Cash Flow Analysis
Cash Flow Analysis: A Private Lesson form Staley Cates
by Dan Ferris
“…The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for…”
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“[The intrinsic value of a business] is the discounted value of the cash that can be taken out of a business during its remaining life.”
Cash Flow Analysis: Listening to Warren Buffet
If that statement merely appeared in a textbook, I might yawn and disregard it. But I didn’t get it from a textbook. I got it from Warren Buffett’s Owner’s Manual, available online at www.berkshirehathaway.com.
Since Buffett is the richest investor alive, I believe knowing how to figure out “the discounted value of the cash that can be taken out of business during its remaining life” must be just about the most important skill you could ever possess, if your goal is getting rich by investing in stocks.
The tools you need to understand Buffett’s definition of intrinsic value go by the soporific moniker of discounted cash flow analysis. But when the richest guy in the world says it’s the most important thing you can know if you want to get rich, I’ll bet it’s worth staying awake for.
Lacking an informal, or formal, or any other type of relationship with the Sage of Omaha, I asked Staley Cates, co-manager of Longleaf Partners Fund, to enlighten me on the scintillating subject of cash flow analysis. (You’ll recall that Longleaf has been in the Extreme Value Model Portfolio since February 2004.)
Cash Flow Analysis: The Lesson
During our conversation, Cates told me exactly what I needed to know.
The following exchange took place by e-mail on May 27, 2004. The conversation starts in mid-thought. I’ll give it to you just the way it happened, and I promise it’ll be clearer by the end of my exchange with Cates.
Ferris: During your latest annual meeting, [Longleaf co-manager] Mason Hawkins mentioned the use of a “terminal multiple” in the process Longleaf uses to appraise business value. What is a terminal multiple?
Cates: When we do a longhand net present value calculation to discount back the free cash flows, we usually use eight years worth of cash flows at a particular assumed growth rate. Then [at the end of] year 8, we put the terminal multiple (almost always one that assumes no growth from that point forward) on the cash flows at that point. That is what values the remaining cash flows from the business beyond year 8. The main thing there is being very conservative since no one can really have a clue what will happen then.
Ferris: So it’s just a price-to cash flow number that’s put on the business at the end of year 8?
Cates: Basically yes; to be more exact it’s price to free cash flow (after taxes, after capital expenditures) so it corresponds more to price to earnings, instead of price to cash flow. Price to cash flow is of limited value since it doesn’t take into account required capital expenditures.
Ferris: Do you use market multiples, or do you assign different multiples to different businesses?
Cates: Way below market multiples because we assume they don’t grow in that period from year 8 on. Like Warren Buffett says, we want to be approximately right, not precisely wrong. So, we use no-growth multiples for everything.
Ferris: No growth…so we’re talking low single digit multiples times free cash flow (less tax and capex)? I don’t expect you to give out proprietary information. I’m just fascinated with what Longleaf does. I want to learn what it is and how to do it myself so I can pass it along to my readers.
Cates: If there are any more questions I’m gonna start sending bills! If you’re using a 9% discount rate, a “no growth” multiple is 11X by definition. If you’re using 10% discount rate it’s 10X, etc. That year 8 multiple, once it’s discounted back to today, probably works out to low single digits. Consider a simplified example: a company with $100 of earnings, which we’re defining once again as free cash flow minus taxes and capital expenditures. Let’s say this earnings stream is growing at 5% a year. It looks like this:
Year 1 $100
Year 2 $105
Year 3 $110
Year 4 $116
Year 5 $122
Year 6 $128
Year 7 $134
Year 8 $141
For a business to grow 5% forever is an incredibly aggressive assumption in the real business world. So instead of this spreadsheet going on with 5% growth forever, year 9 and everything beyond it would be estimated as follows: $141 x 1.05 x 10 = $1,480. So your table looks this:
Year 1 $100
Year 2 $105
Year 3 $110
Year 4 $116
Year 5 $122
Year 6 $128
Year 7 $134
Year 8 $141
Year 9 and beyond $1,480
Note: The year 9 free cash flow total of $1,480 includes the dreaded “terminal multiple, ” i.e., 10x.
Now discount this block of cash flows at desired discount rate and you’ve got your net present value of the free cash flows, for which Longleaf never pays more than 60%. If you simply grew it at 5% forever, you’d get a much higher number, but you’d be kidding yourself about the life expectancy of the business.
After estimating free cash flow growth through a period of several years, each year’s estimate is multiplied by a discount factor to find the present value of the future free cash flow.
That process looks like this:
Earnings Discount factor Discounted cash flow
$100.00 .9091 $90.91
$105.00 .8264 $86.77
$110.00 .7513 $82.64
$116.00 .6830 $79.23
$122.00 .6209 $75.75
$128.00 .5645 $72.26
$134.00 .5132 $68.77
$141.00 .4665 $65.78
$1,480.00 10X .4241 $627.67
Total Present Worth of Discounted Cash Flows: $1,249.77
Total Present Worth of Discounted Cash Flows minus 40% discount: $749.86
Where I got the discount factors is a topic for another day. The point is that cash received farther in the future is worth less today than cash received sooner due to the opportunity cost of not making returns on your money another way. The discount factor tells you how much less it’s worth today, based on (1) how long it’ll be before you get it, and (2) the minimum amount you need to make for investing in stocks to be worth the risk. At 10%, my minimum assumes about twice as much risk as is currently priced into the overall stock market.
Based on this kind of analysis, Longleaf Partners would pay no more than about $749.86 for this hypothetical business. Divide that by the number of outstanding shares and you’ve got the maximum value Longleaf would assign to this stream of cash flows.
That’s the end of my private lesson with Staley Cates.
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