The SEENSCO Operating Cash-Flow Model determines the value of a business as a function of its operating cash flows. There are a number of different cash-flow based valuation models in use today, ranging from pure free cash-flow to the firm and free cash-flow to equity models to approximation based models built around NOPAT or EBITDA. Pure free cash-flow models, typically used in a discounted cash-flow context, suffer from one major drawback when used for stock valuation as free cash-flows have a tendency to fluctuate significantly from year to year due to unpredictable capital expenditures, extraordinary items, and abnormal equity buybacks. It can also tend to be difficult to estimate normalized free cash-flows and normalized free cash-flow multiples. NOPAT and EBITDA models alternatively are highly sensitive to accounting distortions, which can render them completely useless. A reasonable middle ground is to rely on operating cash-flows as the basis for valuation.
Publication Length (Number of Pages)
- Dow Jones Industrial Average (38 pages)
- S&P/TSX 60 (68 pages)
- S&P 500 (518 pages)
Many investors believe that cash flow are a more useful gauge of a stock’s value than earnings. Why? Because the amount of cash a company generates is in fact a more important measure of a company’s health. Investors will almost certainly hear more about company earnings in the media than almost any other metric on valuation, but it doesn’t really provide the most accurate picture of a company’s ability to generate cash, which is ultimately the bottom line.
Operating cash-flows represent the amount of cash that flows through the business after all cash-based sales have been collected and cash-based operating expenses have been paid and necessary investments in working capital (e.g., inventory) and have been made. Operating cash-flows are not affected by sometimes volatile cash-based capital expenditures nor are they affected by cash payments or cash collections from stockholders, bondholders, and sometimes, preferred stockholders.
The equations used to calculate operating cash-flows are a function of the accounting information SEENSCO has available. Operating cash flows are calculated by adding back to net income from continuing operations depreciation and depletion charges, reconciling for changes in receivables, inventory, payables and other working capital requirements, and then adjusting for changes in deferred taxes, stock based compensation, and other items.
Pricing a company’s stock using the SEENSCO operating cash-flow model involves first estimating 10 year forward sales and earnings per share and then applying an operating cash-flow-to-earnings multiple to projected earnings to determine the future cash-flow stream. A valuation for the company is determined by assigning an equilibrium P/OCF ratio to a 10 year average cash flow projection. Adjusting this fair value by the normal trading range of the company’s stock gives the stock’s fair value range. A compound annual growth rate is then computed, assuming a 5 year holding period. Generally, stocks whose compound annual returns exceed the projected long-term annual rate of return on the market will qualify for investment while stocks whose returns are lower will qualify for sale.
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Price Tracking in Excel
Target price estimates and valuation ranges for all companies covered in the S&P 500 are available online, with weekly price refreshes, and are downloadable in Excel spreadsheet format under license from SEENSCO. The spreadsheet service is available with one-year subscriptions and is accessible via your online accounts. This service allows for up-to-date monitoring of return potential expectations.
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