savings account. You start off with some money in the account (i.e. net tangible assets), you make interest off the balance (i.e. return on capital), you can choose to withdraw some (i.e. dividends) or keep all the interest in the account (i.e. increase retained earnings, payout ratio of 0).
Hence I built a simple spreadsheet to model a savings account. The account is started off with $1, with annual interest rate of 10%, and all interest are ploughed back into the account. Hence we have a steady stream of interest cash inflows: 0.1, 0.11, 0.121, etc. Now, if I imagine that this "savings account" is in effect a company (i.e. NTA = $1, ROC = 10%, payout ratio = 0%), and given what I know about its future cash flows, will I be able to determine that the fair value of this company is, in fact, $1? (assuming that a bank does give 10% interest rate on accounts)
The short story is that, you cannot discount each of the future values, sum them up, and expect to get $1. The fact that in order to obtain the cash inflow of $0.121 in year 3, you are _forced_ to re-invest the previous year's $0.11, meant that these cash inflows cannot be freely used. Hence in a sense, the "free cash flow" is 0. How then do you value a company with the characteristics above?
What needs to be done, then, is to project future cashflows, use that to determine the value of the company at some point in future, and perform just ONE discount to determine the present value, i.e the intrinsic value of the company (I am skipping the details to do this properly, but the high-level idea is there).
This example illustrates a difficulty in using traditional DCF – its very difficult to determine what cash flow is _truly_ free. (Operating Cash Flow – Capex) is not good enough. Many companies spend this (Operating Cash Flow – Capex) to repay debt, to invest in short-term securities and to expand into new areas. Can we say that the company does not _need_ to repay debt? does not need to expand into new areas to maintain its competitive advantage? If such spending is necessary, then these money cannot be included in the DCF calculation since they are not truly free money that can be taken out (an implicit assumption when you perform a DCF).
A more accurate definition of FCF is needed: Free Cash Flow = "Truly free" cash flow that can be always taken out of the company and the company will still do well. That is, if all the projected FCFs that you have used in the DCF calculation is taken out of the company (e.g. if you project that Year XX has FCF of $YY, then we will withdraw $YY from the company in Year XX), the company must still be able to do well.