Determining intrinsic value per share of a stocks (Part 1 of 2) - Why free cashflows matters to a business and shareholders?

Why the need to determine intrinsic value per share of a company?

Since I started investing in June 2008, I have not conducted a rigourous determination of intrinsic value per share for the stocks I bought. I understood the importance of intrinsic value per share as it reveals how much the business underlying a stocks is worth. However, due to the lack of discipline to follow through the mathematical calculations behind determining intrinsic value per share, I kept procrastinating on learning this technique. This is an important exercise seeking to determine the true value of a company based on its cashflows. If the stocks market is not to be viewed as a speculative playground whereby securities are bought and sold by the minutes or at best only by the hours, this is where determination of intrinsic value for a stocks comes into play for the serious investor who wishes to invest his money carefully into only prospective stocks that are undervalued for their businesses.

Determining intrinsic value per share for a stocks has its place of importance because whether an investor is aware or not, whenever he is buying shares of a company, he is already having a part-ownership in the business of the company. The returns from his investment in the chosen company is determined by the economic prospects of the company and the price he pays for the shares of the company. If the company does well economically and is exceptionally profitable, the investor can expect bountiful returns from his investment (especially if he has invested at undervalued share prices). If the company fails, the investor may risk losing his invested capital in the company. Even if one is adopting a short-term attitude towards holding shares of a company, it still pays to know some important fundamentals about a company before investing one's money in the company as any unpleasant surprises can catch an ignorant investor unprepared even in short time period. There are already some examples of China concept stocks engaged in bad corporate governance and lack of integrity in management that caught investors unaware short-term before they can react.

Free cashflows is the lifeline of a business

Since I seek to be a focused value investor, determining intrinsic value of a business should be one important skill to master. Determining intrinsic value per share of a business depends on the present value of  future free cashflows a business can generate over a period of time (usually taken to be 10 years). Free cashflows are the lifeline of a company. The ability to generate continuous free cashflows ensures survival of a business. A business needs to generate free cashflows continuously as free cashflows can be used for purposes such as further investing in the business or payout as dividends to shareholders. A business that is unable to generate free cashflows consistently is destined for failure in a matter of time (as this suggests the business is basically not profitable at all).

Free cashflows = Net cash from operating activities - Capital expenditure 

To arrive at positive free cashflows, a company needs to have positive net cash from operating activities. The figure for "net cash from operating activities" can be directly taken from an annual report under the section, "consolidated cashflow statement". A positive net cash from operating activities is important as it shows that the business can generate cash from its operations. A consistent negative net cash from operating activities for a few years maybe a red flag signalling problems with the ability to generate cash from a business's operations. Who wants to invest in a business that cannot even generate cash from its operations? On the contrary, a business that shows consistent growth in its net cash from operating activities over the years shows its excellent business characteristics that allows continued generation of more and more cash from its operations.

Capital expenditure refers to money a company needs to spend on items to keeps its business running and growing at its current rate. Such items include plants, properties and equipments. As such, capital expenditure is a basic necessity to allow the business to maintain its operations and growth. For example, a biscuit making company needs to expend capital to buy a production plant to produce biscuit. It cannot produce biscuit without the necessary production plant with its equipment, so capital expenditure is necessary to produce biscuits. A company that can keep its capital expenditure to a minimum and yet maintain a good rate of growth in business is a good one. An investor can refer to the subsection "cashflow from investing activities" under "consolidated cashflow statement" and look for items such as "investing in/aquisition of plant, property and equipment" to have an idea on how much capital expenditure a company puts into its business.

Thus, free cashflows is whatever free cash left over after necessary capital expenditure is deducted from the net cash produced from a business's operations. An excellent company can produce large amounts of net cash from operating activities while keeping its capital expenditure to its lowest. This is the kind of business an investor will want to invest in, especially if a company can consistently produce significantly large amounts of free cashflows.

Free cashflows can be reinvested into a business to further its growth or to be paid out to shareholders. So, free cashflows is the lifeline of a company, it cannot do without.

More further discussions on determining intrinsic value per share of a company in later posts. I will also seek to critique my own investment portfolio to point out mistakes I committed in purchasing shares of companies that are overvalued based on their intrinsic value per share.

Discussion points:- Free cashflow = Net cash from operating activities - Capital expenditure

It is important to look for companies that shows consistent growth in net cash from operating activites while maintaining low capital expenditure, and yet has high return on equity (ROE).

The ability to consistently generate high free cashflows from a business allows the cash to be reinvested in the business or to be paid as dividends to shareholders.