James A. Ohlson(http://www.cfapubs.org/doi/pdf/10.2469/cp.v1998.n2.6) has derived quite a simple way of determining whether a company is over or under value by just using a few simple parameters on using Free Cash Flow(FCF)
1) Current FCF, the author used FCF = NOPAT - Change in Invested Capital, but I will use an easier format which is cashflow from operation - capital expenditure
2) Anticipate growth in FCF, use growth of sales to infer the growth rate of FCF, but I can also use the past 5 years FCF history to determine the growth rate of FCF.
3) Use modified dividend growth model and applied it to FCF, which is = Current FCF * (1 + Growth)/ (r- Growth)
4) Infer r by reverse engineering, which derive r = Growth + Current FCF/value of the firm(cash yield), where value of the firm = market cap of equity + net debt
5) Decide whether the stock is overvalue or undervalue by looking at r. If r is high, means it is undervalue, vice versa.
This illustrates that investor's expected return has two components: growth and cash yield. What a company does not generate in growth it must generate in current FCF, what it does not provide in current FCF it must provide in growth
I will use an example here to illustrate the formula, Franklin Resources(NYSE:BEN),
1) Current FCF of BEN = 2,566million
2) Growth in sales for the past 5 years = 14.8%
4) Value of firm (enterprise value) = 22,828 mil
5) r = growth + cash yield = 14.8% + 2.566/2,2828 = 26%
Relatively high r, so Franklin Resources is undervalue at this moment
