Much simple way of calculating intrinsic value using FCF

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

Western Union (NYSE:WU; Price= $15.51; Long call with target price=$19.64; P/E=10.9; P/B=7.76) – 16 Oct 2014, With vested interest since Feb 2015.

Business Model: To send money efficiently and cheaply around the world with 510K locations. C2C represents 82% of revenue, geographical diversification of revenue split across Europe(22%), North America(19%), Middle East and Africa(16% with 6% growth YoY),Asia Pacific(12%), Latin & Central America(8%) and WesternUnion.com (4%, C2C E-commerce, with 31% growth YoY in digital expansion). C2B contributed 10% of revenue and Business Solution represents 7% of revenue.

Investment Thesis: 1) Price is low due to worry of compliance cost(4.5% of its revenue), but cost will be normalized in the future(FY14 guidance=3.5% to 4.0% of revenue), other competitors might not be able to compete due to non-compliance issue(country specific) like adhere to money laundering(for e.g. Barclays exited money transfer business in Jul 2013), therefore strong economic moat will most likely enhanced in future due to regulatory moat as shown by past average 5 years ROC = 643.5% 2) shareholder friendly; generate around $1.1b of operating cashflow, with 61% used to do stock repurchase and dividend payback 3) Strong distribution network, with more than 510K locations worldwide, emerging market would still need brick and mortar store to receive physical money with flexibility of doing price adjustment if there is a competition, 4) e-commerce segment is growing, as well as Business Solution segment(average 10% per quarter), 5) potential growth in India, China, Mexico and the Philippines with workers needed to send money back home. Remember spending money using credit card (value for purchased items are relatively lower) and transferring money(notional maybe large) are two different things. Need lower transaction cost, network effect(brick and mortar), compliance and reputation(163 years of history) to be in money transfer business.

Profitability & Financial Ratio:

	2009	2010	2011	2012	2013	TTM	2009-2013 CAGR
Revenue(USD mil)	5084	5193	5491	5665	5542	5587	1.74%
Gross Margin(%)	43.45	42.64	43.51	43.61	41.63	41.13	-0.85%
Operating Margin(%)	25.23	25.04	25.22	23.48	19.98	19.4	-4.56%
Net Margin(%)	16.7	17.52	21.22	18.11	14.41	14.04	-2.91%
Asset Turnover	0.79	0.68	0.65	0.61	0.57	0.56	-6.32%
Equity Multiplier	20.77	13.60	10.13	10.06	9.16	9.23	-15.11%
EPS(diluted)	1.21	1.36	1.85	1.7	1.43	1.44	3.40%
Free Cashflow per share	1.64	1.32	1.6	1.51	1.51	1.52	-1.64%
Number of shares(mil)	701	668.9	634.2	607.4	559.7	539.9	-4.40%
Dividend yield(%)	0.53	1.30	1.63	2.77	2.93	3.00	40.77%
EV/EBIT	11.15	10.21	8.8	7.55	10.44	6.32
ROC(%,Greenblatt definition)	646.85	648.75	701.98	674.78	545.52	526.96
Price to Free Cash Flow	8.93	14.07	11.41	9.01	11.35	10.31

Peer analysis: Xoom is operating on an online model only, trading at x128.7 P/E; Moneygram traded at 5.78 EV to EBIT but with lower net margin of 7.29% and only 300K locations. Euronet has less than 150K locations.

TTM	Western Union	Moneygram	Xoom	Euronet
Revenue(USD$mil)	5587	1516	140	1485
EV/EBIT	6.32	5.78	75.84	19.51
ROC(%)	526.96	4.85	14.25	112.36
Net Margin(%)	14.04	7.29	2.9	6.36
Asset Turnover	0.56	0.31	0.49	0.91

Valuation: Traded at 6.32x EV/EBIT(10 years EV to EBIT range: 5.3 to 19.9); 10.31x P/FCF(10 years P/FCF range =6.69 to 28.69). Using earnings power valuation with no growth assumptionà27% upside from current price

EBIT Margin average for the past 5 years	0.230811
Average Sales for past 5 years(mil)	5404
Average EBIT(mil)	1247.304	Required Return of Equity	9.00%
- Current interest(mil)	174	Forecast equity value(mil)	10603.38
- Current tax(mil)	119	Amount of outstanding share(mil)	539.9
Add: 3 years R&D	0
Earning Power(mil)	954.3039	Fair value of share(US$)	19.64

Risk: Low revenue growth; earnings hurt from strong USD in short term; competition from Peer to Peer transfer and Mobile Payment; economy downturn causes worker to lose job and then sending less money back home. However operating margin maybe able to improve to 25% once the compliance completed, thus offsetting the low revenue growth, with added bonus from digital expansion in C2C channel.

Summary: Buying a high ROC (due to regulatory moat and no high capex needed) company with a cheap price(temporarily low due to compliance cost) will offer decent return in a long run.(credit to Joel Greenblatt). Notable guru holdings: David Abrams(used to work with Seth Klarman, 26.31%), Charles Bobrinskoy(Ariel Focus,4.8%), John Rogers(Ariel Appreciation, 4.51%)