In this video, we shall examine the ultimate formula in greater details and we shall try to apply it in an Indian context. In the process, we will add to our growing arsenal of investing models and frameworks that can make us a better investor over time
📝 RESOURCES
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📝 CHAPTERS
00:00 Introduction
01:07 One formula to rule them all
03:15 Free cash flow
06:53 Applying the formula to Indian stocks
📝 THE ONE FORMULA TO RULE THEM ALL
The term “intrinsic value’ gets thrown around a lot .. which is strange for something that can mean anything to anyone
Operationally .. the intrinsic value of a business is merely a series of assumptions around growth, discount rates, time and its terminal value
Now, most of us are comfortable with the price-earning multiple or the PE ratio as it’s commonly called
To put it simply .. the PE ratio gives us the price or valuation of a company as measured against a rupee of profit it earns
So if a company is valued at 50 crores and delivers a net profit of 4 crores, then the PE ratio of that company is 50 divided by 4 crores .. which comes to 12.5
📝 FREE CASH FLOW
To put it simply .. the free cash flow is the amount of cash that remains .. after the company has paid for all its expenses like salaries, marketing, taxes etc.
Infact, free cash flow importantly also excludes the long term investments made by a company .. like plants, machines, property, trucks, computers etc. .. which in common parlance is called capital expenditure
Now, from a calculation standpoint, a company’s FCF can be computed using either of these two methods
So there is reverse approach which starts from the net profit and then we adjust back the non-cash items as explained in method 1 ..
.. and then there is a much simpler cashflow from operations minus capex approach which is generally the formula I use in my calculations
But irrespective of the formula you use .. what’s important to conceptually understand here is that ..
.. the free cash flow of a company refers to its cash resources that are freely available for distribution to the shareholders ..
.. whether that happens in the form of dividends, buybacks, organic growth, mergers, acquisitions or a combination of these
It’s this generation of usable capital internally and the flexibility in utilizing it .. is what attracts the great investors to this metric ..
.. with Warren Buffett saying on many occasions that a company’s free cash flow is its most important financial metric
Infact companies that produce tons of free cash flow are often
.. more productive
.. less capital guzzling
.. have the ability to grow without external financing
.. and since manipulating cash is a lot more difficult as compared to net profit numbers, these companies are viewed as more reliable in the eyes of investors
📝 APPLYING THE FCF FORMULA TO INDIAN STOCKS
Every investor has some target, some criteria in mind .. and it is our belief that the world’s top investors are generally looking for companies where the free cash flow yield plus growth rate is upwards of 20%
In other words, the quest is to look for returns that can beat the benchmark by 5 to 7% .. which in addition to being a enviable target also allows a decent margin of safety for any errors that might creep into our estimation process
Now, when we sat down to apply the FCF yield plus growth formula on the Indian markets .. we noticed some peculiarities which had to be dealt with
For instance .. the FCF is a very dynamic number and there can be big changes over two financial years
Like say, a new plant is commissioned by the company this year .. which means the capital expenditure in this year will be a lot higher than the last year .. which can wreak our future FCF estimates
Similarly, external conditions and even internal activities can bring about a big change in working capital requirements which needs to be factored in FCF calculations
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