Michael Mauboussin believes this simple, fair-value calculation method deserves a book

The upsurge in the equity markets is not in India alone. In fact, most leading equity markets have been doing quite well for the past few months

Can you know a company’s fair value if you know the cash flows per share, through a ‘reverse Discounted Cash Flow’ calculation? Can you know if a stock is cheap or expensive, without complex formulae?

A Twitter handle Compounding Quality (@QCompounding) explained how to go about it, with a simple example. Ace investor and Adjunct Professor of Finance at Columbia Business School, Michael Mauboussin shared the post adding, “Someone should write a book on this”.

Also read: We should stop bashing share buybacks by Michael Mauboussin

The example given by Compounding Quality’s post assumed a company, called Quality Inc., growing at the same rate forever.

Then to calculate the value of a company, you will need the free cash flow per share, expected return and yearly growth rate of free-cash flow (FCF).

The formula: Value of the company = Free cash flow per share in year 0/ (expected return – yearly growth rate FCF).

If Quality Inc had free cash flow per share of $10, yearly FCF per share growth rate of 8 percent and the investor’s expected rate of return was 10 percent, then the value of the company would be $500.

That is, if an investor buys Quality Inc at $500, then he/she can expect a yearly return rate of 10 percent.

The investor could also check the price at which the company is trading at and see if the expectations built into the price are realistic.

For example, consider the same company was trading at $400, with FCF per share still at $10 and the investor still wanting a 10 percent return.

Then, the earlier formulae can be turned around to what is below:

Yearly growth rate of FCF = Expected return – (FCF per share in year 0/Value of the company)

Then, yearly growth rate of FCF = 10% - ($10/$100) = 7.5%.

The market is paying $400 for the company expecting FCF to grow at 7.5 percent. If you believe that the company gave grow FCF at a higher rate than that, then you should see the company as undervalued.

The first formula could also be turned around to calculate your expected rate of return.

Expected return = Yearly growth rate FCF + (FCF per share in year 0/Value of the company)

If the company is trading at $400, has FCF per share at $10 and can grow its FCF per share every year till perpetuity, you can expect a return of 10.5 percent.

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That is, if you buy the company at $400, you can expect to earn 10.5 percent every year.

The Twitter handle adds a disclaimer that there is no company that can grow its FCF per year at the same rate forever. Therefore, the examples are “good to get a first grasp about a company, but shouldn’t be used to base your investment decisions on”.