My Valuation Techniques

Free Cash Flow Valuation (8 years)

Let’s begin with the Free Cash Flow Valuation. This equation is based off of the payback rate of free cash flow, which in my equation is simply operating cash flow minus maintenance capital expenditures combined with growth and discount rates. I also like to reduce the total long term debt from the final payback number and follow a the historical rate of stock buybacks or dilution.

I use an 8-year timeline instead of the 10-year seen used by most others. Why is this? Well, I stole this one from Phil Town as well, where he speaks about the payback time that private equity investors expect. He literally wrote a book about this, (here) so instead of me wading through it, I suggest you take a look at his explanation. This, again, leaves me more conservative than most.

The discount rate that I typically use is a steady 3%, until the 10 year treasury yield shows me otherwise (2.84% at time of writing). The growth rate I determine based on a number of factors. I typically use a combination of short term (4-5 yr) historical rates of change, such as Book Value, Sales per Share, FCF per Share, and EPS, as well as a few of others. Then I decide whether I see them as realistic and make adjustments as needed.

Earnings per Share Valuation (5 years)

Now let’s move to the earnings per share valuation. This equation I like to use because it not only looks at the EPS of the company but also how the market typically values companies in the particular industry and how the company in question has been valued historically. 

The EPS history of a lot of good companies are relatively consistent, with the exception of crazy events such as 2020. Again I will look at both the average growth rates of EPS, Sales per share, and FCF per share to make an estimation. I also will use take a look at the median and average PEs of the past 5-10 years to make a determination of my multiplier. This isn’t necessarily perfect, but nothing is.

With the goal in mind of doubling my money every 5 years, aka a 14.4% annual return, I cut the potential future (5th year) price in half to reach my fair price to purchase the stock.

FCF per share Valuation (5 years)

My third equation works off free cash flow per share, a variation of our first equation. The one difference between the two equations though is that I will value the company based off of the historical rates of price to free cash flow. This is essentially a mixture of the first two equations we have used.

I use the price to free cash flow over a ten year period, as long as it’s not all over the place, to get a starting point for the company. Next I check the industry median, and make the determination of how closely does this company reflect a normal company in the industry. Finally I plug this into an equation that uses these two numbers as well as the companies share buyback (or issue) history..

Dividends per Share Valuation (5 years)

The final equation, which pertains only to dividend paying companies, runs the same concept as the FCF per share calculation but instead of the FCF multiple using the median dividend yield of the company along with historical dividend growth rate and share buyback (or issue) history. *It also must be noted that many companies make the future of this fairly clear in earnings transcripts.

Fair Value and Buy Price

This one is pretty simple.

I ask myself two questions:

  1. Based on the type of company that I am researching, how would I project each of the four equations to effect share price over the next four years?
    From here I give each equation a weighting percentage.

  2. Do I have high or low confidence in the company?
    If I have high confidence in all of my projections, I use the high confidence price which is tailored to a 15% annual return. If I have low confidence, or merely questioning the industry, then I use the low confidence price which is tailored to a 25% annual return.

After I select these, I have my final calculations.