Another component of the discounted cash flow (DCF) approach is free cash flow (FCF). This concept is a modification of earnings in an attempt to determine the actual cash generated by the business as distinct from its earnings.

Free cash flow is not calculated in Conscious Investor since it is not needed in any of the calculations.

Although STRET (Stock Return) and STRETD (Stock Return assuming dividends are reinvested or “Total Return”) calculations could be based on free cash flow instead of earnings, this would take a large amount of work adjusting every company’s financial statements substantially and therefore be more difficult to implement with accuracy. Most significantly, the free cash flow approach would not increase the accuracy of your results.

Conscious Investor uses a methodology that was designed with the investor’s confidence, ease and accuracy in mind, rather than some text book theory. Read more at “The Hidden Desires of Investors”

Rather than estimating cash flows, whether earnings or free cash flow, out to infinity and “discounting” these back to some theoretical value, Conscious Investor instead provides a “Forward Value” (FV) calculation.

The calculation starts with the premise that we want to know what a company’s performance will look like in 5 or 10 years time. We then look at the current stock price, in relation to the future value generated, to forecast a likely return that we can expect to achieve.

For example, to apply STRETD (i.e. “Total Return”) you need to estimate the Price Earnings (PE) ratio and earnings growth rate (HGROWTH) in 5 years time.

This can be done based on a huge amount of historical and current data about the company including a full history of the PE ratio.

To use free cash flow you would have to estimate the price to free cash flow ratio in 5 years. You would have scant information to do this.

Two final points.

Whether or not free cash flow is a more useful concept than earnings for understanding a business is not relevant to the Conscious Inventor calculations. We simply use earnings as a method for calculating the future market price of an investment.

Finally, free cash flow is also an accounting concept so is no more or less reliable than earnings. It is subject to as much manipulation and misstatement as earnings is.

Conscious Investors can overcome accounting misrepresentation by looking at companies over at least 5 years or more and by ensuring that companies perform well across a range of financial data – not just earnings data. When you do take a more holistic approach, our experience shows that you will get sufficiently early warning of poor performance to preserve your capital in most cases of corporate mismanagement or misrepresentation.

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