Determining Fair Value, Steps 1 and 2: Project Free Cash Flow and Determine a Discount Rate

The first step in projecting future cash flow is to understand the past. This means looking at historical data from the company's income statements, balance sheets, and cash-flow statements for at least the past four or five years.

Step 1: Project the free cash flow

Once you've examined the historical data and perhaps entered it into a spreadsheet program, it's time to project the company's free cash flow in detail for the next couple of years. These projections are the meat of any discounted cash flow (DCF) model. They will rely on your knowledge of the company and its competitive position, and how you expect things will change in the future. If you think profit margins will expand, or sales growth will slow dramatically, or the company needs to increase its capital expenditure to maintain its facilities, your projections should reflect those predictions.

Next, we need to estimate the company's "perpetuity year." This is the year at which we feel we can no longer adequately project future free cash flow. We also need to make a projection concerning what the company's free cash flow will be in that year.

An example

To begin, let's suppose that the fictitious firm Charlie's Bicycles generated $500 million in free cash flow last year. Let's also assume that Charlie's current lineup of bikes are very hot sellers, and the company is expected to grow free cash flow 15% per year over the next five years. After five years, we assume competitors will have started copying Charlie's designs, eating into Charlie's growth. So after five years, free cash flow growth will slow down to 5% a year. Our free cash flow projection would look like this:

Step 2: Determine a discount rate

Because we're using the "free cash flow to equity" method of DCF (discounted cash flow), we can ignore Charlie's cost of debt and WACC (weighted average cost of capital) in coming up with a discount rate. Instead, we'll focus on coming up with an assumed cost of equity, using the principles of discounted cash flow.

Charlie's has been in business for more than 60 years, and it has not had an unprofitable year in decades. Its brand is well-known and respected, and this translates into very respectable returns on its invested capital. Given this and the relatively stable outlook for Charlie's profits, settling for a 9% cost of equity (lower than average) seems appropriate given the modest risks Charlie's faces.