Free Cash Flow Rules: AmEx, Mohawk

Beginning in 2009, it's reasonable to expect free cash to grow by 12% a year for the next four years. Given Mohawk's dominance, I think it will be much more, but let's be conservative. Let's also assume a discount rate of 10%. For a business as strong as Mohawk, 10% might be a notch too high but the goal is to get a really conservative valuation. The numbers are as follows:

Mohawk's Prodigious Free Cash Flow
Year	FCF	Present Value of FCF @ 10% discount rate
2008	$500m	$455m
2009	$560m	$463m
2010	$627m	$471m
2011	$702m	$480m

The sum of the present value of the cash flows is $1.87 billion. Given that Mohawk has grown its profits and cash flow in the high teens for some time, the company's terminal value could easily be worth 15 time's free cash flow of 2011. Discounted back to the present, you get a value of $7.2 billion ($480M *15), or a total company value of approximately $9 billion ($7.2 + $1.8).

Assume shares outstanding increase by 5% percent over the four years to 72 million from 68.5 million today. Since 2004, diluted shares outstanding rose by only one million shares (less than 2%). A $9 billion market cap over 72 million shares equals a share price of $125 in 2011, up from $66 today.

And this valuation hinges on conservative assumptions, but I think it's wise to invest with a wide margin of safety.

Focus on Cold Hard Cash

Fixation on cash generation keeps your analysis focused on what counts. Of course, there will be special investment situations that will be require another set of valuation parameters, but special situation investments are few and far between. Yet in markets like these, with everyone rushing to sell at the first sign of trouble, many wonderful businesses are producing gobs of cash and going unnoticed. It won't last long.

This was originally published on RealMoney on August 15, 2008. For more information about subscribing to RealMoney, please click here.

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