Message Font: Serif | Sans-Serif

No. of Recommendations: 0
I have just finished reading the Cisco Fool research report. I t was very, very informative. However, I don't have a clue regarding the Intrinsic Value Calculation. Can anyone help me find some information on the procedures in this calculation?

First, thanks for the kind words about the report. I'm glad you found it helpful.

Now let me see if I can answer your question.

The basic premise behind an intrinsic value calculation is that you're trying to determine the present value of a series of future cash flows. That might not sound all that basic though, so I'll backtrack a bit from there.

In theory the value of a company is based upon how much money it can return to its shareholders in the form of either dividends or stock buybacks, or alternatively reinvest in the business to help spur future growth. In performing the calculation you also have to take into consideration the fact that due to inflation a dollar today is worth less than a dollar earned a decade from now, a year from now even a month from now. So, we have to discount all the cash flows back to today to try and determine what the estimated future cash flows are worth today.

It is common to use free cash flow (cash from operations on the cash flow statement less net capital expenditures) as the proxy for the amount of cash that a company can return to its shareholders or reinvest in its business. The beginning value of free cash flow can be calculated. There are 2 variables left up to the individual doing the calculation. One is the annual rate of growth for free cash flow. The other is the discount rate that is applied to bring the future value back into today's dollars.

In the report I showed figures using a 12% discount rate. I used this figure because historically the market returns 11%. I wanted to add a little more risk to the equation, so I used 12% rather than 11% (the higher the discount rate the less valuable the future cash figure is today; e.g., \$0.77 -- 1/(1-.12)*(1-12) -- two years from now at a 12% discount rate is worth \$1 today. \$0.81 -- 1/(1-.1)*(1-.1) two years from now at a 10% discount rate is worth \$1 today.

In performing my calculation I used a 15% growth rate in years 6-10 because that implies a doubling of free cash flow every 5 years and I used a 7% growth rate for all years beyond year 10 because that represents a doubling of free cash flow every 10 years (you can estimate how long something takes to double by using the rule of 72; i.e., divide the number of years into 72 and that gives you the growth rate). I then plugged for the growth rate of the first 5 years.

The value at the end of year 10 was the cash flow in year 11 divided by the capitalization rate.

I hope that this at least sheds some light on my calculation.

Fool on!

Phil

### Announcements

What was Your Dumbest Investment?
Share it with us -- and learn from others' stories of flubs.
When Life Gives You Lemons
We all have had hardships and made poor decisions. The important thing is how we respond and grow. Read the story of a Fool who started from nothing, and looks to gain everything.