Nine Steps to Valuation

Valuation is often covered in passing, when it really deserves a fuller explanation of all the hows, whys, and wherefores. The discounted cash flow approach to valuation allows for an analysis of all the value drivers, including expected free cash flow growth, options dilution, and the discount rate. By making educated, conservative estimates of each of these determinants, you can begin to frame a company's range of fair value.

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By Matt Richey (TMF Matt)
September 17, 2002

Valuation is central to all of my investment opinions. Whenever I write about a company, I always try to put a price tag on the business. The problem is, because of space constraints, I typically can only devote one or two paragraphs to the assumptions behind my value estimates. Given that valuation is an imprecise science, there's always much more to say than what I can cram into those few measly paragraphs. That's why today I want to take a more expansive look at valuation, utilizing Group 1 Software (Nasdaq: GSOF) as an example.

I wrote about small-cap software provider Group 1 last week. Here's what I concluded regarding the company's valuation:

Group 1 trades for only 6.5 times free cash flow. But let's break it down a bit further. Over the past year, Group 1 generated free cash flow of $14.5 million. If we back out the interest income, the "operating free cash flow" is $13.6 million, or $1.96 per share. Assuming the company can deliver upper-single digit growth, Group 1 deserves a free cash flow multiple of around 15, in my estimation. The company is on track to grow revenues by 10% this year, so free cash flow growth should be able to at least keep pace with revenue. Applying the 15x multiple to $1.96 per share yields business value of $29.40. Add to this the net cash per share of $6.85, and you get a total intrinsic value estimate of $36.25.

There are reams of assumptions baked into that paragraph: cash flow estimates, growth assumptions, multiples, discount rates, options dilution -- it's all there, whether explicitly stated or not. My goal today is to unpack these variables and discuss them one by one. Below, I've broken out the valuation process into nine steps, including both the key determinants of value and the subsequent methods that synthesize those determinants into a discounted cash flow estimate of intrinsic value. With each step, I'll offer a few words of commentary and explanation.

1. Base "operating free cash flow"
In simple terms, this is the amount of cash a company can spit out in a single year. In more technical terms, I define "operating free cash flow" as cash flow provided by operating activities minus capital expenditures, interest income, and any other non-recurring sources of cash, such as stock option tax benefits.

Conceptually, what matters is the cash that's generated from ongoing business operations. The "ongoing" part is particularly important because valuation revolves around the expected cash flows of all future periods. As such, a one-time cash flow event -- such as the sale of a subsidiary -- is of low importance compared to the recurring earnings power of the business.

Arriving at an exact number for operating free cash flow (FCF) is a somewhat subjective exercise. In my original assessment of Group 1, I used $13.6 million as my starting point. That number was derived from the definition I presented above as applied to the trailing 12 months of Group 1's operations. Arguably, $13.6 million is a somewhat aggressive figure considering the company generated an exceptional amount of cash over the past year from the reduction of accounts receivable, which is not an ongoing source of cash. Then again, there are other cash flow line items over the past year, such as net income and deferred revenues, that have been unusually depressed because of the soft economy. 

An alternative approach, which is sometimes more conservative, is to average the past three years of a company's operating FCF. This approach, which is sometimes called the "normalized" level of FCF, helps to smooth out the lumpiness of a company's earnings power. Group 1's three-year average operating FCF is $9.5 million. Later on, we'll use this as our low-end estimate and $13.6 million as our high-end estimate, en route to arriving at a range of fair value.

2. Expected growth
Here our goal is to estimate the growth of FCF for the indefinite future. This is where we get into the voodoo of valuation. The key here is to be conservative. I usually consider growth over four stages: Years 1-5, Years 6-10, Years 11-20, and thereafter. For Group 1, I estimate growth of 7.5% for Years 1-5 and 6-10, 5% growth in Years 11-20, and 3% growth thereafter.

In choosing these numbers, my goal is to capture a rate of growth that's a) in the ballpark of reality, and b) low enough to capture some years of higher growth and some years of lower growth. In other words, it's not that I actually expect Group 1 to grow its FCF like clockwork. But hopefully these estimates reflect Group 1's ability, as a small company with a lightweight business model, to grow both its market share and its scale as a business. (Sometimes it's useful to look at a range of growth rates, but I won't go to that level of complexity in this example.)

3. Options dilution
Rather than expense employee stock options, I factor in their impact via an annual dilution factor. This is one of the great flexibilities of using a discounted cash flow spreadsheet. Last year, Group 1 issued employee stock options equaling 2.3% of outstanding shares. We know that not every one of those options will become dilutive (because of factors like employee attrition), so my estimate for options dilution is 2% annually for Years 1-20, with no impact thereafter.

4. Discount rate
The discount rate is the rate of return we require as equity investors. Finance practitioners, especially in the academic arena, put a lot of blood, sweat, and tears into determining an "appropriate" discount rate based on factors like stock volatility, financial leverage, and business risk. Personally, I think that's a waste of time. I use 11% as my default discount rate. That's the rate of return for stocks over the past 100 years, and that's the minimum rate of return I'd accept for an investment in any stock. If there's risk to be factored into the equation, I'd prefer to reduce my expected growth rates rather than monkey around with the discount rate.

5. Terminal value
I mentioned earlier that one of the growth stages is "thereafter," the period beyond Year 20. Mathematically, this period of time is accounted for using the stable growth formula. Rather than get into the complexities of that formula, let's conceptualize the value of this terminal period by applying a price-to-free cash flow (P/FCF) multiple to the Year 21 FCF estimate, and then discount that figure back to present value. The key here, once again, is to be conservative. For Group 1, I assumed a terminal period nominal growth rate of 3% and a discount rate of 11%, which translates mathematically (see the above link to the article on calculating stable growth valuation) into a P/FCF of 12.5.

6. Cash per share
So far, we've only been valuing the earnings power of the business. To that we add any excess cash, net of all debt. For Group 1, that's $6.85 per share. In the next step, we'll add that amount to Group 1's business value in order to reach a total intrinsic value estimate.

7. Cranking the assumptions through a DCF
DCF stands for discounted cash flow. This is the science of valuation. Once you plug in your variables, it's all mathematics going forward. The base level of operating FCF is multiplied by your growth rate each year, then discounted by the amount of stock option dilution, and finally discounted back to present value using the discount rate. As you might imagine, a spreadsheet is by far the best way to handle this task. For anyone interested, just email me, and I'll be happy to send you my DCF spreadsheet (no promises on compatibility with older systems or Macs).

8. Arriving at a range of fair value estimates
As I mentioned in Step 1, I looked at two levels of base operating FCF: the conservative three-year average of $9.5 million ($1.37 per share) and the more aggressive trailing-12-month figure of $13.6 million ($1.96 per share). When I apply the same set of assumptions (growth, options dilution, and discount rate) to these two figures, I arrive at business value of $20.85 on the low side and $29.85 on the high side. To both of these figures, I add the cash per share of $6.85, which leads me to an estimated fair value range for Group 1 of $27.70 to $36.70.

9. Linking the DCF value back to the P/FCF multiple
Finally, this DCF methodology can help you understand what types of P/FCF multiples to apply under certain sets of assumptions. If you take our two estimates of business value for Group 1 ($20.85 and $29.85), and divide them by their respective levels of base operating FCF ($1.37 and $1.96), you'll see that the P/FCF multiple in both cases is 15.2. (That's why I used a multiple of 15 in last week's Group 1 article.)

Whew! I know I covered a lot here, but hopefully this step-by-step approach to valuation will help you put a fair-value price tag on stocks. And again, if you're interested in reviewing my Group 1 DCF spreadsheet, just drop me a note.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he held shares of Group 1 Software. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.