# Present Value of Future Cash Flows



## craft

It’s hard to think of a few words that encompass a whole Investment Strategy – The name of this thread is as close as I could come.

Investing in undervalued companies to provide a future passive income stream is my strategy, a simple enough goal but one with many complexities in the detail. Are there any other forum members interested in discussing this approach to investing?  I have read plenty of books but I would be interested to see what else could be learned through a more interactive dialogue.

So who’s out there that’s interested in discussing this or similar approaches.

Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.


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## So_Cynical

*Re: Present Value of Future Cash Flows.*

Happy to discuss under-value in broad terms, but the whole "value" investing criteria i find a little boring and rigid..iam also building a passive revenue stream using a low cost averaging strategy...FY 11/12 dividends and distributions already on target for 20%+ dollar growth.


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## craft

My idea of investing has a basic tenant that the purchase price must be solely justified by the cash flow produced by the asset.

I am solely focused on swapping a capital amount for a cash flow, with no reliance on swapping that cash flow back to a capital amount at a future date.   That is not to say that I don’t ever sell, but selling for me is about an ‘option’ to commute future cash flows back to a capital amount, rather than the necessity to sell in order to vindicate the investment.  

This option to ‘sell or not’ is incredibly powerful and facilitates the ability to sit through market price weakness and eventually take advantage of market strength to realise capital gains, the very thing that the strategy does not focus on and does not pay an ANY opportunity price for.

On the basis of my strategy, gold for example does not fit my definition as a suitable investment because the outcome is solely dependent on the sale price. If you buy gold now you need to pay a price of US$1,600 odd for the opportunity to hopefully be able to convert it back at some future stage to a larger amount of cash.  This investment can only be vindicated on a future sale price. Because you must pay a large price for the opportunity to make a capital gain that puts you in a weak position to sit through market weakness because of the fear that you may never recover the upfront opportunity cost you had to pay to play the game. 

As with gold, buying any stock where you are paying any upfront cost for the opportunity of making a capital gain on the sale does not suit my investment approach. The price I pay must be solely justifiable on my best estimate of its future cash flows.  If I can’t estimate the cash flows because of a lack of knowledge on my part or a lack of predictability or clarity arising from the business then I’m not interested. (or at least I shouldn’t be).


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## craft

*Re: Present Value of Future Cash Flows.*



So_Cynical said:


> using a low cost averaging strategy.




Do you want to expand on what you consider a low cost averaging strategy to be?

How do you define low cost?

Why do you use averaging and what are you averaging - are you slowly deploying an initial lump sum?


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## craft

This is the sort of thing I’m attempting to do.

Consider buying DTL 8 years ago to the day. The price would have been $1.67 on the close following a run up from 90 odd cents in the previous 3 months.

This is not a data mining exercise to find a company that fits the strategy because although the date of 1 Sept 2003 is arbitrary I owned shares in the company prior to that date on an assessment of the then known information. I have held those shares continuously since then including the near 50% market price decline during 2008, because I hadn’t seen a compelling reason to commute the cash flows prior to the decline.  

Cash Flows would be as follow (dividends grossed up to make them comparable to Interest returns)

0	-$1.67
1	.33
2	.27
3	.40
4	.51
5	.66
6	.71
7	.80
8	.54

Cash flow is simplified because it doesn’t take into account semi-annual dividend payment or any tax timing issues in relation to imputation etc – but you get the picture. 

If you wanted to commute the cash flow today the market is offering a price of $13.36, taking advantage of this opportunity would give you a IRR of 43% CAGR over the last 8 years. 

If you are not prepared to commute the cash flow now, you shouldn’t really include the market price in your cash flow because there is no saying that you will make a good decision on when to sell. Eliminating the sell price from the equation the cash flows themselves have returned a CAGR over the last 8 years of 22%. So long as DTL continues to deliver some cash flow into the future or it is eventually sold for a price greater than zero than the ultimate return on that initial $1.67 will be north of 22% CAGR.  The next cash flow of 55 cents gross is due 30 Sept.


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## McLovin

craft said:


> Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.




What do you think it is?


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## craft

McLovin said:


> What do you think it is?




I’ll graciously allow you to go first  because I won’t be persevering with a one person dialogue thread.

Cheers


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## Macros

Whilst I think that the idea is good in principle, you will have a major problem achieving long term success with this model.



> I am solely focused on swapping a capital amount for a cash flow, with no reliance on swapping that cash flow back to a capital amount at a future date.




You say that your intent would be to never sell, but I think there are two problems with this concept. 

Firstly, you are implicitly expecting exponential growth, which given the environment today is very unlikely as we are likely to face deflation in real terms. Therefore on this basis, this type of strategy is best applied earlier on in a long term bull market (e.g. 1980s onwards). We are facing massive credit deflation and this is going to impact us for years, with flow on impact on all types of investments.

Secondly, if you are speaking about investing in companies in Australia, then there is an issue of a growth ceiling. Given that there unlikely to be scalable opportunities for business growth overseas (experienced by most Aus companies), a successful company can grow only so large before the cash flows grow at a declining pace and eventually stagnate if not decline.

It is my view that this type of investment strategy is possible, but unlikely to be successful at this current point of time. When I say successful, it is a relative concept. The sort of environment that we are in is, in my view, best navigated by a adaptable strategy. As a value investor, I'm comfortable to change 100% of my positions at any point in time if I see a value shift up or down. 

It seems that one should constantly be on the look-out for relative value because it is a volatile, dynamic and hazardous environment which is impacted by governmental influences throughout the world. If what I say is true, a static long term dividend growth investment philosophy is going to rely more on luck than insight.


I don't want to get bogged down on this subject, however you say:


> gold for example does not fit my definition as a suitable investment because the outcome is solely dependent on the sale price



This is false. If you had gold, you could technically choose to lend it to someone (e.g. Russia) and receive interest in return, just like cash. However you face counter-party risk and are unlikely to ever get the physical asset back.


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## craft

Hi macros, thanks for your post. I've added some responses.



> You say that your intent would be to never sell




My intent is to never build in the need to sell as part of the purchase equation. There is a big difference.



> two problems with this concept.
> 
> Firstly, you are implicitly expecting exponential growth, which given the environment today is very unlikely as we are likely to face deflation in real terms. Therefore on this basis, this type of strategy is best applied earlier on in a long term bull market (e.g. 1980s onwards). We are facing massive credit deflation and this is going to impact us for years, with flow on impact on all types of investments.




I think this environment is more suited to the strategy then a protracted bull market. It gives me the chance to reinvest the dividends at a higher yield. At the heart of the strategy is investment for cash flow not capital gains. 




> Secondly, if you are speaking about investing in companies in Australia, then there is an issue of a growth ceiling. Given that there unlikely to be scalable opportunities for business growth overseas (experienced by most Aus companies), a successful company can grow only so large before the cash flows grow at a declining pace and eventually stagnate if not decline.




So long as you pay the right price you can make a good return without any growth. You just have to be careful how you re-invest the cash flow.




> It seems that one should constantly be on the look-out for relative value because it is a volatile, dynamic and hazardous environment which is impacted by governmental influences throughout the world. If what I say is true, a static long term dividend growth investment philosophy is going to rely more on luck than insight.




I agree 100% that we should always be looking for relative value. That is why I draw the point that purchasing without basing it on the need to sell is not the same as never selling. Capital Gains Tax (well at least for me for the next 25 years) is a consideration on the costs of moving between relative values



> If you had gold, you could technically choose to lend it to someone (e.g. Russia) and receive interest in return, just like cash



 I take your point. If you want to lend your gold out to the Russians then more power too you. Gold remains outside of MY definition of an Investment. As does cash for that matter, even though it can be lent for interest, it still doesn’t actually produce anything in of itself.


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## Ves

As you know from our private discussions I am very interested in this method. My learning / knowledge is still in its infancy, but I will try to add my two cents worth if I see fit.

The idea originally appealed to me because I want to replace my employment income with passive income. Intuitively, it makes much more sense to do that with the aim for a growing income stream, rather than capital growth. 

Whilst you could aim for capital growth (with the intention of "redeeming" capital when you need income), the process is complicated by tax, brokerage, lumpiness of returns etc (you have to wait until the market gets to your "sell price"). Dividends are far more tax effective. However, a growing dividend naturally leads to capital growth in the long term. Another important metric is "yield on cost" over the long-term. In this type of strategy I would prefer worrying about what the actual business is doing, rather than the whims of the market at the time. Therefore, it is logical to focus on the underlying security as future income stream.

Craft; Have you investigated / or used leverage at all with this strategy?


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## Macros

> My intent is to never build in the need to sell as part of the purchase equation. There is a big difference.




My view is that there is always a need to sell if value is diminished or risks exceed the expected value to be gained. If the value that you thought existed, no longer exists, then a decision must be made as this impacts on future potential cash flows.




> I think this environment is more suited to the strategy then a protracted bull market. It gives me the chance to reinvest the dividends at a higher yield. At the heart of the strategy is investment for cash flow not capital gains.




What I meant was that if you are constantly focusing on value, it is more important to protect and grow your purchasing power by improving your relative value, which should ultimately increase your future yield much more effectively than growing dividends. Since growing dividends are a function of business growth, it will depend on the growth of the business and the economic environment. Therefore the heart of the strategy still is reliant on earnings trajectory, as does value investment.

If you are investing for dividends over value, then you are not necessarily being optimal in your investment strategy and at worst could make decisions which do not conform to a value philosophy.

I agree that transaction costs and tax are an issue, but I think they a secondary consideration after value. At best, if I needed income and was not comfortable in relying on capital, then you could potentially do two things. First would be to add a minimum requirement of a %dividend yield. Second would be to increase the weighting benefit of payout ratio in calculating expected value to reward dividends.

In the end, you are relying on dividend growth through either reinvestment or organic growth. Dividends are a derivative of earnings power and are not guaranteed to increase. Therefore value must be a consideration of first order and dividends second order.



> Gold remains outside of MY definition of an Investment. it still doesn’t actually produce anything in of itself.




It produces a store of value. It may not be prudent to be 100% invested at all times, especially if value cannot be found or if income is received and not immediately invested (i.e. waiting for greater value). In my view, gold as a store of value is infinitely better than cash at this point in time. Thinking about stores of value should be important for all investors in my view.



> If you want to lend your gold out to the Russians then more power too you




I definitely would not consider such a thing! I don't actually hold gold at the moment, but if I didn't see significant value in my investments then I would do so.


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## skc

craft said:


> It’s hard to think of a few words that encompass a whole Investment Strategy – The name of this thread is as close as I could come.
> 
> Investing in undervalued companies to provide a future passive income stream is my strategy, a simple enough goal but one with many complexities in the detail. Are there any other forum members interested in discussing this approach to investing?  I have read plenty of books but I would be interested to see what else could be learned through a more interactive dialogue.
> 
> So who’s out there that’s interested in discussing this or similar approaches.
> 
> Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.




On overall philosophy...

Depends on your overall objective. While it is certainly workable to say I want to invest for cashflow and I am so conservative that I ignore the sale price in the end, one have to question sensibly whether that is the best strategy to achieve your overall objective.

Now if your objective is to earn consistent cashflow without ever needing to sell (acknowledging that it doesn't mean you never sell) and without full time effort (i.e. sit in front of the screen all day), then your philosophy might be suitable. 

My objective is simply to make the most money possible without too much risk. And that means I am open to any investment/trading style that offers the best risk-adjusted returns - subjected to boundaries like skill, knowledge, moral and legality etc etc. And on those objectives the ideal "philosophy" for me will always be short term and take into account of all cashflows.

On undervalue...

You can tell how much a house is worth by looking at the value of the houses around it. Same with businesses. The beauty of relative value consideration is that you more or less left the analysis of the industry to the market. Every bank is capitalised at 12% and that represent the average view of outlook for the banking industry. When you find a bank capitalised at 15%, you have identified relative value. The task then becomes finding out about this "undervalued" bank to make sure there are no skeletons in the closet. 

I think relative value offers the highest possibility of out-performing the market. You won't necessarily achieve absolute performance, however. 

On DTL...

I think IT companies in Australia are overall quite "undervalued" relative to other sectors. They often trade at PE 10 but with much consistent profit and growth even in downtrun. I held TNE for many years. TNE is right next door to DTL and I had a choice between the two and I picked TNE... only underperformed by ~5x


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## craft

Macros said:


> My view is that there is always a need to sell if value is diminished or risks exceed the expected value to be gained. If the value that you thought existed, no longer exists, then a decision must be made as this impacts on future potential cash flows.
> 
> What I meant was that if you are constantly focusing on value, it is more important to protect and grow your purchasing power by improving your relative value, which should ultimately increase your future yield much more effectively than growing dividends. Since growing dividends are a function of business growth, it will depend on the growth of the business and the economic environment. Therefore the heart of the strategy still is reliant on earnings trajectory, as does value investment.
> 
> If you are investing for dividends over value, then you are not necessarily being optimal in your investment strategy and at worst could make decisions which do not conform to a value philosophy.
> 
> I agree that transaction costs and tax are an issue, but I think they a secondary consideration after value. At best, if I needed income and was not comfortable in relying on capital, then you could potentially do two things. First would be to add a minimum requirement of a %dividend yield. Second would be to increase the weighting benefit of payout ratio in calculating expected value to reward dividends.
> 
> In the end, you are relying on dividend growth through either reinvestment or organic growth. Dividends are a derivative of earnings power and are not guaranteed to increase. Therefore value must be a consideration of first order and dividends second order.



 I pretty much agree with all of this. I think because of my criteria for the buy price not to rely on a selling,  you are interpreting me to be a lot more reluctant to sell than I really am.  If things change from what I was expecting, I  act on the new information and if that means selling than that is what I do. If I have led you to believe I focus on dividends then I haven’t written very well. Dividends are secondary - My focus in determining value is Economic Free Cash Flow. I’m perfectly happy if the company retains that cash flow and invests it profitably. 



> It produces a store of value. It may not be prudent to be 100% invested at all times, especially if value cannot be found or if income is received and not immediately invested (i.e. waiting for greater value). In my view, gold as a store of value is infinitely better than cash at this point in time. Thinking about stores of value should be important for all investors in my view.




In relation to Gold. It simply does not suit my investment strategy. In relation to a store of value my defence is attack. I want to own income producing assets at the right price to build my wealth and I also want to own the exact same assets to preserve my purchasing power.

I agree that gold purchased at the right price is probably a better store of value than cash. The problem is that I don't know what the right price is and I really don't have much interest in learning, I'm happy to focus on income producing assets but have no problem that other prefer  gold.


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## craft

Ves said:


> Craft; Have you investigated / or used leverage at all with this strategy?




Short answer is No

I actually built my capital via much more active trading then outlined here. In that environment I felt that I was already exposed to enough risk and wasn’t comfortable holding debt. There was also enough reward potential to not need it. I did use leveraged instruments at time but always managed the risk as if the positions were fully funded. By the time I had adopted the investment strategy outlined here I had enough capital to not really need leverage. Additionally I have used up some headroom for taking on risk by the nature of the stocks I hold and my relative lack of diversity. 

If I was younger, had a secure alternative source of income  and needed leverage to secure my objectives I would consider using a moderate level of debt , tailoring my approach to take some other risks out.
I think you should probably seek advice from some others that do use leverage. I’m guessing there is more than just theory that comes into play in a situation where you are in serious drawdown or suffering a cash flow shock.


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## craft

skc said:


> and without full time effort (i.e. sit in front of the screen all day) :




That’s the whole objective - passive income ie retirement from active trading. Reality is that I still spend a lot of time researching businesses, but that’s because I enjoy it and use it to fill in free time. I do however have the freedom to turn off for a few months and still have an income. 




> My objective is simply to make the most money possible without too much risk. And that means I am open to any investment/trading style that offers the best risk-adjusted returns - subjected to boundaries like skill, knowledge, moral and legality etc etc. And on those objectives the ideal "philosophy" for me will always be short term and take into account of all cashflows.



 Sounds robust to me.



> On undervalue...
> 
> You can tell how much a house is worth by looking at the value of the houses around it. Same with businesses. The beauty of relative value consideration is that you more or less left the analysis of the industry to the market. Every bank is capitalised at 12% and that represent the average view of outlook for the banking industry. When you find a bank capitalised at 15%, you have identified relative value. The task then becomes finding out about this "undervalued" bank to make sure there are no skeletons in the closet.
> 
> I think relative value offers the highest possibility of out-performing the market. You won't necessarily achieve absolute performance, however.



 I agree with all this, my personal focus however is is absolute not relative.


On DTL...



> I think IT companies in Australia are overall quite "undervalued" relative to other sectors. They often trade at PE 10 but with much consistent profit and growth even in downtrun. I held TNE for many years. TNE is right next door to DTL and I had a choice between the two and I picked TNE... only underperformed by ~5x :banghead



 With only two determining decision to focus on, what to hold and at what price - Stock selection is hopefully where the skill (some may say luck) comes in.


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## Macros

> I pretty much agree with all of this. I think because of my criteria for the buy price not to rely on a selling, you are interpreting me to be a lot more reluctant to sell than I really am. If things change from what I was expecting, I act on the new information and if that means selling than that is what I do. If I have led you to believe I focus on dividends then I haven’t written very well. Dividends are secondary - My focus in determining value is Economic Free Cash Flow. I’m perfectly happy if the company retains that cash flow and invests it profitably.




Came across to me more as investment cash flow as opposed to economic cash flow. In this case, we are on the same page and therefore are really just looking at pure value investment and a snowball effect. However there seems to be an infinite amount of possibilities of how one goes about achieving this objective. Of course, there clearly isn't an infinite amount of possibilities that are all successful either.


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## So_Cynical

*Re: Present Value of Future Cash Flows.*



So_Cynical said:


> using a low cost averaging strategy.






craft said:


> Do you want to expand on what you consider a low cost averaging strategy to be?
> 
> How do you define low cost?
> 
> Why do you use averaging and what are you averaging - are you slowly deploying an initial lump sum?




My low cost averaging strategy is based around the fact that shares go up and down, the greater the time frame the greater the up and down movements..in general.

I buy shares when they are in the lower half/third of there price range or pulling back from an upswing...keeping in mind general market sentiment and the fundamentals of the company and how it makes money.

i average because its impossible to pick bottoms but find that in trying to buy bottoms and buying more if the SP falls significantly further, that invariably i end up "capturing" the bottom over the longer term, looking back.

ill post 2 of my older trades so you can see what i mean...keeping in mind i still hold shares in both stocks and have gross divi yields of around 10% on capital







-------------------








Unlike what your thinking of doing...i use capital growth to fund my next trade and grow my dividends by adding new stocks to my portfolio and re-entering stocks already held...i typically exit a trade with 75 to 85% of my original capital leaving the other 15 to 25% in with the profits that are typically between 7 to 15% ~ i grow my dividend and distribution yield by growing my capital and growing the number of shares and stocks held.

Last financial year 24% of my income was from trading and 8% dividends & distributions.  this year that should grow by between 10 to 20%


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## McLovin

My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.

To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.

It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.


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## doctorj

McLovin said:


> My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.
> 
> To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.
> 
> It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.



Interesting approach, though I think you're being relatively modest.  A DCF model isn't straightforward at all.  Do you focus on a particular industry (you mention insurance?) or is your approach applicable across a range of sectors?  Does this mean your universe of "investable" stocks becomes very small and your portfolio very concentrated?

I fully agree with the pen and paper approach - evaluating the risk in a company is a bit like looking for a needle in a haystack.  Management will scream all the good news from the roof tops and bury the bad news in useless detail.


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## McLovin

doctorj said:


> Interesting approach, though I think you're being relatively modest.  A DCF model isn't straightforward at all.




I sort of agree, however I find that doing the model does wonders in actually helping understand the nature of the business. In my previous employment I used to do a bit of of DCF modeling so I'm not completely "green" at it.



doctorj said:


> Do you focus on a particular industry (you mention insurance?) or is your approach applicable across a range of sectors?  Does this mean your universe of "investable" stocks becomes very small and your portfolio very concentrated?




Not really, I have found that businesses with recurring revenue streams occur in almost every industry, to some degree. It's not an absolute must have, it's just something that I have found increases earnings visibility and thus reduces risk. I guess if you are looking for it you'll find it more often.



doctorj said:


> I fully agree with the pen and paper approach - evaluating the risk in a company is a bit like looking for a needle in a haystack.  Management will scream all the good news from the roof tops and bury the bad news in useless detail.




Exactly. It's amazing what a few back of the envelope calculations reveals.


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## craft

McLovin said:


> My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.
> 
> To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.
> 
> It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.




Hi McLovin

Great post – well at least it certainly resonates with me.

Not sure why everybody thinks DCF is so tricky – it’s not like you have to do the calcs longhand any more. And if you put valuation at the end of the research process where it needs to be so that you have the best chance of making realistic assumptions, you probably won’t be doing that many valuations anyway.

In relation to paying for growth – I will include short term growth on a risk weighted basis accoring to it's certainty but I don't generally put growth into any terminal part of the calc, unless it is something like WOW where I would use a conservative estimate of GDP.  Greenwald should be mandatory reading for Investors.   

I agree that once you know a bit about what you are doing the back of an envelope with a few shortcuts can give you a pretty good pre-emption of what the full works analysis will come out at


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## McLovin

craft said:


> Hi McLovin
> 
> Great post – well at least it certainly resonates with me.
> 
> Not sure why everybody thinks DCF is so tricky – it’s not like you have to do the calcs longhand any more. And if you put valuation at the end of the research process where it needs to be so that you have the best chance of making realistic assumptions, you probably won’t be doing that many valuations anyway.




Thanks craft.

I think wrt to DCF there are two big issues most people have:

1) They don't really understand the business. You can't build a DCF valuation by looking at a few numbers on Commsec.

2) Not all businesses are suitable to that type of valuation. Take MCE, if I attempted a DCF on that it would be no better than spinning a roulette wheel and coming up with a number. There are far too many variables to make it reliable.

The closer the business is to an annuity the more accurate a DCF valuation will be, hence I tend to gravitate toward recurring revenue type companies.



			
				craft said:
			
		

> In relation to paying for growth – I will include short term growth on a risk weighted basis accoring to it's certainty but I don't generally put growth into any terminal part of the calc, unless it is something like WOW where I would use a conservative estimate of GDP. Greenwald should be mandatory reading for Investors.




I agree. I think WOW is a classic example of overpaying for growth. It has the highest margins of almost any grocery chain in the world and, as I think I've mentioned before, margins are notorious for being mean reverting.  

Greenwald is excellent and a bit overlooked. He mixes quantitative and qualitative better than most and forces you to really think about how one effects the other, IMO.


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## Ves

Which books from Bruce Greenwald do you guys recommend?


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## skc

McLovin said:


> Thanks craft.
> 
> I think wrt to DCF there are two big issues most people have:
> 
> 1) They don't really understand the business. You can't build a DCF valuation by looking at a few numbers on Commsec.
> 
> 2) Not all businesses are suitable to that type of valuation. Take MCE, if I attempted a DCF on that it would be no better than spinning a roulette wheel and coming up with a number. There are far too many variables to make it reliable.
> 
> The closer the business is to an annuity the more accurate a DCF valuation will be, hence I tend to gravitate toward recurring revenue type companies.




DCF in isolation is useful but I think a lot of value rests in doing sensitivity analysis on the inputs.

So you know what variables drive returns for a business. Is it high or low fix costs? How much profit is lost for every 1c improvement in $A? What input costs are underthreat? What will rising commodity price do to a project? What is the impact of a loss of 5pts market share?...

While equally you can't accurately predict what the $A, input costs, commodity price or market share will behave in the future, it allows you to test your logic for congruency, and it allows you to react quickly when things do change.


----------



## craft

Ves said:


> Which books from Bruce Greenwald do you guys recommend?




'Value Investing: From Graham to Buffett and beyond' and 'Competition Demystified'


Plus there is a fair bit of Greenwald stuff floating around the internet.

This is a good paper (All Strategy is Local) that will give you a feel for Greenwald.
http://www.capatcolumbia.com/Articles/FoStrategy/All Strategy is Local.pdf


If you prefer Videos, this is an appetiser. Lots of others videos on youtube etc. 
http://fora.tv/2009/02/07/Bruce_Greenwald_on_Value_Investing_Buy_Cheap_Obscure_and_Out_of_Fashion


These two videos are a bit more obscure to find. They run to three hours and are pretty poor quality but if you are interested in Greenwald then they are gold.

Part 1
http://www.gurufocus.com/news/97636/value-investing-seminar-by-bruce-greenwald-

Part 2
http://www.dailymarkets.com/stock/2010/06/18/value-investing-seminar-by-bruce-greenwald-part-2/

Lecture Notes
http://www.scribd.com/doc/15987706/Greenwald-Earnings-Power-Value-EPV-lecture-slides


----------



## craft

skc said:


> DCF in isolation is useful but I think a lot of value rests in doing sensitivity analysis on the inputs.
> 
> So you know what variables drive returns for a business. Is it high or low fix costs? How much profit is lost for every 1c improvement in $A? What input costs are underthreat? What will rising commodity price do to a project? What is the impact of a loss of 5pts market share?...
> 
> While equally you can't accurately predict what the $A, input costs, commodity price or market share will behave in the future, it allows you to test your logic for congruency, and it allows you to react quickly when things do change.




Hi SKC

I have a slightly different take on sensitivity analysis for valuing Businesses, and it probably has to do with timeframes.  What you have put is the sort of DFC I would expect business management to be making on their short/medium term Capex,  but I take a longer/larger perspective for the valuation of the business.

I take into consideration the types of variables you are referring to when looking at the business’s competitive advantage and economics. There will always be fluctuations/increases in costs (known and still unknown), what I’m interested in is whether the business can neutralise these through its pricing power and how margins will cycle because of any lags in increasing price. The same goes for demand, is there consistent demand or are will profits cycle because of variable demand. I’m not interested in businesses that experience large volatility in margin or demand.

I’m looking to make the best ‘full cycle’ assumption I can and feed these into the valuation models. I use multiple models but I don’t do sensitivity analysis with each model – To do so, sort of negate my attempts to make my best assumption about the inputs. If I don't feel I can make good full cycle assumptions - that is where it ends - I don't attempt to value them.  Buying cheaper than my valuation is how I attempt to protect myself from making poor assumptions.


----------



## craft

In Collin Nicholson latest free newsletter he has published Michael Kemp’s ‘Intrinsic Valuation’ Presentation given at the 2011 AIA Conference. In my opinion it’s very well articulated piece from an Australian Author. Very worthwhile reading if you are interested.

http://docs.google.com/viewer?url=http://www.bwts.com.au/_n.cfm?127&key=56504047


----------



## Ves

Thanks for all the links and recommendations, Craft. i will definitely add these to my reading list.


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## Ves

Craft, in what sense and in which context are the concepts of portfolio allocation (or weighting) and diversification important to the successful implemetation of your approach?

edit: Personally, I am leaning towards around 10-15 stocks to stop a "dividend cut" from derailing my portfolio in one foul swoop.


----------



## craft

Ves said:


> Craft, in what sense and in which context are the concepts of portfolio allocation (or weighting) and diversification important to the successful implemetation of your approach?
> 
> edit: Personally, I am leaning towards around 10-15 stocks to stop a "dividend cut" from derailing my portfolio in one foul swoop.




Hi V

I have set myself some rules for diversification. Within my SMSF I hold a minimum of 7 and a maximum of 10 Companies when fully invested. Outside Super the respective numbers are 5 and 8.

The minimum number of holdings is there as a protection against unknowns and because I am a minority holder with no control over management.  The maximum number of holdings is to force focus.

These Min and Max have implications for capital allocation. Ie the most I can allocate to one company in my SMSF is 14.2% and the minimum if fully invested is 10%. I work all my calculations on purchase price and don’t adjust for market movements which skew things over time, for example the top 3 stocks currently account for 65.2%

I have no formal rules for diversification between sectors etc, but I do think about how each piece fits as part of the whole.

I’m not sure if any of this is ‘technically’ right but it is what works for me, though I am continually evaluating it. At the moment the merits of rebalancing, is exercising my mind as it has been for the last year or so – I’m a slow thinker, actually the problem is that Logically I don’t want to cut my winners short but psychologically I am uncomfortable with where the market has taken the diversification.


----------



## Julia

craft said:


> I’m not sure if any of this is ‘technically’ right but it is what works for me, though I am continually evaluating it. At the moment the merits of rebalancing, is exercising my mind as it has been for the last year or so – I’m a slow thinker, actually the problem is that Logically I don’t want to cut my winners short but psychologically I am uncomfortable with where the market has taken the diversification.



Craft, you seem to be taking a thoughtful approach.
Personally, I think diversification is over-rated.  If you have some ongoing winners, why would you want to limit your profits just for the sake of diversification?


----------



## craft

Julia said:


> Craft, you seem to be taking a thoughtful approach.
> Personally, I think diversification is over-rated.  If you have some ongoing winners, why would you want to limit your profits just for the sake of diversification?




My head agrees with you – my emotions see me continually re-evaluating the question. The volatility that the concentration causes seems to raise no ends of prompts to re-evaluate.  Normally when I have adopted a strategy based on research and logic the emotions fall into alignment, but not with this issue. So far the head is winning the battle.


----------



## Ves

craft said:


> These Min and Max have implications for capital allocation. Ie the most I can allocate to one company in my SMSF is 14.2% and the minimum if fully invested is 10%. I work all my calculations on purchase price and don’t adjust for market movements which skew things over time, for example the top 3 stocks currently account for 65.2%



Food for thought. 

I can definitely see why you would allocate on cost since you are paying for an income stream in the first instance, not market movements.

My instincts tell me that I should be able to devise some sort of quality rating system or critera to help define allocation. This would be centered around income earning potential / yield on cost growth, rather than the traditional capital growth alternative.

The sentiment of limiting the number of stocks that you invest in is a great idea. You describe it as a way of keeping focus; and it rings true in my limited experience. Keeping a track of more than 12-15 companies at any one time is a nightmare.


----------



## Ves

http://www.thediv-net.com/

Here's a network of US & Canadian investors that aim to build long-term passive income via growth dividend streams.

It's a shame there isn't anything similar for the ASX, but there is some good company analysis theory that could be applicable for those interested.


----------



## craft

Some quotes that indicate that Buffett uses present Value of Future Cash Flows to estimate value.



> How do you think about value?
> The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price.



Q&A with 6 Business Schools 2009



> Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn't gone down if you already factored this in





> If you calculate intrinsic value properly, you factor in things like declining prices.



BRK Annual Meeting 2003



> If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years ... Businesses have coupons too, the only problem is that they're not printed on the instrument and it's up to the investor to try to estimate what those coupons are going to be over time





> If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out--not by selling it to somebody else, that's just a game of who beats who--but by the asset itself ... If you're an investor, you're looking on what the asset is going to do, if you're a speculator, you're commonly focusing on what the price of the object is going to do, and that's not our game. We feel that if we're right about the business, we're going to make a lot of money, and if we're wrong about the business, we don't have any hopes of making money.



BRK Annual Meeting 1997



> To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics.



BRK Annual Meeting 2002


----------



## craft

Some quotes relating to the discount rate.



> We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.



BRK Annual Meeting 2003 

which is a little contradictory to this one



> We don’t formally have discount rates



 but in the same AGM Munger said 







> Everything is a function of opportunity cost.



 & 







> The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about the returns from each.
> 
> The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly



BRK Annual Meeting 2007 

Putting it all together I take it that they don't have a *set*  hurdle rate - but they use a single floating rate for comparison purposes that continually varies to reflect the return of their best current opportunity.    

I have also read but can’t find a quote that Buffets uses a minimum rate if the ‘best alternative opportunity rate’ falls too low. The minimum is based on Government bonds + a liquidity premium. The liquidity premium represents how much current return he is prepared to forego to wait in cash for a better opportunity.


----------



## Huskar

craft said:


> Some quotes that indicate that Buffett uses present Value of Future Cash Flows to estimate value.




Yes: and Robert Hagstrom in The Warren Buffet Way also discusses Warren's use of DCF analysis so no doubt it is another tool in Warren's arsenal (just as - according to Snowball and all technical analysts might note - when Warren was young he read everything he could on stock market trends and technical charts). But I think on closer analysis the quotes you give still are consistent with Greenwald's warning that DCF analysis is to be used with caution. Greenwald agrees that short to medium term cash flows can be predicted with quite good accuracy. The problem comes when you try and predict the longer term. And as he says, good information + bad information = bad information...

WB relates the discount of cash flows specifically to bond coupons - and relates this to stocks only with the warning that it is up to the investor to discern what the coupons of a stock held for a 100 years might be.


----------



## craft

Huskar said:


> Yes: and Robert Hagstrom in The Warren Buffet Way also discusses Warren's use of DCF analysis so no doubt it is another tool in Warren's arsenal (just as - according to Snowball and all technical analysts might note - when Warren was young he read everything he could on stock market trends and technical charts). But I think on closer analysis the quotes you give still are consistent with Greenwald's warning that DCF analysis is to be used with caution. Greenwald agrees that short to medium term cash flows can be predicted with quite good accuracy. The problem comes when you try and predict the longer term. And as he says, good information + bad information = bad information...
> 
> WB relates the discount of cash flows specifically to bond coupons - and relates this to stocks only with the warning that it is up to the investor to discern what the coupons of a stock held for a 100 years might be.




Estimating the future cash flows is where all the skill is required. There is no valuation model that will substitute for a failure in getting the future cash flows reasonably accurate.

Greenwald’s advice is very astute. Best to err on the conservative side in calculating cash flows especially the further you go out eventually paying nothing for the potential long dated cash flows.  Better to be pleasantly surprised down the track then remorseful.

Cheers and thanks.


----------



## odds-on

craft said:


> Estimating the future cash flows is where all the skill is required. There is no valuation model that will substitute for a failure in getting the future cash flows reasonably accurate.
> 
> Greenwald’s advice is very astute. Best to err on the conservative side in calculating cash flows especially the further you go out eventually paying nothing for the potential long dated cash flows.  Better to be pleasantly surprised down the track then remorseful.
> 
> Cheers and thanks.




Hi Craft,

Would you be willing to post an example of a DCF? I posted my simple method of DCF on another thread. See below:-

“Have you ever used the valuation tools on www.moneychimp.com? They have a tool which converts a 2 stage DCF into an benjamin graham style intrinsic value formula. Using the credit suisse global investment returns yearbook 2011 as a reference the nominal return from equities on the ASX is 12.4%, this is sufficent as a discount rate and assuming that a company will continue to grow after the first 5 years at a rate of 2% you end up with a simple conservative IV formula of P/E ratio = 8.5 + 0.5 x G where G is the growth rate. I like the simplicity of the formula and believe it is sufficient to see if there is any of margin of safety particularly with established companies”

For an established company the remainder of my valuation is to somehow quantify my confidence that the company is still going to making cash in a few years time. The confidence comes from the profitability, operating history of the company, management and my view of the world. I am looking for a business where I am at least 80% confident it is going to be making cash in a few years time. 80% confidence and a discount of 30-40% to my conservative IV is a fair investment, note the use of the word fair, not great just fair. 5 minutes to do the DCF and a couple of hours to quantify my confidence.

Cheers

Oddson


----------



## craft

odds-on said:


> Hi Craft,
> 
> Would you be willing to post an example of a DCF? I posted my simple method of DCF on another thread. See below:-
> 
> “Have you ever used the valuation tools on www.moneychimp.com? They have a tool which converts a 2 stage DCF into an benjamin graham style intrinsic value formula. Using the credit suisse global investment returns yearbook 2011 as a reference the nominal return from equities on the ASX is 12.4%, this is sufficent as a discount rate and assuming that a company will continue to grow after the first 5 years at a rate of 2% you end up with a simple conservative IV formula of P/E ratio = 8.5 + 0.5 x G where G is the growth rate. I like the simplicity of the formula and believe it is sufficient to see if there is any of margin of safety particularly with established companies”
> 
> For an established company the remainder of my valuation is to somehow quantify my confidence that the company is still going to making cash in a few years time. The confidence comes from the profitability, operating history of the company, management and my view of the world. I am looking for a business where I am at least 80% confident it is going to be making cash in a few years time. 80% confidence and a discount of 30-40% to my conservative IV is a fair investment, note the use of the word fair, not great just fair. 5 minutes to do the DCF and a couple of hours to quantify my confidence.
> 
> Cheers
> 
> Oddson




Hi Oddson

Money chimp looks good to me. There are quite a few free valuation models on the internet and most of them are pretty good. 

What you are doing seems logical enough to me. I like the fact that you have found credit Suisse year book and are using some long dated history to ground your thinking. 

When I think about risk – and I predominantly think my job as an investor is risk management. – I split risk into three categories.


Default risk
Valuation Risk 
Earnings risk.
When I look at default risk – I am looking to see if the company is likely to experience an event that could cause its bankruptcy.  There is no use in a company having great prospects in 5-10 years time if it is dead in 4. The company default analysis require one assumption that is *NOT* true, and that is that I can predict the future cash flows and company structure correctly.

The same with the Valuation Models – they require the *incorrect* assumption that I can predict the future cash flows correctly.  As I can’t, all a valuation model really does is stop you over paying for the cash flow you have projected.

Given the first two models are dependent on getting the cash flows accurate, 99% of my time and thinking goes into earnings risk.

The companies I hold or are really interested in, I model their financial reports and project them forward based on my assumptions.  Those assumptions and how well I can make them is where earnings risk comes into play. My valuation is simply to run an IRR on the bottom line to determine the projected yield. The yield is determined without the sale of the asset, but a terminal valuation is included at the end of the cash flow projections, that terminal value is normally the replacement value of the physical assets unless I am absolutely convinced the company has a *sustainable* competitive advantage, in which case It will be some sort of multiple of replacement asset value.

I have a minimum yield below which I stay in cash (Online saver interest rate + liquidity option value) otherwise I concentrate my buying on the highest yielding opportunities.

My rudimentary valuation when scouting for potential research opportunities has now become internalised – I don’t do any explicit valuation, but am looking at a whole raft of things EV/EBIT, ROIC/NTA, FCF  blah blah blah.  I find valuation at this stage a bit like beauty – you know it when you see it but it’s hard to define.  I have nothing against using something more explicit at this stage but I found everything potentially gives false positives and negatives.  You miss some opportunities you should investigate further and pick up some dogs that can potentially bite. Any rudimentary valuations which ignore earnings risk should never be the sole basis for investment decisions IMO.

Cheers


----------



## McLovin

craft said:


> When I look at default risk – I am looking to see if the company is likely to experience an event that could cause its bankruptcy.  There is no use in a company having great prospects in 5-10 years time if it is dead in 4. The company default analysis require one assumption that is *NOT* true, and that is that I can predict the future cash flows and company structure correctly.




Hi craft

It's interesting that you attempt to measure default risk. I've always considered that as an equity investor quantifying default risk is of little value; by the time it gets to that stage equity will be severely impaired. Of course I get your point about a company needing to be a going concern, but wouldn't that just present itself while analysing earnings risk? I guess what I'm saying is my investment threshold is a bit higher than "will this company be around in 4 years". I assumed your own risk profile would also steer you away?

Agree on the rest of your post, especially on the earnings risk. My biggest investments are always in companies with high recurring revenue streams, so the 99% of time going into assessing the sustainability and direction of earnings is something that definately resonates with me.


----------



## craft

McLovin said:


> Hi craft
> 
> It's interesting that you attempt to measure default risk. I've always considered that as an equity investor quantifying default risk is of little value; by the time it gets to that stage equity will be severely impaired. Of course I get your point about a company needing to be a going concern, but wouldn't that just present itself while analysing earnings risk? I guess what I'm saying is my investment threshold is a bit higher than "will this company be around in 4 years". I assumed your own risk profile would also steer you away?
> 
> Agree on the rest of your post, especially on the earnings risk. My biggest investments are always in companies with high recurring revenue streams, so the 99% of time going into assessing the sustainability and direction of earnings is something that definately resonates with me.





I don’t so much measure default risk and apply it as you would for valuing debt instruments, but I certainly consider it and think about it as its own distinctive risk. I generally analyse it by stress testing my best guess earning assumptions to see how far out I can before things get terminal.  Default risk is present as soon as a company takes on a fixed expense, predominantly debt or lease.  It is a major consideration when looking at financial stocks and many other stocks carry enough debt to make it a serious consideration under stressful trading conditions.

As for my risk profile - I may be more aggressive then you imagine.  Prices just aren’t that attractive when everything looks rosy to all. It's darkest just before the dawn and that's where you get the best prices.


----------



## McLovin

craft said:


> I don’t so much measure default risk and apply it as you would for valuing debt instruments, but I certainly consider it and think about it as its own distinctive risk. I generally analyse it by stress testing my best guess earning assumptions to see how far out I can before things get terminal.  Default risk is present as soon as a company takes on a fixed expense, predominantly debt or lease.  It is a major consideration when looking at financial stocks and many other stocks carry enough debt to make it a serious consideration under stressful trading conditions.




I understand, so you take it as a worst case scenario and work back from there.



craft said:


> As for my risk profile - I may be more aggressive then you imagine.  Prices just aren’t that attractive when everything looks rosy to all. It's darkest just before the dawn and that's where you get the best prices.




No, I think I understand your risk profile, just needed clarification on how you used default risk.

We're probably more a like than different. One of the first shares I ever bought (at 17) was Crown back in late '98 when it was seriously under the pump, just before Packer bought it.


----------



## craft

> Sorry to continue this off topic stuff but I was just wondering Tyson, what % of disposable income did you have to put aside and what % return did you have earn to achieve this?





> I apologize if I am intruding, but would appreciate if you could give a rough indication of the answer to this question for yourself too.




Hi V, I hope you find this response here - save cluttering up the housing thread

The time needed to accumulate the funds to be financially self sufficient depends on amount saved and return achieved.

To get some idea of a realistic answer needs some maths.

If we say the income you earn is 1 (you can multiply this to suit your requirements) and your after tax and inflation return is 5% then you will need to save 25% of your income for 33 years to accumulate 20 times your income. 20 / 5% will gives you 1 which means you are now financially independent at the income level you are used to.

The inflation figure I include is wage inflation and have estimated it runs at about 4.5% p.a long term.  To achieve a 5% return after inflation and tax you need to make a nominal return of 1*1.05*1.045-1/(1-tax rate). The tax rate looms large in this calculation so you will want to pay it some attention and a 15% tax rate in a SMSF is a big advantage as is any tax you can delay by not realising capital gains.

The current grossed up dividend yield on the ASX is 7%. Long term, I would expect capital and labour to benefit from productivity gains at the same rate, so capital gains on shares should match wage increases. History also sugest you can can also factor in about a 1% real return from retained earnings for shares. If you figure you can make 8% after inflation *and* tax you would be building in a requirement to do better than the market as a whole. 

With a 8% after inflation and tax return you would need a capital amount of 12.5 times to be financial self sufficient. This could be accumulated in 21 years by saving 25% of your wage.

If you know how to use the excel functions – play around with the PV, FV, PMT and Rate functions. Come up with a plan that suits you. 

If you want to speed things up safely, save more; or relatively safely, increase return by buying things for less then they are worth or actively trading *with proper risk control*; or not so safely look at leverage or higher risk investments.


----------



## Ves

Thanks craft - just for the assumption's sake - is the 25% invested after tax?


----------



## craft

Ves said:


> Thanks craft - just for the assumption's sake - is the 25% invested after tax?




Hi V

Either or. 

AWOTE is around $70K gross which would give you approx $55K after tax.

In the case of a 5% return;

If you save 25% of $70K you will end up with 20 x 70K in 33 years which means you can fund a before tax income of $70k without eating into your capital.

If you save 25% of $55K you will end up with 20 x 55K in 33 years which means you can fund a before tax income of $55K without eating into your capital.

There are lots of nuances you can factor in to suit your own needs. For example you may be happy to run your capital down when living off it so you may need less than 20 times  income  to fund a given level of income. Also if you have been saving 25% then you are used to living on 75% of your earned income - so again you may need less than 20 times income. And finally as you know taxation rates are different between accumulation and pension phase if you are using a SMSF again meaning you may be able to get away with a lower multiple of income to be financially independent if you will be over 60 by the time you reach your goal.

The key is to model your plan, which can easily be done in Excel. Set your target, be realistic about the return you can achieve (I would recommend 3 – 5% after inflation and tax as it is better to be pleasantly surprised then disappointed down the track)  and calculate for yourself what % of income you need to save to reach your goals.

Incidentally, changing variables in such a model is quite revealing as well.  To get to your goal faster you can earn/save more or focus on learning how to make a better return.  It takes an awful lot of earning/saving to compete with being able to increase your return by just a couple of % over the long term. This understanding changed the direction of my life.


----------



## Ves

I'll play around with it later. I'm currently saving about 60% of my wage before tax. I am however, under the average wage at the moment. Until my career experience increases. However, in the accounting profession, if I work hard and smart I should be able to increase it above the average wage in the future.

I am currently using a different model. 
	

		
			
		

		
	

View attachment 45233


It seems to work on a similar principle.


----------



## McLovin

craft said:


> It takes an awful lot of earning/saving to compete with being able to increase your return by just a couple of % over the long term. This understanding changed the direction of my life.




Einstein said his greatest discovery was compound interest, so the story goes. Human brains aren't very good at understanding exponentials, which is a shame because the power of compounding is one of the most important things to know about investing.


----------



## craft

http://www.youtube.com/watch?v=xVOn371TCPo

An interesting WB interview. I'll post it here so I can find it again in the future.


----------



## odds-on

Hi craft,

Do you use reverse DCF? Michael Mauboussin and James Montier seem to rate it as a valuation tool.
If you were to use reverse DCF, what assumptions would you use?
How do you calculate cashflow that you use for the DCF?
Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.

Cheers

Oddson


----------



## craft

odds-on said:


> Hi craft,
> 
> Do you use reverse DCF? Michael Mauboussin and James Montier seem to rate it as a valuation tool.
> If you were to use reverse DCF, what assumptions would you use?
> How do you calculate cashflow that you use for the DCF?
> Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.
> 
> Cheers
> 
> Oddson




Reverse DCF or reverse anything is just determining what discount rate causes the model to produce the current price (given your assumptions). Tells you what discount the market is applying.  

A quick and dirty I use initially is to reverse the dividend growth model to see what perpetual growth rate is embedded in a price.

I don't think your FCF shortcut is going to be very accurate expect by chance. The assumptions are everything - no shortcuts, you have to understand the business and how capital flows through or sticks to it and you need to understand it across a range of revenue and expense possibilities. - The valuation is just some mechanical model(s) applied to the assumptions.


----------



## McLovin

odds-on said:


> Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.




The problem with using too many rules of thumb is that each time you use one you're giving up some possible advantage. If your whole analysis is built on rules of thumb then I'd argue you have not really gained any insight. If you're going to get to the stage of calculating FCF, then the benefit to your analysis is in actually calculating FCF not a proxy of it.

Having said that, as a screener, it might be worth seeing what it tosses out.

ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.


----------



## odds-on

craft said:


> Reverse DCF or reverse anything is just determining what discount rate causes the model to produce the current price (given your assumptions). Tells you what discount the market is applying.
> 
> A quick and dirty I use initially is to reverse the dividend growth model to see what perpetual growth rate is embedded in a price.
> 
> I don't think your FCF shortcut is going to be very accurate expect by chance. The assumptions are everything - no shortcuts, you have to understand the business and how capital flows through or sticks to it and you need to understand it across a range of revenue and expense possibilities. - The valuation is just some mechanical model(s) applied to the assumptions.




Interesting, I would approach a reverse DCF to work out the implied growth rates and compare the implied growth rates to historic long term industry growth rates. This is due to my understanding that DCF is the correct way to calculate the intrinsic value if the investor knows with certainty the future cash flows over the long term, therefore discount rate that should applied in the reverse DCF should be equal to the stock market long term returns (12.4%). Just my thoughts.

I am going to step away from DCF and FCF as it creates too many questions in my head and suspect the effort required to fine tune DCF will not actually pay off in improved portfolio performance.  Thanks for the feedback. I am going to stick with the PE ratio and dividends paid. 

If you have not read the following you may find it interesting. 
http://www.smartmoney.com/invest/strategies/the-400-man-1328818316857/

http://www.smartmoney.com/invest/stocks/the-400-mans-new-big-bet-1332271348707/

His big bet seems sensible to me, borrow at 1.5% then put half your fund in Berkshire Hathaway, whatever happens to WB, Berkshire is an economic powerhouse.


----------



## odds-on

McLovin said:


> The problem with using too many rules of thumb is that each time you use one you're giving up some possible advantage. If your whole analysis is built on rules of thumb then I'd argue you have not really gained any insight. If you're going to get to the stage of calculating FCF, then the benefit to your analysis is in actually calculating FCF not a proxy of it.
> 
> Having said that, as a screener, it might be worth seeing what it tosses out.
> 
> ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.




Good points. No more DCF or FCF for me!

Altman Z score. As mentioned in another thread there becomes a point with accounting that I lose interest or am too lazy to understand. Two or three ratios are sufficient for me to have confidence that a company will not go broke in the short term.

Cheers

Oddson


----------



## Ves

Craft -  I found these.  Share holder letters of Marty Whitman.

http://www.thirdave.com/ta/shareholder-letters-mf.asp

Do you know anything about them?  Saw them mentioned as worthwhile reading for any value investor, especially since they are free.


----------



## craft

Ves said:


> Craft -  I found these.  Share holder letters of Marty Whitman.
> 
> http://www.thirdave.com/ta/shareholder-letters-mf.asp
> 
> Do you know anything about them?  Saw them mentioned as worthwhile reading for any value investor, especially since they are free.




Havn't seen them - will check them out. 
Thanks for the link.


----------



## McLovin

If anyone is looking for something to read, I highly recommend the book reviews on the Aleph Blog

http://alephblog.com/categorized-book-reviews/

The blog is also pretty damn good.


----------



## Ves

Thanks I will certainly check it out.


----------



## McLovin

I'm about half way through this at the moment

http://alephblog.com/2012/03/17/book-review-the-most-important-thing/

Great book, I highly recommend it.


----------



## matches

McLovin said:


> ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.




I found this interesting also
http://www.oldschoolvalue.com/blog/investing-strategy/best-piotroski-screen-combination/


----------



## Ves

Hi Craft  /  McLovin,

I have actually started to take the plunge and delve into some NPV calculations for Free Cash Flow lately.

I am happy to play around the the ROE / ROIC, the retention rate, working capital requirements etc.  I usually try to use a very conservative estimate of these, to come up with a basic growth rate that may vary slightly over a 5-10 year period. I then discount these basic over a range of discount rates.  I take it when you say "sensitivity analysis" you mean that various scenarios (say they make an unexpected loss in a year) should be run using fluctuations of these figures? Is there a systematic way of doing this?   

It is the "perpuity" part of the valuation that has me the most uncomfortable.  It is obviously the biggest component of the NPV. Generally I set this growth rate to match inflation. The problem I have, even with this, is that no company lasts forever.  How do you account for this? Are there any alterations or adjustments that can be made? I guess the whole learning how to forecast for myself, and realising that you will never be accurate to the nth degree, and sometimes not at all, is quite daunting for a relative beginner.


----------



## odds-on

Good article by Geoff on gurufocus.

http://www.gurufocus.com/news/175393/free-cash-flow-isnt-everything


----------



## Ves

odds-on said:


> Good article by Geoff on gurufocus.
> 
> http://www.gurufocus.com/news/175393/free-cash-flow-isnt-everything



Cheers Oddson - I read the first part and seems interesting.  I will read the rest of it over the weekend when my head feels a bit clearer.


----------



## McLovin

Ves said:


> It is the "perpuity" part of the valuation that has me the most uncomfortable.  It is obviously the biggest component of the NPV. Generally I set this growth rate to match inflation. The problem I have, even with this, is that no company lasts forever.  How do you account for this? Are there any alterations or adjustments that can be made? I guess the whole learning how to forecast for myself, and realising that you will never be accurate to the nth degree, and sometimes not at all, is quite daunting for a relative beginner.




Sorry, I missed this. I usually use 0 as my growth rate for the perpetuity. Sometimes, I'll include some growth 1-2%, never more than 3% though and usually it's when assessing a company like COH or CSL which has a global market for its products. I wouldn't include any growth in something like TGA, for example. 



			
				Vespuria said:
			
		

> I take it when you say "sensitivity analysis" you mean that various scenarios (say they make an unexpected loss in a year) should be run using fluctuations of these figures? Is there a systematic way of doing this?




Yeah, you can learn a lot about a company by running a DCF under various scenarios I often compare across an industry, especially with things like margins and working capital which tend to mean revert (one of my old finance lecturers used to drum in that the benefit of ratio analysis was in comparing across time and sector, the actual calculation of the ratio was of secondary importance as long as you were consistent in applying it). And then see how that reversion would effect DCF. I guess the important thing to remember is that you're not trying to come up with an answer, rather a guide. Like any way of attempting to estimate IV really. I don't make mine overly complex or systematic but I do often look for discrepencies in ratios as a good starting point for sensitivity analysis.

Hope that helps.


----------



## craft

Ves said:


> Hi Craft  /  McLovin,
> 
> I have actually started to take the plunge and delve into some NPV calculations for Free Cash Flow lately.
> 
> I am happy to play around the the ROE / ROIC, the retention rate, working capital requirements etc.  I usually try to use a very conservative estimate of these, to come up with a basic growth rate that may vary slightly over a 5-10 year period. I then discount these basic over a range of discount rates.  I take it when you say "sensitivity analysis" you mean that various scenarios (say they make an unexpected loss in a year) should be run using fluctuations of these figures? Is there a systematic way of doing this?
> 
> It is the "perpuity" part of the valuation that has me the most uncomfortable.  It is obviously the biggest component of the NPV. Generally I set this growth rate to match inflation. The problem I have, even with this, is that no company lasts forever.  How do you account for this? Are there any alterations or adjustments that can be made? I guess the whole learning how to forecast for myself, and realising that you will never be accurate to the nth degree, and sometimes not at all, is quite daunting for a relative beginner.




Does post 21 or 40 in this thread help at all with your thinking?

You have to be incredibly careful with terminal values. You only have to change the inputs by small margins to produce any number you like. Consider that if future perpetual growth is 5% and future cost of capital is 9% then the terminal value multiple is 25. Changing those two variables by just one 1% can produce multiples from 16 to 50 times.    

I prefer to discount only the cash flow horizon I can have some certainty about and then calculate a terminal value based on the replacement cost of tangible assets and possible some multiple of that if the business has a true sustainable competitive advantage.


----------



## Ves

craft said:


> Does post 21 or 40 in this thread help at all with your thinking?
> 
> You have to be incredibly careful with terminal values. You only have to change the inputs by small margins to produce any number you like. Consider that if future perpetual growth is 5% and future cost of capital is 9% then the terminal value multiple is 25. Changing those two variables by just one 1% can produce multiples from 16 to 50 times.
> 
> I prefer to discount only the cash flow horizon I can have some certainty about and then calculate a terminal value based on the replacement cost of tangible assets and possible some multiple of that if the business has a true sustainable competitive advantage.



Thanks to you both - it does give me some ideas.

I think the trouble I am having is relates to the practice, rather than the theory. I really enjoy reading both of your posts and a few others on this subject and related topics. Theoretically most of it makes sense in my mind. I have been trying to focus on the first two things on your list: earnings risk and default risk. Playing around with a few ratios and looking at business models / financial structures hasn't been so bad.  You can usually discard the dogs pretty easy from just doing some work (or even a glance) at the balance sheet. Most companies do not fit in with what I am trying to achieve in this respect. I wouldn't bother valuing them. It seems far easier to find a company I wouldn't invest in. Probably a good thing for "risk management."

However I get confused when I have to start coming up with my own forecasts (or the numbers going forward).  Perhaps I need to re-read Greenwald.  I sometimes watch 5-10 of Sky Business when eating my dinner.  Roger Montgomery was on the other night saying how his Skaffold system relies on broker forecasts and "conservative past assumptions" and you should buy when price is lower than both of these.  I feel frustrated when I hear things like this, because the point is to do your own forecasting (not rely on brokers who always get it wrong by large margins).  Relying on the past without any thought for how it will change in the future is also lunacy. This guy is supposed to be a professional, yet he seems to lack any clue as the theory behind forecasting, even when compared to a beginner.

If anything, the opportunity is there, becoming good (not perfect) at valuation puts you far ahead of the pack if coupled with in-depth analysis and an intimate understanding of the company.

I will try to explain what I try to include in my models:

Once I have attempted to make a judgment on the earnings risk or the default risk of the company and I am satisfied I started looking more closely at the underlying cash flow.  I like trying to compare it to NPAT to see if I can discern the differences.

I then try to calculate a normalised version of Free Cash Flow to Firm for as many years as I can find using the published financials.

To do this I look for how much it costs to fund working capital and capex as a % of the cash flow or NPAT depending on what I feel is most relevant (_ie. what Damodaran calls the reinvestment rate_.

The left over after this reinvestment rate is the FCFF. The firm can either pay this out as a dividend or use it to fund future expansion  (_retention rate_).

I then forecast for the next, say five years or as far as I am comfortable with, the growth rate of the FCFF using a more conservative than historical calculation  using the retention and reinvestment rates compared to ROE or ROIC.

The terminal value is added to this.  I will play around with some of the suggestions that you both mentioned, to see what disparities are thrown up!

I discount all of these cash flows and terminal back over a wide range of discount factors to compare. I usually feel most comfortable with the results between 12-16%.

My way of doing it seems to be pretty big picture.  

I more than understand that it is mostly an 'airy fairy' scenario and in the end it is your gut feel stemming from your analysis and intuition vs the market's perception. I often wonder if it is just better to chase businesses that I find have the least earnings and default risk and substitute an earnings multiple (or yield) or something similar.  Doing industry wide comparisons etc.

I don't really know what else you can say to me, or guide me with!   I feel like I could be doing much, much better.


----------



## Ves

Probably another thing that I also need to focus on and did not mention:   

Incremental capital in the respect of it is fine to have a high ROE / ROIC, but if you can no longer re-invest capital then growth must slow down or become non-existent going forward  (other than perhaps inflation or GDP growth). Finding companies that can utilise high amounts of incremental capital going forward is important to me.

edit:

Example.

Company A    -   Cashflow  $1,000    -   50% ROIC    -   But can only re-invest 10% of this profit.   Growth is only 5% or  $50.

Company B   -    Cash flow  $1,000    -   10% ROIC   -   But can re-invest 50% of this profit.   Growth is also 5% or $50.


----------



## skc

Ves said:


> Probably another thing that I also need to focus on and did not mention:
> 
> Incremental capital in the respect of it is fine to have a high ROE / ROIC, but if you can no longer re-invest capital then growth must slow down or become non-existent going forward  (other than perhaps inflation or GDP growth). Finding companies that can utilise high amounts of incremental capital going forward is important to me.
> 
> edit:
> 
> Example.
> 
> Company A    -   Cashflow  $1,000    -   50% ROIC    -   But can only re-invest 10% of this profit.   Growth is only 5% or  $50.
> 
> Company B   -    Cash flow  $1,000    -   10% ROIC   -   But can re-invest 50% of this profit.   Growth is also 5% or $50.




Ves - have you tried say pick a company and look at their reports from 2001 to 2005, then try to come up with some forecasts / DCF / valuation for 2006 to 2012 (or 2008 if you want to avoid the GFC)? Preferrably companies that you understand (so you can assess the industry) but don't really know much about (so you are not biased). You can then check your answers against the real figures.

Sounds like a fun exercise and I might just try it myself.


----------



## Ves

skc said:


> Ves - have you tried say pick a company and look at their reports from 2001 to 2005, then try to come up with some forecasts / DCF / valuation for 2006 to 2012 (or 2008 if you want to avoid the GFC)? Preferrably companies that you understand (so you can assess the industry) but don't really know much about (so you are not biased). You can then check your answers against the real figures.
> 
> Sounds like a fun exercise and I might just try it myself.



Actually did think of that, but have never tried.  I like the disclaimer about not knowing much about the company, but I wonder how you would over-come this if you were to practice a full-analysis on it? I guess you could use the search feature for announcements on ASX.com and limit yourself to 2005 and before, reading some of their presentations etc. Not quite the same, as you couldn't use other sources, but what do you think?


----------



## craft

Ves said:


> Probably another thing that I also need to focus on and did not mention:
> 
> Incremental capital in the respect of it is fine to have a high ROE / ROIC, but if you can no longer re-invest capital then growth must slow down or become non-existent going forward  (other than perhaps inflation or GDP growth). Finding companies that can utilise high amounts of incremental capital going forward is important to me.
> 
> edit:
> 
> Example.
> 
> Company A    -   Cashflow  $1,000    -   50% ROIC    -   But can only re-invest 10% of this profit.   Growth is only 5% or  $50.
> 
> Company B   -    Cash flow  $1,000    -   10% ROIC   -   But can re-invest 50% of this profit.   Growth is also 5% or $50.




Company A can fund a dividend of $900 and fund 5% growth

Company B can fund a dividend of $500 and fund 5% growth

Dividend discount model with a 15% RR

Company A value = 9000- Investment capital required 2,000 (value/Invested capital = 4.5) 
Company B value = 5000- Investment capital required 10,000 (value/Invested capital = .5)


----------



## Ves

How did you calculate the "investment capital required" part down the bottom? Agree with the dividend,  I must admit I overlooked this.

Also will note that if I had have used ROE instead of ROIC,  the dividend would depend on debt repayments (if any).  That's why I like to use ROIC.


----------



## Ves

Never mind -   Profit  / ROIC


----------



## craft

Ves said:


> How did you calculate the "investment capital required" part down the bottom? Agree with the dividend,  I must admit I overlooked this.
> 
> Also will note that if I had have used ROE instead of ROIC,  the dividend would depend on debt repayments (if any).  That's why I like to use ROIC.




50% ROIC / 1000 = 2000
10% ROIC / 1000 = 10000


----------



## Ves

Apologies for not being very sharp tonight!


----------



## craft

Ves said:


> I don't really know what else you can say to me, or guide me with!   I feel like I could be doing much, much better.





I think you are teaching yourself more than 99.9% of people do and that will give you an advantage. 

The journey goes from complexity to simplicity with lots of light bulb moments along the way that give you the knowledge of when and where to utilise simple.


----------



## Ves

I will practice a few older ones like SKC suggested.   It couldn't hurt.  I think the main thing is if I keep enjoying it and maintain patience with myself  (and importantly the market) I will get somewhere eventually.


edit:  Maybe I will also play around with some "blue chips" like the Banks.   Run some simulations using some American style figures or European even that have been reported since the GFC. Since our banks have gotten out of it much better and may see some pain to come.   See what the possibilities throw out in terms of valuation.


----------



## craft

There are 4 cards E, 4, K, 7. Each card has a letter on one side and a number on the other.

If I tell you that an E card has a 4 on the other side, which cards would you like to turn over to verify I was telling the truth?


----------



## Ves

craft said:


> There are 4 cards E, 4, K, 7. Each card has a letter on one side and a number on the other.
> 
> If I tell you that card E has a 4 on the other side, which cards would you like to turn over to verify I was telling the truth?



I don't quite understand, but if you turned E over and it had a 4 on it, that does not prove or disprove the theory of letter on one side, number on the other.  You need to turn them all over.  I take it that this is the moral of the question.


----------



## craft

Ves said:


> I don't quite understand, but if you turned E over and it had a 4 on it, that does not prove or disprove the theory of letter on one side, number on the other.  You need to turn them all over.  I take it that this is the moral of the question.




No I'm just saying that E cards should hvae 4 on the other side. Which cards? You don't need to turn them all over.


----------



## Ves

I guess another way of looking at it is to ignore your comment about the E and the 4.  And turn over the other two cards, K and 7.


----------



## Ves

Couldn't you just pick one of E and 4 (proving or disproving the latter rule) and then one of  K and 7 (proving the former rule)?  I feel like I am missing the point horribly, I need some sleep.  I will be back tomorrow.


----------



## craft

Ves said:


> Couldn't you just pick one of E and 4 (proving or disproving the latter rule) and then one of  K and 7 (proving the former rule)?  I feel like I am missing the point horribly, I need some sleep.  I will be back tomorrow.




The answer is the E and the 7.

Apparently the most common answer is E and 4. But E and 7 are the only cards that can confirm if I’m lying. The E card is obvious, Turning the 4 over tells you nothing but most people choose it because of a bias to look for confirming information, rather than information that will show us to be wrong, which the 7 would do if there’s an E on the back.

Not sure how many people come up with K or why


----------



## Ves

craft said:


> The answer is the E and the 7.
> 
> Apparently the most common answer is E and 4. But E and 7 are the only cards that can confirm if I’m lying. The E card is obvious, Turning the 4 over tells you nothing but most people choose it because of a bias to look for confirming information, rather than information that will show us to be wrong, which the 7 would do if there’s an E on the back.
> 
> Not sure how many people come up with K or why



 Ok, you're right.   I was conflating the E and the 4 cards as the same thing in my response above.  (ie. confirmation bias).

Cheers.  Have a good one.


----------



## skc

craft said:


> There are 4 cards E, 4, K, 7. Each card has a letter on one side and a number on the other.
> 
> If I tell you that an E card has a 4 on the other side, which cards would you like to turn over to verify I was telling the truth?




The question doesn't make sense to me... can I paraphrase?

So there are 4 cards.

Each card has a letter on one side and a number on the other.

The letters can only be E or K... so there may be 0, 1, 2, 3 or 4 cards with E's on it.
The numbers can only be 4 or 7. Again, there may be 0, 1, 2, 3 or 4 cards with 4's on it.

If you tell me an E card has a 4 on the other side, I assume that doesn't exclude another E card having a 7 on the other side.

So to verify that you are telling the truth, I would first have to turn over all cards with E's and then all cards with 4's. 

I am failing to see how this connect to the thread (or may be it doesn't?).

P.S. Please ignore all the above... read your question again and got what you are asking. It must be getting late.


----------



## craft

skc said:


> The question doesn't make sense to me... can I paraphrase?
> 
> So there are 4 cards.
> 
> Each card has a letter on one side and a number on the other.
> 
> 
> The letters can only be E or K... so there may be 0, 1, 2, 3 or 4 cards with E's on it.
> The numbers can only be 4 or 7. Again, there may be 0, 1, 2, 3 or 4 cards with 4's on it.
> 
> If you tell me an E card has a 4 on the other side, I assume that doesn't exclude another E card having a 7 on the other side.
> 
> So to verify that you are telling the truth, I would first have to turn over all cards with E's and then all cards with 4's.
> 
> I am failing to see how this connect to the thread (or may be it doesn't?).
> 
> P.S. Please ignore all the above... read your question again and got what you are asking. It must be getting late.




Yep, missed  







> Each card has a letter on one side and a number on the other



 Problem with going from memory. (EDIT, didn't miss it after all.) .

Nothing really to do with the thread except I recall my gut reaction when I first saw this problem was to go E and 4. Confirmation bias, actually bias of all types and we all have them is a problem when analysing businesses. I think I learnt the concept of inverting from reading something by Charlie Munger – It’s a good way to work around mental biases.


----------



## waimate01

skc said:


> The question doesn't make sense to me... can I paraphrase?
> 
> So there are 4 cards.
> 
> Each card has a letter on one side and a number on the other.
> 
> The letters can only be E or K... so there may be 0, 1, 2, 3 or 4 cards with E's on it.
> The numbers can only be 4 or 7. Again, there may be 0, 1, 2, 3 or 4 cards with 4's on it.
> 
> If you tell me an E card has a 4 on the other side, I assume that doesn't exclude another E card having a 7 on the other side.
> 
> So to verify that you are telling the truth, I would first have to turn over all cards with E's and then all cards with 4's.
> 
> I am failing to see how this connect to the thread (or may be it doesn't?).
> 
> P.S. Please ignore all the above... read your question again and got what you are asking. It must be getting late.




This is a nice clear description of the problem space. But I think the other thing that needs elucidation is:

"out of the universe of cards described, four are provided. The visible sides of the four cards are revealed to be E, K, 4 & 7"

To verify the posited rule that "E's always have 4 on the other side", you obviously need to turn the "E" to check it has a "4" on the other side.

There's no need to turn the "K", since it isn't implicated in the rule, and no need to turn the "4", since the rule doesn't state that "*only* E's will have 4 on the other side". Eg, that card might be K/4 and that wouldn't disprove the rule.

If the other card, the "7" holds an "E" on the other side, then that would disprove that "E's always have 4 on the other side".

It's subtle and needs careful wording of the question. The crux of it is to avoid the assumption that since E correlates with 4, then 4 must correlate with E.


----------



## craft

Remembered the name for the experiment below. Here’s something a little more precise then what I asked. 

Doing the experiment won’t have the same effect now you know the answer, but go through and see the results in further analysis.

Confirmation bias is the norm.

http://www.philosophyexperiments.com/wason/Default.aspx


----------



## craft

At the end of this month, if the XAO and 10yr bond yield both stay where they are we will have the highest Equity Risk Premium (based on trend earnings) priced into the overall market since 1974. Nice


----------



## Ves

Also here:

http://en.wikipedia.org/wiki/Wason_selection_task


----------



## Ves

craft said:


> I think I learnt the concept of inverting from reading something by Charlie Munger – It’s a good way to work around mental biases.



 Craft -  any idea which book  / essay / article you may have read about this in?


----------



## craft

Ves said:


> Craft -  any idea which book  / essay / article you may have read about this in?




Hi V

Sorry missed this post.

I’m not sure where I have seen the invert line, probably on some video or another. 







> Invert – Always Invert



seems to have become his motto for summing up the psychological issues. Here is well known speach he gave on psychology of human misjudgment.

http://www.rbcpa.com/Mungerspeech_june_95.pdf


----------



## craft

craft said:


> Hi V
> 
> I have set myself some rules for diversification. Within my SMSF I hold a minimum of 7 and a maximum of 10 Companies when fully invested. Outside Super the respective numbers are 5 and 8.
> 
> The minimum number of holdings is there as a protection against unknowns and because I am a minority holder with no control over management.  The maximum number of holdings is to force focus.
> 
> These Min and Max have implications for capital allocation. Ie the most I can allocate to one company in my SMSF is 14.2% and the minimum if fully invested is 10%. I work all my calculations on purchase price and don’t adjust for market movements which skew things over time, for example the top 3 stocks currently account for 65.2%
> 
> I have no formal rules for diversification between sectors etc, but I do think about how each piece fits as part of the whole.
> 
> I’m not sure if any of this is ‘technically’ right but it is what works for me, though I am continually evaluating it. *At the moment the merits of rebalancing, is exercising my mind as it has been for the last year or so – I’m a slow thinker, actually the problem is that Logically I don’t want to cut my winners short but psychologically I am uncomfortable with where the market has taken the diversification*.




I’ve done a little more thinking on this rebalancing issue.  Please critique, because I am not sure I have got it right and its hard to see the trees for the forest inside my own thoughts.

The decision (or lack of decision) to date has been to let the profits run.  I have now decided to limit the mark to market exposure to 25% of an account.  If it goes above I will trim it back to just under.

MTU was one of the companies that had climbed in % and it has had a fair impact on my final decision. One morning I looked at the screen and seen a little icon in the announcement field.  A little icon that meant MTU wanted me to invest a big chuck of money at short notice at a price over 4 times my average cost – It was renounceable and the price held up early allowing options but it gave me a jolt as to the difficulties around this weighting issue.

MTU was trimmed during the rights period and got another haircut yesterday as did MMS.  The gut still doesn’t quit feel right selling for weighting issues rather than business performance reasons. Still not a totally settled issue for me – more a work in progress probably awaiting some lessons to be learnt the hard way.


----------



## Ves

craft said:


> Hi V
> 
> Sorry missed this post.
> 
> I’m not sure where I have seen the invert line, probably on some video or another. seems to have become his motto for summing up the psychological issues. Here is well known speach he gave on psychology of human misjudgment.
> 
> http://www.rbcpa.com/Mungerspeech_june_95.pdf




Cheers.  I remember reading a few weeks back when I made the post that he took the maxim from a famous German mathematician.  It's a good maxim to follow; in all endeavour of life.  Now to make it a habit.


----------



## Ves

Craft,  I know you use your dividend cash flow to support your family.  How do the numbers compare if you look at those holdings in terms of portfolio income?  What is the impact of the worst case scenario? I guess what I am trying to get at is that it would be more useful to look upon what effect that it would have on your lifestyle, rather than portfolio value. After all, that is why you invest (and for enjoyment, I assume) not because you hoard wealth. You could always set a trailing stop loss for the proportion that you want to have "at price risk" (rather than business risk) if the over-balancing concerns you.  Besides what would you do with the sale proceeds? Are there better, lower risk assets out there?


----------



## ROE

Ves said:


> Craft -  any idea which book  / essay / article you may have read about this in?




I have this book, it's massive, it heavy and it best lay on a coffee table and browse through
it will you sit there enjoy a nice cuppa of tea/coffee

some very good advices

http://www.amazon.com/Poor-Charlies-Almanack-Charles-Expanded/dp/1578645018/ref=cm_lmf_tit_1


----------



## ROE

Dont know if there is an upgrade to this forum but
the editing -> save function doesn't work any more

I tried with Firefox, Chrome and Internet Explorer and Apple Safari, iPad etc...


----------



## Ves

ROE said:


> I have this book, it's massive, it heavy and it best lay on a coffee table and browse through
> it will you sit there enjoy a nice cuppa of tea/coffee
> 
> some very good advices
> 
> http://www.amazon.com/Poor-Charlies-Almanack-Charles-Expanded/dp/1578645018/ref=cm_lmf_tit_1




Thanks heaps for the rec.   Looks like I have some homework to do.  

Yes - there is currently software issues with the forum.  Joe is fixing them according to one of the threads.  Editing posts isn't working.


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## craft

craft said:


> At the end of this month, if the XAO and 10yr bond yield both stay where they are we will have the highest Equity Risk Premium (based on trend earnings) priced into the overall market since 1974. Nice
> 
> View attachment 47158




I have updated my numbers for month end and get an Equity risk premium of 6.74%

Last time we were in this range was July 1974 (6.55%) by Sept 1974 it was 11.23% by Jan 1975 it was back down to 6.15% a figure not beaten until now.

Price instability from inflation fears was the culprit in 1974 to cause the spike. 

Are we about to get another generational spike in the equity risk premium? If so, what will be the culprit this time?

The major contributor to the equity risk premium this time around as opposed to 1974 is the low rate on Gov’t Bonds. It seems to me that this needs to be unwound before a proper bull market can get underway.  In 1974 the large ERP was unwound by a Bull market into 1980 and fairly stable bond rates.  Perhaps/probably the ERP unwinds this time over a long period via a range bound market [I’m imagining the range as the 2008 down leg] and rising bonds. My big picture


IF however interest rates remain stable at low levels then equities are cheap.  (notice the big if)


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## Ves

How do they calculate this?  Average earnings yield of the market  less 10 year bond yield or something similar?


----------



## McLovin

craft said:


> Perhaps/probably the ERP unwinds this time over a long period via a range bound market [I’m imagining the range as the 2008 down leg] and rising bonds. My big picture




Probably. But we have also been in a very long period of cheap bonds, perhaps because equities were so much more attractive. Using the example of US Treasuries, real yields have been falling for decades after having spiked during the era of stagflation. I think it's wholly unrealistic to expect anything much above 0% in real terms over the long run for treasuries, or similar assets. If risk is positively correlated with reward then it seems to be an aberration of history that an asset approaching "risk free" was yielding 3-4%+ over the inflation rate.

Just my


----------



## Huskar

ROE said:


> I have this book, it's massive, it heavy and it best lay on a coffee table and browse through
> it will you sit there enjoy a nice cuppa of tea/coffee
> 
> some very good advices
> 
> http://www.amazon.com/Poor-Charlies-Almanack-Charles-Expanded/dp/1578645018/ref=cm_lmf_tit_1




I gotta agree with ROE here - great book!

And here as well unfortunately...



> Dont know if there is an upgrade to this forum but
> the editing -> save function doesn't work any more
> 
> I tried with Firefox, Chrome and Internet Explorer and Apple Safari, iPad etc...


----------



## Ves

Huskar said:


> I gotta agree with ROE here - great book!
> 
> And here as well unfortunately...




Spent an hour or so searching this afternoon! Looks rare and out of print unfortunately.  Fairly expensive.  Might monitor ebay for a few weeks and see if it appears at a reasonable price.


----------



## odds-on

craft said:


> I’ve done a little more thinking on this rebalancing issue.  Please critique, because I am not sure I have got it right and its hard to see the trees for the forest inside my own thoughts.
> 
> The decision (or lack of decision) to date has been to let the profits run.  I have now decided to limit the mark to market exposure to 25% of an account.  If it goes above I will trim it back to just under.
> 
> MTU was one of the companies that had climbed in % and it has had a fair impact on my final decision. One morning I looked at the screen and seen a little icon in the announcement field.  A little icon that meant MTU wanted me to invest a big chuck of money at short notice at a price over 4 times my average cost – It was renounceable and the price held up early allowing options but it gave me a jolt as to the difficulties around this weighting issue.
> 
> MTU was trimmed during the rights period and got another haircut yesterday as did MMS.  The gut still doesn’t quit feel right selling for weighting issues rather than business performance reasons. Still not a totally settled issue for me – more a work in progress probably awaiting some lessons to be learnt the hard way.




Craft, from your posts to date, you come across as a business analyst not a portfolio manager, i therefore recommend you sell due to business performance issues not weighting issues. As you advised me - one master! As long as you are taking into account the big picture from a business risk perspective, everything should work out just fine. 

Personally i allocate capital as % of my net worth. I do not care how many different businesses i hold, i care more about the  % of my net worth that is in a business where i am a minority shareholder with no control.


----------



## odds-on

Ves said:


> Spent an hour or so searching this afternoon! Looks rare and out of print unfortunately.  Fairly expensive.  Might monitor ebay for a few weeks and see if it appears at a reasonable price.




Hi V,

I own the book and recommend it. 

Cheers 

Oddson


----------



## Huskar

Ves said:


> Spent an hour or so searching this afternoon! Looks rare and out of print unfortunately.  Fairly expensive.  Might monitor ebay for a few weeks and see if it appears at a reasonable price.




Actually you buy it direct from Charlie Munger's website. It is still expensive however.

http://www.poorcharliesalmanack.com/

Also can buy "The Most Important Thing" which McLovin recommended earlier.


----------



## Huskar

Munger also recommends a number of fascinating books which I have read on broader topics such as psychology, social Darwinism, biographies, etc. They are mostly listed here:

http://www.amazon.com/Books-Recommended-by-Charlie-Munger/lm/SP7BNI47VM8O


----------



## Ves

Thanks Hesking for both the recommendations and the purchase information.   I was on that site, for some reason missed the "orders" section.  Hmm.


----------



## ROE

Ves said:


> Thanks Hesking for both the recommendations and the purchase information.   I was on that site, for some reason missed the "orders" section.  Hmm.




also Read BRK letter to shareholder every year, it is my most eager read every year and it's FREE ...
and he archives all the letter going back many decades, if you haven't read them you can spend a good few hours on them.
http://www.berkshirehathaway.com/letters/letters.html

Every year Warren has something to say and this year he talked about Gold, previous year he talked about leverage, corporate advisers derivatives, complex products etc... etc...

you can skip all the business reporting and go straight to his wisdom it usually a 1-3 page long ...

and the strange thing is when he start mentioned these stuff it start to unravel and blow up


----------



## Ves

I have those on my Kobo e-reader.  They're great.  I'm not finished them all though.  There's so much information stored over the past 30-odd years that you can re-read them and learn new things.


----------



## craft

McLovin said:


> Probably. But we have also been in a very long period of cheap bonds, perhaps because equities were so much more attractive. Using the example of US Treasuries, real yields have been falling for decades after having spiked during the era of stagflation. I think it's wholly unrealistic to expect anything much above 0% in real terms over the long run for treasuries, or similar assets. If risk is positively correlated with reward then it seems to be an aberration of history that an asset approaching "risk free" was yielding 3-4%+ over the inflation rate.
> 
> Just my




This is US spreads over CPI. average for that period is 2.9%.




0% doesn't compensate for time preference/term risk or the fact that CPI isn't the most robust measure of inflation  (Just ask an Austrian economist)

Inflation/Disinflation is the main game in town not spread beyond it.


----------



## craft

odds-on said:


> Craft, from your posts to date, you come across as a business analyst not a portfolio manager, i therefore recommend you sell due to business performance issues not weighting issues. As you advised me - one master! As long as you are taking into account the big picture from a business risk perspective, everything should work out just fine.
> 
> Personally i allocate capital as % of my net worth. I do not care how many different businesses i hold, *i care more about the  % of my net worth that is in a business where i am a minority shareholder with no contro*l




This is the exact risk I'm grappling with. I'm not trying to maximise anything through weighting the portfolio. My one master is business perspective - but I need to weigh my lack of information and control.



Ves said:


> Craft,  I know you use your dividend cash flow to support your family.  How do the numbers compare if you look at those holdings in terms of portfolio income?  What is the impact of the worst case scenario? I guess what I am trying to get at is that it would be more useful to look upon what effect that it would have on your lifestyle, rather than portfolio value. After all, that is why you invest (and for enjoyment, I assume) not because you hoard wealth. You could always set a trailing stop loss for the proportion that you want to have "at price risk" (rather than business risk) if the over-balancing concerns you.  Besides what would you do with the sale proceeds? Are there better, lower risk assets out there?




V

Have and will continue to consider the points you make.  I may expand on some of the points you raise if I get my thoughts clear. My lack of response to your points is not a lack of appreciation or consideration of your post.
Thanks


----------



## McLovin

odds-on said:


> Craft, from your posts to date, you come across as a business analyst not a portfolio manager, i therefore recommend you sell due to business performance issues not weighting issues. As you advised me - one master! As long as you are taking into account the big picture from a business risk perspective, everything should work out just fine.
> 
> Personally i allocate capital as % of my net worth. I do not care how many different businesses i hold, i care more about the  % of my net worth that is in a business where i am a minority shareholder with no control.




I agree with this. I wouldn't have the confidence to hold a single position of 25% of my portfolio. To be honest, it's a risk I need not take.


----------



## craft

McLovin said:


> I agree with this. I wouldn't have the confidence to hold a single position of 25% of my portfolio. To be honest, it's a risk I need not take.




What exposure per company do you set at the time you buy in and what size would you let something grow to before thinking about reweighting?


----------



## McLovin

craft said:


> What exposure per company do you set at the time you buy in and what size would you let something grow to before thinking about reweighting?




Usually between 5-10%. To be honest, I've never had the situation you are in. I see your dilemma. Personally, above 20% I'd be starting to get concerned. It's difficult because at the time your analysis looks sound. But I see it more as recognition that I'm a minority shareholder and have to spend a fair amount of time "connecting the dots"  between reality and what management says. Perhaps it would also depend on the type of business, strong recurring revenues might lead me to allow it take up a larger maximum before I started to rebalance it (the theory being that strong recurring revenues don't stop overnight).

Sorry, not a great answer. Maybe I need to think more about this.


----------



## sinner

craft said:


> I’ve done a little more thinking on this rebalancing issue.  Please critique, because I am not sure I have got it right and its hard to see the trees for the forest inside my own thoughts.




Hi craft,

This might be too technical for you, but the guys at GestaltU have done huge amounts of work on rebalancing and the 'rebalancing phenomenon', Shannons demon, etc.

This article is a good place to start
http://gestaltu.blogspot.com.au/2011/12/rebalancing-japan.html

But the whole blog has huge amounts of info on rebalancing. 

If the blog is too technical, or too long to read I will summarise for you:
Mechanical rebalancing every N months can be hugely beneficial natural portfolio mechanism for both increasing profits and reducing risk.


----------



## odds-on

craft said:


> This is the exact risk I'm grappling with. I'm not trying to maximise anything through weighting the portfolio. My one master is business perspective - but I need to weigh my lack of information and control.




Craft,

I spent sometime thinking about this. Ultimately my greatest concern is permanent loss of capital and the decrease in my net worth, even if a business has a robust business model there is always the possibility of something causing a catastrophic failure of the business and losing capital. I therefore think the question is best answered by asking yourself how much are you comfortable losing due to a catastrophic failure of one of your holdings? Remember as a business grows, the probabilities of continued business success and your future return on capital change over the course of time - it is possible that the more success a business has the more likely things could actually go wrong!

IMO a maximum 10% of my net worth at time of buying sounds right to me and letting it grow to a maximum of 20% of net worth for a high conviction position seems right. If you a long term business analyst investor I think any rebalance need only be done every 6 months around HY/FY report dates.

Hope this helps.

Cheers

Oddson


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## craft

Another perspective on the equity risk premium. 





Current position is represented by the yellow cross.

What gets my attention is that we are in uncharted waters since the floating of the dollar, prior to that the data presents problems for drawing comparisons. It might just be my misplaced sense of adventure but I love uncharted waters.


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## sinner

craft said:


> Another perspective on the equity risk premium.
> 
> View attachment 47379
> 
> 
> 
> Current position is represented by the yellow cross.
> 
> What gets my attention is that we are in uncharted waters since the floating of the dollar, prior to that the data presents problems for drawing comparisons. It might just be my misplaced sense of adventure but I love uncharted waters.




Is that chart based on equity returns or equity yield?


----------



## craft

sinner said:


> Is that chart based on equity returns or equity yield?




Yield = Trend market earnings [exponential trend of all my earnings history] / Monthly XAO close.




Equity risk premium = 'above yield' minus the monthly close of the 10YR Government bond yield.


----------



## odds-on

It would be interesting to compare equity risk premium against a measure of investor sentiment. I know it sounds a bit fluffy, but the number of negative articles in the media, public surveys etc. The combination of high equity risk premium AND negative investor sentiment would be the green light to go on a buying spree.

Sometimes AFR Smart Investor does surveys and produces the results. Interesting reading how other people are allocating capital and their views on the future.
Cheers

Oddson


----------



## odds-on

This forum is sometimes a good gauge of investor sentiment.


----------



## ROE

odds-on said:


> It would be interesting to compare equity risk premium against a measure of investor sentiment. I know it sounds a bit fluffy, but the number of negative articles in the media, public surveys etc. The combination of high equity risk premium AND negative investor sentiment would be the green light to go on a buying spree.
> 
> Sometimes AFR Smart Investor does surveys and produces the results. Interesting reading how other people are allocating capital and their views on the future.
> Cheers
> 
> Oddson




You can also find that in put premium and put volume -


----------



## sinner

craft said:


> Yield = Trend market earnings [exponential trend of all my earnings history] / Monthly XAO close.
> 
> View attachment 47385
> 
> 
> Equity risk premium = 'above yield' minus the monthly close of the 10YR Government bond yield.




Very nice. I like the CAPE (EP in your case) and I like comparing it to credit even better.


----------



## Ves

Hey guys,

Return on invested capital  (ROIC)  and / or Return on Capital Employed (ROCE).

I am currently playing around with this.   It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.

Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation?   I would like to explore issues surrounding goodwill  /  other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible.  For instance, it is possible that a company has overpaid for an acquisition in the past  (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.

Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.


----------



## craft

Ves said:


> Hey guys,
> 
> Return on invested capital  (ROIC)  and / or Return on Capital Employed (ROCE).
> 
> I am currently playing around with this.   It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
> 
> Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation?   I would like to explore issues surrounding goodwill  /  other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible.  For instance, it is possible that a company has overpaid for an acquisition in the past  (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
> 
> Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.




V your post makes me smile, you are getting to the pointy end now.

I haven’t really seen much written on the points you raise.

The penny dropped for me form one of the BH letters (can’t remember which one) but the discussion was around ownership change accounting.

Returns that include indefinite life intangibles have no bearing on incremental returns on new capital and shouldn't in turn be used to calculate "implied" growth rates (retained  x ROE) because that will misrepresent future growth rates available. Reasonable future growth estimates and incremental return is what you need to make reasonable estimation of value and you can't obtain them from the historical when change of ownership transactions cloud the balance sheet.

For example, and using a smaller and easier to understand example then WES:

Look at PMV – look at the segment information for Just Group and work out what that business is worth as if it was still standing alone and then ask how much capital can be deployed organically at this rate.  If you analyse PMV as a whole it hides the return on capital employed, that its major business segment generates.


----------



## McLovin

Thanks for that post, craft. This is something I've been thinking about while I was on holiday. So much attention is paid to the possibility of a write-down of goodwill but I'm not sure why such a write down is important, unless of course there are debt/equity loan convenants etc. Capital budgeting 101 tells you that sunken costs are not important in future decision making and yet for some reason so much attention is paid to what a company paid for an asset x years ago rather than what is on the horizon. As you say, it's the return that the next $1 can be invested into the business that's important. I guess in the same vein, it's the ability of the business to generate cash on its tangible assets that really counts. Goodwill is just an accounting construct, to me it seems neither here nor there, except in limited circumstances (esp a growth by acquisition strategy).

I think the BH letter you are referring to is one of the early ones...around 1980, I could be wrong though.


----------



## McLovin

I guess what I'm trying to say, in a terribly round-about way, is that RoE is such a dirty number, with so many historic accounting adjustments in it that its use is pretty limited.


----------



## Ves

craft said:


> Look at PMV – look at the segment information for Just Group and work out what that business is worth as if it was still standing alone and then ask how much capital can be deployed organically at this rate.  If you analyse PMV as a whole it hides the return on capital employed, that its major business segment generates.



Actually this is the exact business that made something  "click" in my head for some reason.  I had thought about a lot of the principles, but for some reason they never came together, or they didn't feel like they needed to be pursued in a holistic fashion.

The words "incremental capital",  "cash flow generation" etc are starting to strike me as much more important to investment decisions that something as basic (but obscured with accounting treatments) as return on equity. Profit is a short-term accounting function, just look at the recent JP Morgan results for an example of what is possible!! But cash is king, it is much harder to hide that without being completely fraudulant in the long run.  I think my main purpose as an investor is to find how the business generates cash flow and to find as best as possible how it "sticks" to it in the long-term.

To use a basic example a business like Myer listed upon absolute premium multiples (at least to those who coffed up the money to the private equity cohort), but it never made sense to me to view the profitability of this business going forward based on what equity holders previous coughed up. In this case,  I would argue that you can never know the true economics of the business by looking at its ROE.


----------



## Ves

McLovin said:


> I think the BH letter you are referring to is one of the early ones...around 1980, I could be wrong though.



I will have a flick through, I honestly still need to read these properly.  Now might be a good time since  I have a better idea of what questions I want them to answer.


----------



## Ves

This could be what you guys were referring to:

http://gregspeicher.com/?p=1708

Possibly the 2003 letter?  I will have a read of the actual letter after work,  I don't have the time at the moment unfortunately.


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## craft

Ves said:


> This could be what you guys were referring to:
> 
> http://gregspeicher.com/?p=1708
> 
> Possibly the 2003 letter?  I will have a read of the actual letter after work,  I don't have the time at the moment unfortunately.




Try the 1986 appendix – The concept is littered throughout the years though.


----------



## Ves

craft said:


> Try the 1986 appendix – The concept is littered throughout the years though.



This makes sense - but you were dead right when you once said you have to know what questions to ask before getting any answers out of the great man's letters.

There's a few other pearls of widsom in that very letter too.  Just small tidbits that hopefully start to add up for me. The bit about being patient and waiting for your turn to bat again is a good reminder.

The major lesson seems to be:  a premium can be paid for a business with good economics, but in the long run, if you can put large amounts of incremental capital into it and earn large returns on this the purchase price often becomes unimportant.


----------



## craft

Ves said:


> purchase price often becomes unimportant.




?????



> It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price




I wholeheartedly agree with this Buffet quote – but only because conventional valuation wisdom generally mis-judges/mis-values cash flow from wonderful as opposed to fair businesses. 

However interpreting the principal as wonderful business at any price is a mistake. The purchase price *ALWAYS* matters. Pay more than the present value of the future cash flows – no matter how wonderful the business and your only possible mechanism for making your required return is selling to a greater fool.

The possibility of future high(er) market price- to-value should be utilised for excess return not made a requirement to make your hurdle rate.


----------



## Ves

I meant the purchase price of an entry as defined by the accounting entries.  This can create artificially low return on equity in the beginning.

But over time,  the cash flows that the asset generates more than make up for this. The purchase price, loses context over time, in this respect, that's what I meant by unimportant, not that you would pay well over-the-odds for an asset of any sort.
When I say premium I refer to "goodwill" and the associated purchase entries that are added to the balance sheet.


----------



## craft

Ves said:


> I meant the purchase price of an entry as defined by the accounting entries.  This can create artificially low return on equity in the beginning.
> 
> But over time,  the cash flows that the asset generates more than make up for this. The purchase price, loses context over time, in this respect, that's what I meant by unimportant, not that you would pay well over-the-odds for an asset of any sort.
> When I say premium I refer to "goodwill" and the associated purchase entries that are added to the balance sheet.




Hi V

Looks like I read your initial comment about buying price too literally. sorry



Ps. Have you been posting on a certain face book site re PMV or are the PM’s here not so private?


----------



## craft

Some back of the envelope numbers for PMV to illustrate how intangibles on the balance sheet distort the economic reality and usefulness of ROE.

Market Cap:  $770M
BRG Investment:  $175M
Cash: $300M

Market Cap less Cash and BRG = $295M + $135M debt gives EV of $430M

Forecast guidance for Just Group = EBIT of 80M.

EV/EBIT of  5.4 times on subdued retail market profit. Average profitability suggests 95M EBIT in more normal conditions.

As I see it PMV is cheapest retail asset comparatively, but by no means the worst. Just generates a normalised EBIT margin on funds employed of 43%. Has 5 proprietary clothing brands with big online presence that will do O.K over time plus Peter Alexander and Smiggle which have bright prospects.  PMV has a cashed up balance sheet and about 230M in franking credits to boot.

Mis-understood and out of fashion – produces buying opportunities.  Mind you it’s not as cheap now as in the GFC where you could buy it for less than its cash holdings.

Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.


----------



## RandR

craft said:


> Mis-understood and out of fashion – produces buying opportunities.  Mind you it’s not as cheap now as in the GFC *where you could buy it for less than its cash holdings*.
> 
> Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.




Im personally very keen to be able to find and identify any business that is trading at a value less then its cash holding. Does anyone have any quick method of scanning to identify possible culprits that can then be weedled down properly ?


----------



## Ves

Ves said:


> I meant the purchase price of an entry as defined by the accounting entries.  This can create artificially low return on equity in the beginning.
> 
> But over time,  the cash flows that the asset generates more than make up for this. The purchase price, loses context over time, in this respect, that's what I meant by unimportant, not that you would pay well over-the-odds for an asset of any sort.
> When I say premium I refer to "goodwill" and the associated purchase entries that are added to the balance sheet.



Craft,

This is what I meant.

Let us say an entity is purchased and after all the accounting adjustments the cost on the balance sheet is $10.
The entity earns $0.70 of profit on this asset.  The return on equity would read 7%.   But they can retain 50% of these earnings and re-invest them at a return of 25%.



	year	equity	earnings	roe	dividend	retained
	1	10	        0.7	        7%	 0.35	         0.35
	2	10.35	        0.7875	8%	 0.39	         0.39
	3	10.74	        0.89	        8%	 0.44    	 0.44
	4	11.18	        0.99	        9%	 0.49	         0.49
	5	11.69	        1.12	        10%	 0.56	         0.56
	6	12.25	        1.26	        10%	 0.63	         0.63
	7	12.88	        1.42	        11%	 0.71	         0.71
	8	13.59	        1.60	        12%	 0.80	         0.80
	9	14.38	        1.80	        12%	 0.90	         0.90
	10	15.28	        2.02	        13%	 1.01	         1.01
	11	16.29	        2.27	        14%	 1.14	         1.13

After only 10 years the reported return on equity has doubled!!  There are limitations to this example  (my rounding being one of them).   It does not take into account any discount rate or inflation, it just shows you what the return on equity figure will be like over time in such a business...


----------



## craft

Ves said:


> Craft,
> 
> This is what I meant.
> 
> Let us say an entity is purchased and after all the accounting adjustments the cost on the balance sheet is $10.
> The entity earns $0.70 of profit on this asset.  The return on equity would read 7%.   But they can retain 50% of these earnings and re-invest them at a return of 25%.
> 
> 
> 
> year	equity	earnings	roe	dividend	retained
> 1	10	        0.7	        7%	 0.35	         0.35
> 2	10.35	        0.7875	8%	 0.39	         0.39
> 3	10.74	        0.89	        8%	 0.44    	 0.44
> 4	11.18	        0.99	        9%	 0.49	         0.49
> 5	11.69	        1.12	        10%	 0.56	         0.56
> 6	12.25	        1.26	        10%	 0.63	         0.63
> 7	12.88	        1.42	        11%	 0.71	         0.71
> 8	13.59	        1.60	        12%	 0.80	         0.80
> 9	14.38	        1.80	        12%	 0.90	         0.90
> 10	15.28	        2.02	        13%	 1.01	         1.01
> 11	16.29	        2.27	        14%	 1.14	         1.13
> 
> After only 10 years the reported return on equity has doubled!!  There are limitations to this example  (my rounding being one of them).   It does not take into account any discount rate or inflation, it just shows you what the return on equity figure will be like over time in such a business...




Spot on.

Accounting ROE will always be dragged towards incremental return on new investments.

my original ????? were just because I read your line 







> purchase price often becomes unimportant



 to literally. I agree with your clarifications.

I think the PMV example I put up spells out what you are saying in real life – A fair chunk of their incremental investments will not be earning 5% as per their accounting ROE but ~40% as per their subsidiary’s return on funds employed. 

Big question is how wisely will they deal with the cash and franking credits on hand.


----------



## Ves

I feel like I've found the tip of a really big iceberg in this last week or two.   There's a lot to go over, and the issue of incremental capital is not always straight forward  (ie.  service companies that require very, very little capital to expand).  DTL is possibly the first to come to mind in this respect.  It would appear on first glance that their "capital", since they have very little in the way of physical assets, revolves around expanding their skilled workforce as their market share expands, or indeed improving revenue per employee if possible.  It seems hard to imagine return on invested capital in this situation.  The report will be released tomorrow.  Perhaps it will help me if I give it a thorough read.


----------



## doctorj

RandR said:


> Im personally very keen to be able to find and identify any business that is trading at a value less then its cash holding. Does anyone have any quick method of scanning to identify possible culprits that can then be weedled down properly ?




The easiest way to do it is via a bloomberg terminal.... Unfortunately I'm not aware of a free/affordable way to do it.  

Attached is a list of the all companies that had a market cap, as at close of trade today, less than the sum of their cash/near cash items as at the date of their last filing.  I've also included the cash burn where available.  The data may be a bit patchy, but you get what you pay for


----------



## craft

RandR said:


> Im personally very keen to be able to find and identify any business that is trading at a value less then its cash holding. Does anyone have any quick method of scanning to identify possible culprits that can then be weedled down properly ?




Hi R&R

I run a cash per share(from last report) greater then price(current) per share scan and got about 225 companies – problem is they nearly all seem to either have cash burn or need the cash for operations. Scanning for ‘Idle’ cash in a profitable business (such as PMV was in the GFC) is a bit trickier.


----------



## craft

RandR said:


> Im personally very keen to be able to find and identify any business that is trading at a value less then its cash holding. Does anyone have any quick method of scanning to identify possible culprits that can then be weedled down properly ?




Looks like I crossed with DctorJ last time.

Here’s another list to sift.

If you take only profitable companies and adjust the cash by the working capital (absolute) to try and get idle cash these companies come up. I know some have had capital returns since report date so the scan will be out because of that (as well as jujt bad data generally) but perhaps there’s a flower in the weeds there somewhere. 

AGG  
AYE
JRL
PSA
IRM
TYO
WEC
ATI
ESV
DSQ
MUE
GLL
RIS
LMC
EXS
DMX
EAU
TWT
MSC
MMX
ATM


----------



## Ves

Ah,  "Economic Goodwill" is the term I needed.   I believe Oddson once posted an article on a similar subject.  Something from gurufocus that was about Walmart and Buffet's  method of calculating net tangible worth.  It appears there may be more to learn from that article.


----------



## RandR

craft said:


> Hi R&R
> 
> I run a cash per share(from last report) greater then price(current) per share scan and got about 225 companies – problem is they nearly all seem to either have cash burn or need the cash for operations. Scanning for ‘Idle’ cash in a profitable business (such as PMV was in the GFC) is a bit trickier.





Thanks, yeah, I assumed any scan directed towards finding such companies would throw up a lot of turnips. Ive got zero interest in buying a company at cash value thats operating negative cashflow. There is probably no better way for myself then to run a scan like youve described and then cross them off one by one by going through the individual companies. Perhaps filtering by some basic profit ratios could weedle a list a little further.


----------



## Ves

Ves said:


> I feel like I've found the tip of a really big iceberg in this last week or two.   There's a lot to go over, and the issue of incremental capital is not always straight forward  (ie.  service companies that require very, very little capital to expand).  DTL is possibly the first to come to mind in this respect.  It would appear on first glance that their "capital", since they have very little in the way of physical assets, revolves around expanding their skilled workforce as their market share expands, or indeed improving revenue per employee if possible.  It seems hard to imagine return on invested capital in this situation.  The report will be released tomorrow.  Perhaps it will help me if I give it a thorough read.



Working capital expansion is another corollary of their business expansion...  guess this counts as incremental capital too.


----------



## odds-on

Ves said:


> Ah,  "Economic Goodwill" is the term I needed.   I believe Oddson once posted an article on a similar subject.  Something from gurufocus that was about Walmart and Buffet's  method of calculating net tangible worth.  It appears there may be more to learn from that article.




Ves,

I personally recommend reading articles by Geoff Gannon. He has his own blog and he regularly contributes to gurufocus. He seems to have spent alot of time thinking about the WB letters and using it to analyse companies, he usually has decent examples in his posts. 

Also do google "NYU Stern Prof. Aswath Damodaran", his website has lots of information. For example working capital requirements by sector.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wcdata.html

Hope the above helps. Apologies if you have seen it all before. Please note even though I post all of the above I am very much a back of an envelope fundamental investor!

Cheers

Oddson


----------



## Ves

Thanks very much Oddson!  Looks like there is a ton of reading there - all helpful.   

You should keep looking for this sort of thing, you never know when something will click and your investment analysis starts to take the next step. I do a lot of "back of the envelope" calculations, but I am beginning to expand on that more recently.


----------



## Ves

I hear  EV  / EBIT (DA)  come up a lot - and it comes up again on the blog Oddson mentioned above.   Is there any way  (preferably free) that I can use to run a scan for this multiple on the Australian market?  FYI - I currently use Commsec as my broker - I couldnt see any search for either of these variables.


----------



## doctorj

Ves said:


> I hear  EV  / EBIT (DA)  come up a lot -




See attached


----------



## Ves

doctorj said:


> See attached




Thanks - may I ask where you got the data from?


----------



## doctorj

Ves said:


> Thanks - may I ask where you got the data from?




From my bloomberg terminal...


----------



## Ves

doctorj said:


> From my bloomberg terminal...



OK thanks!


----------



## craft

craft said:


> Some back of the envelope numbers for PMV to illustrate how intangibles on the balance sheet distort the economic reality and usefulness of ROE.
> 
> Market Cap:  $770M
> BRG Investment:  $175M
> Cash: $300M
> 
> Market Cap less Cash and BRG = $295M + $135M debt gives EV of $430M
> 
> Forecast guidance for Just Group = EBIT of 80M.
> 
> EV/EBIT of  5.4 times on subdued retail market profit. Average profitability suggests 95M EBIT in more normal conditions.
> 
> As I see it PMV is cheapest retail asset comparatively, but by no means the worst. Just generates a normalised EBIT margin on funds employed of 43%. Has 5 proprietary clothing brands with big online presence that will do O.K over time plus Peter Alexander and Smiggle which have bright prospects.  PMV has a cashed up balance sheet and about 230M in franking credits to boot.
> 
> Mis-understood and out of fashion – produces buying opportunities.  Mind you it’s not as cheap now as in the GFC where you could buy it for less than its cash holdings.
> 
> Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.




The cat’s probably out of the bag to an extent with the latest report but I still get a back of the envelope EV/EBIT from the reported numbers of 6.5 @$5.60, still pretty cheap really considering the context of the retailing cycle and that Smiggle and Peter Alexander offer Premier something very rare in retail at the moment which is organic growth within a profitable franchise.  

The cost control in this report is very good. Mark McInnes is worth his weight in harassment suits.

Negotiating rents with these guys is going to be even harder going forward as they have shown no reluctance to shut down where rent is not justified.

I think I had better start running the ruler over DJS in anticipation that Sol Lew and Mark Mc would be.


----------



## robusta

Must admit I took a glance at the low ROE of this one and immediately moved on, perhaps it deserves a deeper look if only to learn for next time.


----------



## Ves

craft said:


> Negotiating rents with these guys is going to be even harder going forward as they have shown no reluctance to shut down where rent is not justified.



This has been a common theme in a lot of annual reports this year.  Retail rents are sky high against a back drop of sub-dued profits (a media euphemism for "falling") in the sector (and other sectors).  It will be interesting to see what happens when the rent bubble pops (Westfield shares could get much cheaper).  Something has to give.  I would be interested to see a ratio of average leasing expenses as a proportion of revenue for the sector.  I would say it would be near the high-end of the scale on historical terms.  Not sure where if this information is easily found, however.

Following PMV over the last few weeks and waiting for the result before I made a purchase decision has taught me a lot about how the human mind (at least my poor old specimin ) has the potential to "anchor" thoughts against previous circumstances (in this case price - OMG it was $5!) and lose perspective _vis a vis_ reality.  The question should be "How much do I think it is worth?" and then "Is the price on offer reasonable when taking into account _my assumptions_?"

I find I often get those two questions around the wrong way or plain confused with other "emotional" questions in the heat of battle (and that is what reporting season is), and anchored thoughts such as "it was 10% cheaper on Thursday and 20% last month" come into play, when they are really irrelevant unless you are a technical trader.

I think sometimes you just need to bite your tongue and realise you cannot pick the very best bargain every time, some times settling for "cheap enough"*** is still very good in the long run, especially with companies that have the potential to re-invest incremental capital at high rates of return.  Maybe others do not have this problem, but I need to remember that investing is not an exact science, it's an _art-form_ of sorts (although I will take Beethoven or Liszt any day thanks!).

What I really need to do (and I am slowly doing), and this will come with experience, and time in the game, is thoroughly research a heap of companies (as Buffett says A to Z) and have a list ready to pounce when opportunities come along. This is probably better than looking at what is cheap at the moment because your initial research has no reference to current market prices which could get me out of the "anchoring" loop.  The saying goes that an experienced investor will know exactly how to fill a portfolio during a market crash and the inexperienced investor will run around like a headless chook hoping the dart hits the right part of the dartboard.

The question of whether I needed to see the 2012 results to make a decision is another valid one, but I don't think it is as important as the first issue.


***  Please do not confuse "cheap enough", with changing your valuation criteria to make it look cheap just because the price has increased. I mean a fair or reasonable price for a great company, rather than a bargain price.  The opposite is obviously true for companies that have halved in price overnight (ie.  value traps).


----------



## Ves

craft said:


> Some back of the envelope numbers for PMV to illustrate how intangibles on the balance sheet distort the economic reality and usefulness of ROE.
> 
> Market Cap:  $770M
> BRG Investment:  $175M
> Cash: $300M
> 
> Market Cap less Cash and BRG = $295M + $135M debt gives EV of $430M
> 
> Forecast guidance for Just Group = EBIT of 80M.
> 
> EV/EBIT of  5.4 times on subdued retail market profit. Average profitability suggests 95M EBIT in more normal conditions.
> 
> As I see it PMV is cheapest retail asset comparatively, but by no means the worst. Just generates a normalised EBIT margin on funds employed of 43%. Has 5 proprietary clothing brands with big online presence that will do O.K over time plus Peter Alexander and Smiggle which have bright prospects.  PMV has a cashed up balance sheet and about 230M in franking credits to boot.
> 
> Mis-understood and out of fashion – produces buying opportunities.  Mind you it’s not as cheap now as in the GFC where you could buy it for less than its cash holdings.
> 
> Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.



I noticed something inadvertently when doing my own analysis of PMV since we have discussed it.

I think for the last 10 years I had an average ROIC of about 41%.  

I am curious if you treated the PP&E on the balance sheet the same as me.   I PP&E in the denominator "net assets employed figure" at cost rather than written down value.  If I did not do this the ROIC would obviously be much higher. I thought it made sense because it would be closer to the replacement cost of those assets.   However, you could get technical and adjust them for inflation over the years, but that seems like pointless complexity at this stage.

I also included about $30-45 million operating cash in my calculations for each year after PMV took over JST.

I am also using EBIT as my numerator  (I know some people use EBIT * (1- tax rate)).  EBIT  /  (Total assets - excess cash - intangible assets - non-interest bearing liabilities ) = ROIC

The reason I ask is because I am interested if we get a similar end result using different methods.


----------



## Ves

Buffett's speech from Monte Carlo if anyone is interested or has not read it:

http://www.tilsonfunds.com/BuffettNotreDame.pdf


----------



## Ves

Ves said:


> Buffett's speech from Monte Carlo if anyone is interested or has not read it:
> 
> http://www.tilsonfunds.com/BuffettNotreDame.pdf



Apologies... I meant to type Notre Dame last night.  I must have been tired.


----------



## Ves

Somewhere at the start of the thread craft provided some quotes that indicated that Buffett used DCF analysis to calculate intrinsic value.

The speech transscript that I linked above has another on the topic that may be of interest:



> If you can tell me what all of the cash in and cash out of a business will be, between now and
> judgment day, I can tell you, assuming I know the proper interest rate, what it’s worth. It doesn’t make any difference whether you sell yo-yo’s, hula hoops, or computers. Because there would be a stream of cash between now and judgment day, and the cash spends the same, no matter where it comes from. Now my job as an investment analyst, or a business analyst, is to figure out where I may have some knowledge, what that stream of cash will be over a period of time, and also where I don’t know what the stream of cash will be. I don’t have the faintest idea of where Digital Equipment will be in next week, let alone the next 10 years. I just don’t know. I don’t even know what they do. And I never would know what they did. Even if I thought I knew what they did, I wouldn’t know what they did. Hershey bars I understand.
> 
> So, my job is to look at the universe of things I can understand – I can understand Ike Friedman’s jewelry store – and then I try to figure what that stream of cash, in and out, is going to be over a period of time, just like we did with See’s Candies, and discounting that back at an appropriate rate, which would be the long term Government rate. [Then,] I try to buy it at a price that is significantly below that. And that’s about it.




Also really liked this passage as I have been putting more thought into this side of my investing than any other in recent times:



> ... Incidentally, I would say that almost everybody I know in Wall Street has had as many good ideas as I have, they just had a lot of [bad] ideas too. And I’m serious about that. I mean when I bought Western Insurance Security selling at $16 and earning $20 per share, I put half my net worth into it. I checked it out first – I went down to the insurance commission and got out the convention statements, I read Best’s, and I did a lot of things first. But, I mean, my dad wasn’t in it, I’d only had one insurance class at Columbia – but it was not beyond my capabilities to do that, and it isn’t beyond your capabilities.
> 
> Now if I had some rare insight about software, or something like that – I would say that, maybe, other people couldn’t do that – or biotechnology, or something. And I’m not saying that every insight that I have is an insight that somebody else could have, but there were all kinds of people that could have understood American Express Company as well as I understood it in ‘62. They may have been...they may have had a different temperament than I did, so that they were paralyzed by fear, or that they wanted the crowd to be with them, or something like that, but I didn’t know anything about credit cards that they didn’t know, or about travelers checks. Those are not hard products to understand. But what I did have was an intense interest and I was willing, when I saw something I wanted to do, to do it. And if I couldn’t see something to do, to not do anything. By far, the most important quality is not how much IQ you’ve got. IQ is not the scarce factor. *You need a reasonable amount of intelligence, but the temperament is 90% of it.*




My bold.

I hope people find these quotes as enlightening as I do!


----------



## McLovin

> Incidentally, I would say that almost everybody I know in Wall Street has had as many good ideas as I have, they just had a lot of [bad] ideas too.




I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.


----------



## Klogg

McLovin said:


> I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.




Agreed. In my limited experience, when I manage my poor choices well and simply accept I made the wrong decision, the rest manages itself.


----------



## Ves

McLovin said:


> I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.



I agree - this sort of thing was fairly natural to me. However, the more experience I get the more situations I can come up with that I do not want to be put in.

In a sense risk mitigation (and investing in general) has a lot to do with pattern recognition, and Buffett seems to have that in truckloads, in both positive (positions he exposes himself to) and negative (those he avoids) elements.


----------



## craft

Ves said:


> Buffett's speech from Monte Carlo if anyone is interested or has not read it:
> 
> http://www.tilsonfunds.com/BuffettNotreDame.pdf




Thanks V

Probably only those who appreciate Buffett will wade through  39 pages – but well worth it.

Thanks for posting.


----------



## Ves

craft said:


> Thanks V
> 
> Probably only those who appreciate Buffett will wade through  39 pages – but well worth it.
> 
> Thanks for posting.



No worries!

I actually found it pretty light reading - he has an entertaining way of explaining things.  An hour tops - unless you really want to get into it and take notes.  

Can you have a look at my reply to your post about PMV please?  It got left behind on the previous page last week.


----------



## systematic

I've read the second quote before, thanks for posting it...the part that you bolded is the crux for me.  For me that means the temperament, discipline etc to avoid style drift and stick to proven methods in good times and bad.


----------



## craft

Ves said:


> I noticed something inadvertently when doing my own analysis of PMV since we have discussed it.
> 
> I think for the last 10 years I had an average ROIC of about 41%.
> 
> I am curious if you treated the PP&E on the balance sheet the same as me.   I PP&E in the denominator "net assets employed figure" at cost rather than written down value.  If I did not do this the ROIC would obviously be much higher. I thought it made sense because it would be closer to the replacement cost of those assets.   However, you could get technical and adjust them for inflation over the years, but that seems like pointless complexity at this stage.
> 
> I also included about $30-45 million operating cash in my calculations for each year after PMV took over JST.
> 
> I am also using EBIT as my numerator  (I know some people use EBIT * (1- tax rate)).  EBIT  /  (Total assets - excess cash - intangible assets - non-interest bearing liabilities ) = ROIC
> 
> The reason I ask is because I am interested if we get a similar end result using different methods.




Sorry for not replying

 Generally written down value is used for calculating ROIC by the data providers. I understand the argument for using cost price or even more ideally replacement cost; however I don’t feel the need to go to that level of detail.  The standard measure paints a rough enough picture of capital intensity which is what I want to know from ROIC.

Your figure look reasonable if you are using ‘cost’. However as I don’t use ROIC implicitly for valuation I have not recorded it over a historical range.

For valuation purposes;

The parts of the business that have no enduring competitive advantage I use replacement value of its assets.

For the franchise parts of the business I use expected returns on new Investments.  (This figure is where a historical ROIC number could inform your thinking)  [My assumption for this figure is deliberately absent from this post]

I feel I probably haven’t answered what you are looking for which is why I guess I didn’t respond initially.


----------



## Ves

craft said:


> Sorry for not replying
> 
> Generally written down value is used for calculating ROIC by the data providers. I understand the argument for using cost price or even more ideally replacement cost; however I don’t feel the need to go to that level of detail.  The standard measure paints a rough enough picture of capital intensity which is what I want to know from ROIC.
> 
> Your figure look reasonable if you are using ‘cost’. However as I don’t use ROIC implicitly for valuation I have not recorded it over a historical range.




My view is that if it is possible to calculate all of them over a reasonable period of time and compare them. It should be easy to see if the capital intensity of the business as a whole.  Generally anything above 20%  (especially if it is over a period of 10 years is more) is pretty solid and worthy of further investigation in my view).   



> For valuation purposes;
> 
> The parts of the business that have no enduring competitive advantage I use *replacement value of its assets*.
> 
> For the franchise parts of the business I use *expected returns on new Investments*.  (This figure is where a historical ROIC number could inform your thinking)  [My assumption for this figure is deliberately absent from this post]
> 
> I feel I probably haven’t answered what you are looking for which is why I guess I didn’t respond initially.



As per my bolds - both of these things are obviously mystical and arcane to a beginner like me.  They make sense when written in a book, but beyond that...

For instance, I have read about practical solutions to assess replacement value in authors like Greenwald, but it seems to me that they require a high level of industry knowledge, and in a lot of cases the balance sheet does not go into enough detail to be able to base much of an _opinion_ on these things.  It might click for me one day, and I will keep bashing away at it like I am now, but I will admit the concept, although theoretically easy to understand on face value, still boggles me in practice.

Expected returns on new capital deployed is also tough.  I try to find businesses that have a long, predictable history if possible.  Forecasting is not my forte, at the moment, my best application of this in practice is reviewing the past, playing with a range of variables in the future and trying to determine which is most probable on the limited information that I have.  This probably seems hocus pocus to most people reading, and it might turn out that my figures are ridiculous in ten years time. Conservatism seems to be my best weapon whilst learning, but it also opens up errors of omission if you are not brave enough.

I'm still not really confident in the valuations that I am producing  (but saying that I would rather do them than rely on a magic-bullet formula).  However, if I do not do them, I will become lazy and never get better - so I am trying to be as persistant as possible and come up with some conclusions that seem reasonable enough to act on in the mean time.

I think the best thing I can possibly do at the moment is try to find as many businesses as possible that I can understand.

*edit:   I never thought of this before, but it is possible that the replacement value concept gives me grief because of the fact that I am a trained accountant who sat through many discussions in university, and whilst studying for my CPA, on the pitfuls of asset values on the balance sheet.  Perhaps I am bogged down by academic discourse and I am struggling to see it in a practical light like someone such as yourself who was probably never exposed to such things?*


----------



## craft

Ves said:


> My view is that if it is possible to calculate all of them over a reasonable period of time and compare them. It should be easy to see if the capital intensity of the business as a whole.  Generally anything above 20%  (especially if it is over a period of 10 years is more) is pretty solid and worthy of further investigation in my view).



 Seems reasonable.   




> As per my bolds - both of these things are obviously mystical and arcane to a beginner like me.  They make sense when written in a book, but beyond that...



Until you are comfortable with the concepts then perhaps the bold should be on *'This figure is where a historical ROIC number could inform your thinking' *which is what you are doing - and is where I started. 




> For instance, I have read about practical solutions to assess replacement value in authors like Greenwald, but it seems to me that they require a high level of industry knowledge, and in a lot of cases the balance sheet does not go into enough detail to be able to base much of an _opinion_ on these things.  It might click for me one day, and I will keep bashing away at it like I am now, but I will admit the concept, although theoretically easy to understand on face value, still boggles me in practice.
> 
> 
> Expected returns on new capital deployed is also tough.  I try to find businesses that have a long, predictable history if possible.  Forecasting is not my forte, at the moment, my best application of this in practice is reviewing the past, playing with a range of variables in the future and trying to determine which is most probable on the limited information that I have.  This probably seems hocus pocus to most people reading, and it might turn out that my figures are ridiculous in ten years time. Conservatism seems to be my best weapon whilst learning, but it also opens up errors of omission if you are not brave enough.
> 
> I'm still not really confident in the valuations that I am producing  (but saying that I would rather do them than rely on a magic-bullet formula).  However, if I do not do them, I will become lazy and never get better - so I am trying to be as persistant as possible and come up with some conclusions that seem reasonable enough to act on in the mean time.




Seems you undersatnd better then you may think. The Investors job is not one of absolutes but of judjement and skill, for which you get paid well if you get it right and slapped if you get it wrong.




> I think the best thing I can possibly do at the moment is try to find as many businesses as possible that I can understand.



 The world’s best documented investor sticks tightly to his circle of competence - coincidence - I think not.




> *edit:   I never thought of this before, but it is possible that the replacement value concept gives me grief because of the fact that I am a trained accountant who sat through many discussions in university, and whilst studying for my CPA, on the pitfuls of asset values on the balance sheet.  Perhaps I am bogged down by academic discourse and I am struggling to see it in a practical light like someone such as yourself who was probably never exposed to such things?*



 Being a simplton is my advantage.


----------



## Ves

Thanks, dont get me wrong, I do have ideas on this sort of thing, but they require further refinememt before they can be used! I am still certain that this would be easier to implement in practice if it were my full time focus. A long way to go yet until I am able to finance the capital and income to do this.


----------



## craft

Ves said:


> Thanks, dont get me wrong, I do have ideas on this sort of thing, but they require further refinememt before they can be used! I am still certain that this would be easier to implement in practice if it were my full time focus. A long way to go yet until I am able to finance the capital and income to do this.




It’s not that complex or time consuming. (Says he who soaks up far too much time on it – but I’m happily addicted)

It’s more that you are at the stage equivalent of ‘proof’ in mathematics.   You don’t need to be able to prove a formula to use it – but in an investment perspective with randomness effecting individual outcomes you do need to go through a very complex proving stage to identify, trust and stick to some simple approaches.

Every time I have mastered some piece of complexity down to simple - I find Buffett has already simply stated my ‘aha’ concept. That’s why he is my touch stone.


----------



## Huskar

Ves said:


> Buffett's speech from Monte Carlo if anyone is interested or has not read it:
> 
> http://www.tilsonfunds.com/BuffettNotreDame.pdf




I love this sort of stuff. Thanks Ves!

I also find it interesting to note the sometime inconsistencies between what Uncle Warren says and what he does. 

For example, his oft-cited confession that he was born with a brain for asset allocation. My opinion is that his expertise came all from hard work. The biography Snowball relates how he knew the important accounting attributes for nearly _every_ listed stock on the American exchange: this gives a pretty damn good base to be able to say this or that company is over/underpriced.

And on the last page of the speech he talks about never using leverage. But this also is illusory. He has never borrowed heavily in a conventional sense (bank debt), but his whole fortune has been built on leveraging off of other people's money, whether in his partnership days or in Berkshire days.

A very interesting recent Buttonwood article in the Economist to which a link was posted somewhere else on this forum (sorry I forget where) relates how Buffet's outperformance came from the use of leverage by way of the large insurance float he had access to. That Buttonwood article cites "Buffet's Alpha" which concludes that Buffet has consistently had 1.6-to-1 leverage.

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

Some food for thought...


----------



## craft

Huskar said:


> I love this sort of stuff. Thanks Ves!
> 
> I also find it interesting to note the sometime inconsistencies between what Uncle Warren says and what he does.
> 
> For example, his oft-cited confession that he was born with a brain for asset allocation. My opinion is that his expertise came all from hard work. The biography Snowball relates how he knew the important accounting attributes for nearly _every_ listed stock on the American exchange: this gives a pretty damn good base to be able to say this or that company is over/underpriced.
> 
> And on the last page of the speech he talks about never using leverage. But this also is illusory. He has never borrowed heavily in a conventional sense (bank debt), but his whole fortune has been built on leveraging off of other people's money, whether in his partnership days or in Berkshire days.
> 
> A very interesting recent Buttonwood article in the Economist to which a link was posted somewhere else on this forum (sorry I forget where) relates how Buffet's outperformance came from the use of leverage by way of the large insurance float he had access to. That Buttonwood article cites "Buffet's Alpha" which concludes that Buffet has consistently had 1.6-to-1 leverage.
> 
> http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf
> 
> Some food for thought...




Free/cheap money, that and pricing power are the economics of a wonderful business – It is Buffett 101 and he has deliberately built internal funding via insurance float, deferred Capital Gains Tax and derivative premiums into Berkshire Hathaway.

Taking  DTL as an example of the concept:

In 2012 they had

Return on Assets of 8.1% (Ebit/Total Assets)

An  Internally financed leverage of 647% which juices the return on funds employed up to  52% (Ebit/equity+debt). This is the line at which Buffett utilises leverage.

Financial Leverage for DTL is just 107% producing Ebit on Equity of 56.3%. (It is at this line that Buffett warns against and steers clear of leverage). 

Although some see a contradiction in his use of leverage – I see that he has sung the same tune for a very long time. Free(cheap) , variable with revenue,  leverage that doesn’t risk control is wonderful – the other stuff can be toxic even in small doses under the wrong conditions. 

Not sure why people are suddenly surprised about the academic paper results, but perhaps they might start to cotton onto the importance of a business’s structural economics – maybe not.


----------



## Ves

craft said:


> It’s not that complex or time consuming. (Says he who soaks up far too much time on it – but I’m happily addicted)



You are right - I don't think it is so much the time factor, it has something to do with focus / energy / distraction / inconvenience.  Working full-time can drain focus and concentration levels.   You can of course mix both, but by the time I get home at 6pm, have some dinner and sit down to task it is a tough slog to get much done before I realise I probably should be winding myself down before bed.   I have often had 'aha' moments and not been able to sleep!  It would be nice not having the additional commitment of work in these cases.  




> It’s more that you are at the stage equivalent of ‘proof’ in mathematics.   You don’t need to be able to prove a formula to use it – but in an investment perspective with randomness effecting individual outcomes you do need to go through a very complex proving stage to identify, trust and stick to some simple approaches.
> 
> Every time I have mastered some piece of complexity down to simple - I find Buffett has already simply stated my ‘aha’ concept. That’s why he is my touch stone.



I really like how you put this and I can see what you mean (at least more so than I would have 12 months ago). 

I often find asking questions on forums (as dumb as they may seem to others) helps clarify my own thought process too.  I'll ask a question and for some reason answers that were not previously coming often start to form. I know Buffett (and many other successful people from all fields) say that writing something down or typing it out has this effect.


----------



## Ves

craft said:


> Free/cheap money, that and pricing power are the economics of a wonderful business – It is Buffett 101 and he has deliberately built internal funding via insurance float, deferred Capital Gains Tax and derivative premiums into Berkshire Hathaway.
> 
> Taking  DTL as an example of the concept:
> 
> In 2012 they had
> 
> Return on Assets of 8.1% (Ebit/Total Assets)
> 
> An  Internally financed leverage of 647% which juices the return on funds employed up to  52% (Ebit/equity+debt). This is the line at which Buffett utilises leverage.
> 
> Financial Leverage for DTL is just 107% producing Ebit on Equity of 56.3%. (It is at this line that Buffett warns against and steers clear of leverage).
> 
> Although some see a contradiction in his use of leverage – I see that he has sung the same tune for a very long time. Free(cheap) , variable with revenue,  leverage that doesn’t risk control is wonderful – the other stuff can be toxic even in small doses under the wrong conditions.
> 
> Not sure why people are suddenly surprised about the academic paper results, but perhaps they might start to cotton onto the importance of a business’s structural economics – maybe not.



Great post.

Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA?  In this case 52% / 8.1%  = 641%?


----------



## McLovin

Ves said:


> Great post.
> 
> Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA?  In this case 52% / 8.1%  = 641%?




(Equity + debt)/total assets?

craft, thanks for this thread, it's one of the most interesting reads.


----------



## McLovin

McLovin said:


> (Equity + debt)/total assets?




Flip that around...


----------



## Ves

McLovin said:


> Flip that around...



Now I am at home I have actually been able to have a proper look.

As follows:

165602	Current liabilities
-135883	Current Assets
1899	Current Tax liability
1433	Current Provisions
20701	Other Current Provisions
1344	Non-current Provisions
671	Other non-Current Provisions
-2222	Other Assets
165602	Current liabilities
-135883	Curren Assets
1899	Current Tax liability
1433	Current Provisions
20701	Other Current Provisions
1344	Non-current Provisions
671	Other non-Current Provisions
-2222	Other Assets
*53545	Net internal financing*


8278	Contributed Equity

646.8%

Craft can correct me if I am wrong of course, but I assume it is no mere coincidence that I came up with the same figures.  I find it weird that there is no literature coming up via a google search in terms of "how to guides" for this. Working it out blind was fun though!


----------



## Ves

Ves said:


> 165602	Current liabilities
> -135883	Current Assets
> 1899	Current Tax liability
> 1433	Current Provisions
> 20701	Other Current Provisions
> 1344	Non-current Provisions
> 671	Other non-Current Provisions
> -2222	Other Assets
> *53545	Net internal financing*




Not sure what happened, but for some reason when I editted my original post for a spelling error the calculations in this part duplicated on my screen.  I have had this issue on the forum before,  it is possibly a glitch with Mozilla firefox or the forum software.  any how, should look like this for those curious.


----------



## craft

Ves said:


> Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA?  In this case 52% / 8.1%  = 641%?





As McLovin posted,  Total Assets/Funds Employed(debt+equity)




Ves said:


> Now I am at home I have actually been able to have a proper look.
> 
> As follows:
> 
> 165602	Current liabilities
> -135883	Current Assets
> 1899	Current Tax liability
> 1433	Current Provisions
> 20701	Other Current Provisions
> 1344	Non-current Provisions
> 671	Other non-Current Provisions
> -2222	Other Assets
> 
> *53545	Net internal financing*
> 
> 
> 8278	Contributed Equity
> 
> 646.8%
> 
> Craft can correct me if I am wrong of course, but I assume it is no mere coincidence that I came up with the same figures.  I find it weird that there is no literature coming up via a google search in terms of "how to guides" for this. Working it out blind was fun though!




You have (nearly) provided the long hand proof here – the ratio is much quicker.


----------



## Ves

craft said:


> As McLovin posted,  Total Assets/Funds Employed(debt+equity)
> 
> 
> 
> 
> You have provide the long hand proof here – the ratio is much quicker.




So it is.  For some reason I completely misunderstood McLovin's suggestion.   

Apologies guys!

So to calculate Fund's employed for DTL (or any company for that matter)  you just add together Debt + Equity?

Call me silly, but I always do it long hand  (Total assets - indeterminible life intangibles - non interest bearing debt - excess cash) with company specific adjustments if I feel there is a need. I don't know why but it feels more accurate to me.  Provisions and deferred tax assets and liabilities and such book entries I usually do not take into account unless they are really material, either. I find doing it long hand like that is so much easier to make adjustments if need be (and especially easy to follow if I ever need to revisit my calculations ).  I guess both figures are going to be in the ball park at the end of the day.


----------



## craft

> The Hunter Hall Value Growth Trust
> 
> The best performing fund in Australia
> over a 18 year period (since inception in May 1994) listed by Morningstar.
> 
> (Source: Morningstar)





Haven’t checked the validity of this claim but the below clip is succinct and probably deserves a reference in this thread.


http://www.youtube.com/watch?v=2SaedGAnJmE


----------



## craft

Howard Marks latest memo.

http://www.oaktreecapital.com/MemoTree/On%20Uncertain%20Ground%2009_11_12.pdf

As always, a thoughtful read on risk.


----------



## Ves

craft said:


> Howard Marks latest memo.
> 
> http://www.oaktreecapital.com/MemoTree/On%20Uncertain%20Ground%2009_11_12.pdf
> 
> As always, a thoughtful read on risk.



The parts on perception are very pertinent, and would be useful to remember for all conditions (and of course useful in other walks of life).  I like the question that he asks that goes something along the lines of:  "Are conditions really uncertain now or were they always like this but we did not perceive them to be?"  It is hard to answer this, even for people who have been through a few cycles, because memories of experiences and moods fade incrementally over time. The human mind is very susceptible to the illusion of motion as seen through the filter of time!

Thanks for the interesting read.


----------



## craft

Stumbled across this on a Google search. 


James Montier – Value Investing 



> http://www.scribd.com/doc/86467853/Value-Investing




Wonder if Oddson is still around?


----------



## craft

V

I have a super accounting question for you.

Bill M in another thread that I better not sidetrack any further, talked about switching within a superfund, which re-ignited a question I haven’t answered for myself yet.

How does the tax work in these big superfunds. Switching seems to have no effect on the value of an individuals account but the changes must affect the fund as it buys and sells the assets and pays out tax relating to relised gains/losses.

Now I know they handle tax through accruals – but is there a big averaging process going on?  Are people who stick solidly to one asset class subsidising the tax implications of those that switch regularly ? And what happens with the benefit of turning 60 and being able to realise longer term (though most funds don’t seem to do long term) gains tax exempt – does that benefit go to the person involved or is it spread? 

I don’t know but I’m guessing the pooling of tax probably means you don’t necessarily get the same entitlement from a big fund as you would a SMSF. Some win some lose.  – Right or wrong?


----------



## RandR

craft said:


> V
> 
> I have a super accounting question for you.
> 
> Bill M in another thread that I better not sidetrack any further, talked about switching within a superfund, which re-ignited a question I haven’t answered for myself yet.
> 
> How does the tax work in these big superfunds. Switching seems to have no effect on the value of an individuals account but the changes must affect the fund as it buys and sells the assets and pays out tax relating to relised gains/losses.
> 
> Now I know they handle tax through accruals – but is there a big averaging process going on?  Are people who stick solidly to one asset class subsidising the tax implications of those that switch regularly ? And what happens with the benefit of turning 60 and being able to realise longer term (though most funds don’t seem to do long term) gains tax exempt – does that benefit go to the person involved or is it spread?
> 
> I don’t know but I’m guessing the pooling of tax probably means you don’t necessarily get the same entitlement from a big fund as you would a SMSF. Some win some lose.  – Right or wrong?




I can confirm that the super fund im with (I need to be careful because I now work for them ) factors the individual results of taxation into the wider 'pool'. Essentially all tax is factored into the returns distributed and reported to the individual members on a unit price basis within any specific investment option ... at least thats how we do it.

I believe they had an issue previously within the fund where excess taxation was set aside for one of the investment options. Upon realisation of this the 'spare' tax funds were re distributed into the options unit price (they did it in one hit and it was actually quite a considerable hit ... 10% or so )


> And what happens with the benefit of turning 60 and being able to realise longer term (though most funds don’t seem to do long term) gains tax exempt – does that benefit go to the person involved or is it spread?




There is no benefit for the individual.  As you have observed, the more people chop and change within their super funds investment options the more 'friction' (cost to the investment option) they create.


----------



## Ves

craft said:


> V
> 
> I have a super accounting question for you.
> 
> Bill M in another thread that I better not sidetrack any further, talked about switching within a superfund, which re-ignited a question I haven’t answered for myself yet.
> 
> How does the tax work in these big superfunds. Switching seems to have no effect on the value of an individuals account but the changes must affect the fund as it buys and sells the assets and pays out tax relating to relised gains/losses.
> 
> Now I know they handle tax through accruals – but is there a big averaging process going on?  Are people who stick solidly to one asset class subsidising the tax implications of those that switch regularly ? And what happens with the benefit of turning 60 and being able to realise longer term (though most funds don’t seem to do long term) gains tax exempt – does that benefit go to the person involved or is it spread?
> 
> I don’t know but I’m guessing the pooling of tax probably means you don’t necessarily get the same entitlement from a big fund as you would a SMSF. Some win some lose.  – Right or wrong?



I've never worked in corporate superannuation - so I don't actually know the specific workings of them.

But I know that different funds have different structures.  When you talk about averaging, in terms of weighting and pools, you are referring to a master trust.

This works similarly to a unit trust.  Each member who has superannuation in such an account owns a certain amount of units in the trust.   Tax is calculated as a whole for the entity, and is paid on a per unit basis, I believe. Only contributions tax is member specific. Although, clearly they would need to do this on a weighted average basis because people are making contributions and switching in and out of these investments all through-out the year.

I believe that these funds most likely keep a large enough liquid asset component (ie. cash) to deal with people who constantly switch in and out of funds.  Most funds also charge a switching fee, which probably helps in part to pay the tax and reduces the cross-subsidisation by other members??? I am not really sure on this and I have no idea how material the taxation consequences of member switches are.

Pension accounts are held within a separate master trust.  When you start a pension in these big funds they transfer you into one of these.  I do not think that these funds pay tax at all.  But you are right, compared to a superannuation fund who has held say a property for 20 years, when a member switches into pension mode, they still hold the property and will not have to pay capital gains tax on the gain (as long as they stay in pension mode).  There seems to be no longevity of asset holdings in master trust accounts, so the long-term tax benefit of superannuation would be diminished to an extent.

As far as I know master funds are more cost-effective to run because everything is calculated and invested in at a fund level, rather than an individual level. So you should be paying less fees.  Industry funds usually work in this way, I believe.

Alternatively there are a whole raft of products in retail funds that are referred to as "Wrap investments" - the pool of investments in these are member specific.  A member puts cash into their Wrap account and it is invested as per their own individual decisions (or as per their adviser).  Taxation is calculated on a member level in Wrap accounts.  So effectively if you are worried about cross-subsidisation you would be able to avoid it by using a Wrap product. 

The link below might help explain the difference:

http://www.wealthtrac.com.au/Assets/61/1/L6344_0812_Wealthtrac_Wrap_FlyerWEB.pdf


----------



## McLovin

Ves said:


> Taxation is calculated on a member level in Wrap accounts.  So effectively if you are worried about cross-subsidisation you would be able to avoid it by using a Wrap product.
> 
> The link below might help explain the difference:
> 
> http://www.wealthtrac.com.au/Assets/61/1/L6344_0812_Wealthtrac_Wrap_FlyerWEB.pdf





I might be misunderstanding something here (I use a family SMSF, so have pretty much zero experience with retail super), but if the wrap account is invested into unit trusts (managed funds) which distribute tax liabilities to unit holders on an equal basis then wouldn't any CGT event from individual unit holders redeeming their units be spread across all unit holders, albeit at the unit holders own tax rate?

I guess what I'm saying is that the actions of person A can create a tax liability for person B, even in a wrap product, right?


----------



## Ves

McLovin said:


> I might be misunderstanding something here (I use a family SMSF, so have pretty much zero experience with retail super), but if the wrap account is invested into unit trusts (managed funds) which distribute tax liabilities to unit holders on an equal basis then wouldn't any CGT event from individual unit holders redeeming their units be spread across all unit holders, albeit at the unit holders own tax rate?
> 
> I guess what I'm saying is that the actions of person A can create a tax liability for person B, even in a wrap product, right?



You can also hold managed funds or similar unit trust investments in your personal name, a company or an SMSF as well.  I would think your observation, if it is true, would be just as valid for those vehicles as it would be for a superannuation Wrap product?  

Managed funds (and superannuation master trusts) are heavily audited, so you would only hope that they would have a formula or a system so that much of the inequality of what Craft and yourself are asking about is avoiding.  

If I get a chance I will ask some people I know that have worked for companies such as Mercer.


----------



## craft

Thanks guys for your posts and PM’s

The more I think about this area the more I like the transparency of SMSF’s for the long term holding of equities.

I’m sure that a lot of effort and cost goes into trying to keep things equitable but it just seems a very complex job to me. R&Rs indication of a 10% adjustment is probably testimony to the difficulty.

The big point for me is the tax treatment at the transition into pension phase. The wiping of the Deferred Tax Liability on your 60th birthday is potentially a huge benefit if you are in a SMSF. Yet it seems your account balance in a large fund doesn’t budge one point on that day. I guess it’s all swings and round abouts based on actuary estimates and so forth – but expenses from complexity and ‘friction’ through member switching etc must all add up. (not to mention the glossy comunications, the efforts to grow members/merge and other bells and whistles...blah blah blah ) 

I think SMSF’s are the best thing since sliced bread and when you think about incidental benefits like we are talking about here and if you have a bent towards the long term and DIY – I suspect a SMSF becomes viable even at fairly modest balances.


----------



## Ves

Craft - I trust that McLovin passed on some of the same information that he shared with me. 

Completely agree - the closest alternative to these benefits (and could be a better option for those not as sophisticated) is a Wrap account that allows you to buy shares (probably limited to ASX 300) and term deposits as well as managed funds.  If you did not invest in the managed funds, I do not see why you would be at a tax disadvantage at any stage compared to someone who is using a SMSF.  All tax in a Wrap account as I understand it is levied on the individual and not pooled at all. But of course your investment options and flexibility is somewhat limited.


----------



## craft

Here’s an Ironic post for a stock forum.

*The best way to think about investments is to be in a room with no one else and just think.*


http://www.youtube.com/watch?v=aL766NK2ynw


I think he’s trying to tell me something.


----------



## Ves

craft said:


> Here’s an Ironic post for a stock forum.
> 
> *The best way to think about investments is to be in a room with no one else and just think.*
> 
> 
> http://www.youtube.com/watch?v=aL766NK2ynw
> 
> 
> I think he’s trying to tell me something.



There is a lot of wisdom in the bolded part alone... a life-time full of it.

There is also this from an arguably wiser source (even more estranged from the normal stock market banter):

http://en.wikipedia.org/wiki/Golden_mean_(philosophy)

The purpose of the link is to remind myself, and maybe others, that you need not run from one excess to another (ie. going from one extreme "watching price action all day" to "ignoring the market altogether"  or better yet from "wasting too  much time on chat forums" to "locking yourself in your room"! )

Sorry there is a bit of cheek in my comment - I hope others find some enjoyment and meaning in there some where.


----------



## Huskar

craft said:


> Here’s an Ironic post for a stock forum.
> 
> *The best way to think about investments is to be in a room with no one else and just think.*
> 
> 
> http://www.youtube.com/watch?v=aL766NK2ynw
> 
> 
> I think he’s trying to tell me something.




So good. Call me a fawning Buffetologist but I can't get enough of the bloke.

On the other hand, I can't help but always see the inconsistencies between what he has done and what he says. He admits that for 40 (!) years he was involved in arbitrage plays which requires, in his own words, to be constantly on the phones. 

Yet surely this was a complement to his business-picking skills rather than a distraction - it gave a breadth of business knowledge and attunement to relative (mis)pricing.

Am I just finding shapes in shadows here or does anybody agree?


----------



## Andrew Newman

Hi

With discussion about Warren Buffet, I thought I would share some information about the direct share investing method that I use, which is similar to that used by Warren Buffet.
www.cmpfinancialplanning.com.au/blog/direct-share-investing-warren-buffet-investment-method

Let me know your thoughts.

Kind Regards


----------



## McLovin

Andrew Newman said:


> Hi
> 
> With discussion about Warren Buffet, I thought I would share some information about the direct share investing method that I use, which is similar to that used by Warren Buffet.
> www.cmpfinancialplanning.com.au/blog/direct-share-investing-warren-buffet-investment-method
> 
> Let me know your thoughts.
> 
> Kind Regards




Are these actual returns or have you just made some assumptions and arrived at those returns? If they are assumptions that have been arrived at non-mechanically, how did you manage to retrospectively do this without only picking winners?...



> The third and final step is to perform detailed analysis on the companies that passed through the first scan.


----------



## Andrew Newman

Hi McLovin

The performance charts relate to hypothetical returns, with the portfolios updated each year. 

Actual client returns are also outperforming the market but don’t go back as far. 

Kind Regards


----------



## McLovin

craft said:


> Thanks guys for your posts and PM’s
> 
> The more I think about this area the more I like the transparency of SMSF’s for the long term holding of equities.
> 
> I’m sure that a lot of effort and cost goes into trying to keep things equitable but it just seems a very complex job to me. R&Rs indication of a 10% adjustment is probably testimony to the difficulty.
> 
> The big point for me is the tax treatment at the transition into pension phase. The wiping of the Deferred Tax Liability on your 60th birthday is potentially a huge benefit if you are in a SMSF. Yet it seems your account balance in a large fund doesn’t budge one point on that day. I guess it’s all swings and round abouts based on actuary estimates and so forth – but expenses from complexity and ‘friction’ through member switching etc must all add up. (not to mention the glossy comunications, the efforts to grow members/merge and other bells and whistles...blah blah blah )
> 
> I think SMSF’s are the best thing since sliced bread and when you think about incidental benefits like we are talking about here and if you have a bent towards the long term and DIY – I suspect a SMSF becomes viable even at fairly modest balances.






Ves said:


> Craft - I trust that McLovin passed on some of the same information that he shared with me.
> 
> Completely agree - the closest alternative to these benefits (and could be a better option for those not as sophisticated) is a Wrap account that allows you to buy shares (probably limited to ASX 300) and term deposits as well as managed funds.  If you did not invest in the managed funds, I do not see why you would be at a tax disadvantage at any stage compared to someone who is using a SMSF.  All tax in a Wrap account as I understand it is levied on the individual and not pooled at all. But of course your investment options and flexibility is somewhat limited.




This thread has been enlightening. I had some knowledge about unit trusts but had never really thought about the long run tax consequences of super funds; the DTL been cleared at 60. Ves, out of curiosity, and I'm pretty at sea on all things that aren't SMSF super, but what's the running costs of a wrap account? When they were first introduced, iirc, they were primarily the domain of the HNW investors. But they seem to be for all and sundry now. I guess that's a as more and more HNW's have moved their money in to SMSF those wrap products needed to find new customers.

The only thing that worries me about super is that the government might change the tax treatment before I get to 60.


----------



## McLovin

Andrew Newman said:


> Hi McLovin
> 
> The performance charts relate to hypothetical returns, with the portfolios updated each year.
> 
> Actual client returns are also outperforming the market but don’t go back as far.
> 
> Kind Regards




Thanks Andrew, what I'm actually asking is how can you perform step 3 of your analysis retrospectively and without bias?


----------



## RandR

McLovin said:


> Thanks Andrew, what I'm actually asking is how can you perform step 3 of your analysis retrospectively and without bias?




+1.

Wording like "suppose we used" and ... "I have assumed" ...

For a professional to use ambiguous wording in relation to what has been a*admitted by him are some hypothetical returns* doesnt inspire a lot of confidence in the actual product he's selling. I wonder why it doesnt state clearly on his webpage clearly the returns shown are hypothetical in nature.

I wonder what sort of fee is charged for performing this 'market scan' and stock selection and what sort of professional qualifications andrew has to select individual stocks based upon 'detailed analysis'. I wonder if his insurance covers his clients for any losses in response to his individual stock selection. I also wonder if the returns posted on his website take into consideration any fees or costs involved with the investment he's offering. It doesnt state clearly as to wether they are 'results net of fees' or 'gross returns'.


----------



## Ves

McLovin said:


> This thread has been enlightening. I had some knowledge about unit trusts but had never really thought about the long run tax consequences of super funds; the DTL been cleared at 60. Ves, out of curiosity, and I'm pretty at sea on all things that aren't SMSF super, but what's the running costs of a wrap account? When they were first introduced, iirc, they were primarily the domain of the HNW investors. But they seem to be for all and sundry now. I guess that's a as more and more HNW's have moved their money in to SMSF those wrap products needed to find new customers.
> 
> The only thing that worries me about super is that the government might change the tax treatment before I get to 60.



I often see a lot of our clients who have financial advisers with these Wrap accounts in their SMSFs too.   When you include the adviser fees they usually have fees that range between 1-2% of the funds under management.

I believe that most of the Wrap accounts need an adviser - someone off the street just cannot access them.  So you are effectively paying two lots of commission.


----------



## McLovin

Ves said:


> I often see a lot of our clients who have financial advisers with these Wrap accounts in their SMSFs too.   When you include the adviser fees they usually have fees that range between 1-2% of the funds under management.
> 
> I believe that most of the Wrap accounts need an adviser - someone off the street just cannot access them.  So you are effectively paying two lots of commission.




Wow. So if you invest in a fund through a wrap account linked to your SMSF, you could be paying 4-5% in fees all up.


----------



## Ves

Interesting, and I didn't consciously realise this until I was reading a James Montier book, that I usually look for reasons why I wouldn't buy shares in a company, rather than for reasons why I would.  Rather than looking at this negatively, it is in a sense a built in risk management mechanism.  If a company can pass most of the outright negative elements that stop purchase - then it must be pretty solid.

Anyone else look at things in this way?  I know most people are the complete opposite.


----------



## McLovin

Ves said:


> Anyone else look at things in this way?  I know most people are the complete opposite.




Ha! All the time. Just look at my posts in the stock threads on here, I'm usually negative. Sometimes, I feel like maybe I shouldn't say anything because I just tend to be Mr Negativity.


----------



## craft

Ves said:


> Interesting, and I didn't consciously realise this until I was reading a James Montier book, that I usually look for reasons why I wouldn't buy shares in a company, rather than for reasons why I would.  Rather than looking at this negatively, it is in a sense a built in risk management mechanism.  If a company can pass most of the outright negative elements that stop purchase - then it must be pretty solid.
> 
> Anyone else look at things in this way?  I know most people are the complete opposite.




Negative / Positive – you need both to arrive at balance.

On balance, considered against market price uncovers the potential opportunities.


----------



## Ves

craft said:


> Negative / Positive – you need both to arrive at balance.
> 
> On balance, considered against market price uncovers the potential opportunities.



Yes - knowing when to strike is also important! But only after it passes rigorous standards.  I think that is what I am trying to say.


----------



## skc

Ves said:


> Interesting, and I didn't consciously realise this until I was reading a James Montier book, that I usually look for reasons why I wouldn't buy shares in a company, rather than for reasons why I would.  Rather than looking at this negatively, it is in a sense a built in risk management mechanism.  If a company can pass most of the outright negative elements that stop purchase - then it must be pretty solid.
> 
> Anyone else look at things in this way?  I know most people are the complete opposite.




It's always risk/reward. You can only determine appropriate position size by looking at downside scenario. 

If you only looking at upside then every trade would be all-in!




craft said:


> Negative / Positive – you need both to arrive at balance.
> 
> On balance, considered against market price uncovers the potential opportunities.




Good to have you back, craft.


----------



## McLovin

skc said:


> It's always risk/reward. You can only determine appropriate position size by looking at downside scenario.
> 
> If you only looking at upside then every trade would be all-in!




I think part of it stems from the fact that the overwhelming majority of businesses don't actually represent good investments. So naturally, you'll be saying no a lot more than you say yes.

I do often wonder if I'm being overly picky about some things. I guess doing it by yourself, sometimes you can magnify what's not important and miss the big picture.

Sometimes a long cycle out to La Perouse clears the head.



skc said:


> Good to have you back, craft.




Hear, hear.


----------



## Ves

skc said:


> It's always risk/reward. You can only determine appropriate position size by looking at downside scenario.
> 
> If you only looking at upside then every trade would be all-in!



Perhaps skepticism is a better description of what I mean that negativity?  Healthy skepticism!


----------



## skc

McLovin said:


> Sometimes a long cycle out to La Perouse clears the head.




From your spare Mc-mansion at Vaucluse?

I learned diving there at Bare Island. Great spot.


----------



## McLovin

skc said:


> From your spare Mc-mansion at Vaucluse?
> 
> I learned diving there at Bare Island. Great spot.




Yeah...It looks expensive, but I just got a good deal from AV Jennings. The way the market is at the moment I was able to drive a hard bargain (and park it in my 1000 car driveway.




I never knew that island was called Bare. Fact of the day!


----------



## odds-on

Ves said:


> Interesting, and I didn't consciously realise this until I was reading a James Montier book, that I usually look for reasons why I wouldn't buy shares in a company, rather than for reasons why I would.  Rather than looking at this negatively, it is in a sense a built in risk management mechanism.  If a company can pass most of the outright negative elements that stop purchase - then it must be pretty solid.
> 
> Anyone else look at things in this way?  I know most people are the complete opposite.




Ves,

I assess a business using the Altman Z Score over a period of 5 years - I think this makes me Mr Negative! I found an interesting article on the Z score and how effective it is. The article is heavy reading for my simple mind but I got the key point  - watch the trend of the Altman Z score over a period of a few years. I find this is useful when assessing an ordinary business which has a business model and balance sheet which means it is always in the "grey area". A large difference in price to value (book/tangible/NCAV) has a nice risk/reward.

Cheers

odds-on


----------



## Ves

odds-on said:


> Ves,
> 
> I assess a business using the Altman Z Score over a period of 5 years - I think this makes me Mr Negative! I found an interesting article on the Z score and how effective it is. The article is heavy reading for my simple mind but I got the key point  - watch the trend of the Altman Z score over a period of a few years. I find this is useful when assessing an ordinary business which has a business model and balance sheet which means it is always in the "grey area". A large difference in price to value (book/tangible/NCAV) has a nice risk/reward.
> 
> Cheers
> 
> odds-on



Am I correct in saying that an Altman Z Score is probably more useful in evaluating things such as Graham Net/nets?  I haven't actually made much use of it in my search for quality companies - but I would be happy to incorporate it if I could understand it's utility for assessing such companies.


----------



## odds-on

Ves said:


> Am I correct in saying that an Altman Z Score is probably more useful in evaluating things such as Graham Net/nets?  I haven't actually made much use of it in my search for quality companies - but I would be happy to incorporate it if I could understand it's utility for assessing such companies.




You are correct. I find it a useful tool for Graham Net/nets and Graham Enterprising Investor type stocks. As for your search for quality companies, the article discusses the new ZETA bankruptcy model, the studies show the importance of cumulative profitability (measured by Retained Earnings/Total Assets) and Stability of Earnings (five to ten year trend of Return on Assets - EBIT/Total Assets), it would be interesting to do a data mining exercise of all companies listed on the ASX, i reckon a if a company scores well on those two tests alone it is probably a quality company without even evaluating the business model.

Cheers

Oddson


----------



## Ves

Just finished reading:

http://www.amazon.com/The-Little-Bo...&keywords=little+book+of+behavioral+investing

*James Montier - The Little Book of Behavioral Investing: How not to be your own worst enemy *

I found it a very insightful introduction to the behavioural pyschology side of investing.  There are some good examples and question based learning to help explain the various biases and mental challenges that everyone has to face in investing (and all activities of life).

It would appear that all of the great investors seem to have processes in place to protect them from themselves!


----------



## craft

Ves said:


> Just finished reading:
> 
> http://www.amazon.com/The-Little-Bo...&keywords=little+book+of+behavioral+investing
> 
> *James Montier - The Little Book of Behavioral Investing: How not to be your own worst enemy *
> 
> I found it a very insightful introduction to the behavioural pyschology side of investing.  There are some good examples and question based learning to help explain the various biases and mental challenges that everyone has to face in investing (and all activities of life).
> 
> It would appear that all of the great investors seem to have processes in place to protect them from themselves!




Thanks for the review - the 'little book series' seems to have quite a few good reads in their line up.



> It would appear that all of the great investors seem to have processes in place to protect them from themselves!




Thats gold.


----------



## odds-on

This might be of interest...

http://www.gurufocus.com/news/201254/what-is-the-best-way-to-learn-accounting


----------



## humblelearner

Hi Oddson/all,

Sorry if this has been asked someone else before but would you mind pointing me to the article/study you referred to regarding the Z-score?

Is there a good financial data mining package that someone could recommend where you could test your own ratios/analytical strategies? (I'm curious as to what James Montier's team uses in his books for their analysis)

Thanks very much!

Cheers
humblelearner


----------



## Ves

humblelearner said:


> Hi Oddson/all,
> 
> Sorry if this has been asked someone else before but would you mind pointing me to the article/study you referred to regarding the Z-score?



I can't help you with the second part of your post - but here is an article regarding the Altman Z-score:

*http://www.gurufocus.com/news/97312...ns-podcast-13-how-do-you-find-a-stocks-zscore*


----------



## odds-on

humblelearner said:


> Hi Oddson/all,
> 
> Sorry if this has been asked someone else before but would you mind pointing me to the article/study you referred to regarding the Z-score?
> 
> Is there a good financial data mining package that someone could recommend where you could test your own ratios/analytical strategies? (I'm curious as to what James Montier's team uses in his books for their analysis)
> 
> Thanks very much!
> 
> Cheers
> humblelearner




Hi humblelearner,

Altman papers

http://people.stern.nyu.edu/ealtman/papers.html

I read - Predicting Finanical Distress of Companies: Revisiting the Z score and ZETA models.

Do not know of data mining packages that you could use for backtesting.

Cheers

Oddson


----------



## humblelearner

Thanks Ves / Oddson

A bit of light holiday reading 

Much appreciated to both of you!

humblelearner


----------



## Ves

I'm finding myself using EV / EBIT a lot more than something like P/E these days as it looks at the whole capital structure not just the equity. You often see EBITDA quoted by analysts, but I would rather remove depreciation from the equation, especially with capital intensive businesses.  EBITDA seems as if it can be used to manipulate earnings streams to make them look 'cheaper' than they actually are.

Do any of you guys have a rough system in your head for back of the envelop calculations and comparison (obviously based on your own arbitrary conditions and hurdle rates) where you equate an EV / EBIT multiple as being cheap?   For instance I have seen Buffett as quoted saying an EBIT multiple of under 7x for a fantastic company that can grow 8-10% for many years is where he looks.

It obviously varies - an EBIT of 12x for a company with no growth prospects is clearly different to one that can grow at 15% p.a on the same multiple.

Are there any rules of thumb?


----------



## craft

Ves said:


> I'm finding myself using EV / EBIT a lot more than something like P/E these days as it looks at the whole capital structure not just the equity. You often see EBITDA quoted by analysts, but I would rather remove depreciation from the equation, especially with capital intensive businesses.  EBITDA seems as if it can be used to manipulate earnings streams to make them look 'cheaper' than they actually are.
> 
> Do any of you guys have a rough system in your head for back of the envelop calculations and comparison (obviously based on your own arbitrary conditions and hurdle rates) where you equate an EV / EBIT multiple as being cheap?   For instance I have seen Buffett as quoted saying an EBIT multiple of under 7x for a fantastic company that can grow 8-10% for many years is where he looks.
> 
> It obviously varies - an EBIT of 12x for a company with no growth prospects is clearly different to one that can grow at 15% p.a on the same multiple.
> 
> Are there any rules of thumb?




For a no growth business flip your pre-tax required return.

ie if you want 15% return before tax then 1/15% gives a EV/EIBT of 6.6.

If the business is growing then you can pay a higher multiple where the return on incremental re-investments  is higher than your required return, if the return is lower than you will need to pay a lesser multiple to achieve your required return.  The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.

ps

Its understanding what happens between EBITDA and EBIT lines and how the accounts reflect or distort the economic reality that can really give you an analyse edge.


----------



## Ves

craft said:


> For a no growth business flip your pre-tax required return.
> 
> ie if you want 15% return before tax then 1/15% gives a EV/EIBT of 6.6.
> 
> If the business is growing then you can pay a higher multiple where the return on incremental re-investments  is higher than your required return, if the return is lower than you will need to pay a lesser multiple to achieve your required return.  The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.
> 
> ps
> 
> Its understanding what happens between EBITDA and EBIT lines and how the accounts reflect or distort the economic reality that can really give you an analyse edge.



Thanks craft

I knew there was some maths behind it somewhere - but I couldn't calculate it myself.  There's so much stuff on his site that it is quite intimidating.  I will need to trawl though it until I find what I am looking for.  Thanks for the starting point.  

I agree with your last line about entries between EBITDA and EBIT - I think you provided a good example for instance in the FWD thread.   There are so many problems with the "accounting reality" and what actually happens.  Estimating cash flow is a fine art. I can't say I'm any where near being good at it yet.


----------



## Ves

I believe that an example of the Aswath Damodaran content that craft mentioned can be found here:

http://pages.stern.nyu.edu/~adamodar/pdfiles/damodaran2ed/ch9.pdf

I still need to read this in detail, but I think I can see where he is going with some of the maths.  It's amazing how a lot of the valuation models can be inter-linked with the power of maths.


----------



## McLovin

On the topic of Damodaran:

Craft or anyone else, can you explain how the return on R&D is calculated on p26 of this paper? http://pages.stern.nyu.edu/~adamodar/

I'm completely missing how it is done.


----------



## craft

McLovin said:


> On the topic of Damodaran:
> 
> Craft or anyone else, can you explain how the return on R&D is calculated on p26 of this paper? http://pages.stern.nyu.edu/~adamodar/
> 
> I'm completely missing how it is done.




which paper? link doesn't seem to be to a particular paper.


----------



## McLovin

craft said:


> which paper? link doesn't seem to be to a particular paper.




Sorry it opens in the frame (who still uses frames!)...

Here's correct link.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf


----------



## craft

McLovin said:


> Sorry it opens in the frame (who still uses frames!)...
> 
> Here's correct link.
> 
> http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf




My take 

If the current years R&D wasn’t expensed it would have been capitalised and had an equivalent boost to profit. Amort of R&D is the reverse. The net is the effect on profit.

The net effect of profit recognition foregone by R&D acounting is then divided by capitalised amount of R&D to get an estimated return on R&D investment on the balance sheet.

Changes in levels of R&D spend/capitalisation/amort would affect a 1 year calculation but averaged over a few years or on consistent R&D spend it is more useful.


----------



## McLovin

craft said:


> Changes in levels of R&D spend/capitalisation/amort would affect a 1 year calculation but averaged over a few years or on consistent R&D spend it is more useful.




Thanks craft

I think this might have been the bit confusing me. If you look at a single year it will obviously be very affected by the current year's R&D spend.

So basically, you're measuring the uplift in profitability from the change in recognition and understanding that the value of the R&D spend is captured by the company over several years. I think I understand now.


----------



## Ves

craft said:


> The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.



At the more complicated end of the spectrum, say you wanted a two or three stage multiple calculation for EBIT multiples (high growth, steady, some sort of residual or no growth), aren't you basically doing a DCF?

This little exercise has shown me why WOW and CCL and some others trade at their current multiples.  The market seems to use perpetuity-like EBIT multiples and forecast GDP or GDP+1% growth (and some adjustment for risk, of course). The results are remarkably close to the current EV/EBIT for both of these if you do such a simple calculation...   however, don't be fooled it's more complicated obviously.


----------



## odds-on

Ves said:


> At the more complicated end of the spectrum, say you wanted a two or three stage multiple calculation for EBIT multiples (high growth, steady, some sort of residual or no growth), aren't you basically doing a DCF?
> 
> This little exercise has shown me why WOW and CCL and some others trade at their current multiples.  The market seems to use perpetuity-like EBIT multiples and forecast GDP or GDP+1% growth (and some adjustment for risk, of course). The results are remarkably close to the current EV/EBIT for both of these if you do such a simple calculation...   however, don't be fooled it's more complicated obviously.




Hi V,

Have you seen this? http://www.moneychimp.com/articles/valuation/graham.htm

The maths should be the same for EV/EBIT.....i hope.

Cheers

Oddson


----------



## Ves

Thanks odds-on I have come across that Graham method before.


----------



## craft

The GDP deflator (broadest measure of Inflation in the economy) for the last few quarters are interesting.

Sept 2011           0.6%
Dec 2011          -0.4%
Mar 2012          -0.9%
Jun 2012          0.4%
Sept 2012          -0.3%

That’s YOY deflation, wonder if it will have an impact on RBA decision today.


----------



## Ves

I was doing some more thinking on the EBIT vs DCF scenarios in valuation. There is obviously not any right or wrong answer - in the end they are both just vehicles from presenting assumptions that either do or do not become approximentations of the eventual reality. 

However,  I was considering the following...

I'll keep it simple.  Assume the assumptions are sound. Say, you wanted a before tax return of 12.5%.    You see Woolworths trading on an EBIT multiple of 8. Your assumption (and this is hypothetical and has nothing to do with any actual opinion formed) is that Woolworths can maintain its current profitability over the long term and you would only sell if this view changed.

Under what circumstances would you guys still do a DCF valuation? Do you always use a DCF for valuation for long-term holds? Or do you occasionally use EBIT multiples if it looks clear cut?

The advantage of a DCF valuation is that you have greater control and scope over the inputs (obviously this is a disadvantage if your inputs are way off what eventually happens in the future).  For instance,  you can modify the perpetuity component of the valuation to something more conservative, such as replacement costs of assets or a multiple of this figure.  You can modify the earnings cycle and the timing of payments.  It comes with high flexibility.

Any thoughts would be appreciated - I find the philosophy of valuation interesting to say the least.

edit:  I am away there are many more valuation models in existence, feel free to bring those into the mould too.   However,  I am not really talking from a systematic stand point, rather a stock picker's view point. I think that has a much different answer!


----------



## craft

Ves said:


> I was doing some more thinking on the EBIT vs DCF scenarios in valuation. There is obviously not any right or wrong answer - in the end they are both just vehicles from presenting assumptions that either do or do not become approximentations of the eventual reality.
> 
> However,  I was considering the following...
> 
> I'll keep it simple.  Assume the assumptions are sound. Say, you wanted a before tax return of 12.5%.    You see Woolworths trading on an EBIT multiple of 8. Your assumption (and this is hypothetical and has nothing to do with any actual opinion formed) is that Woolworths can maintain its current profitability over the long term and you would only sell if this view changed.
> 
> Under what circumstances would you guys still do a DCF valuation? Do you always use a DCF for valuation for long-term holds? Or do you occasionally use EBIT multiples if it looks clear cut?
> 
> The advantage of a DCF valuation is that you have greater control and scope over the inputs (obviously this is a disadvantage if your inputs are way off what eventually happens in the future).  For instance,  you can modify the perpetuity component of the valuation to something more conservative, such as replacement costs of assets or a multiple of this figure.  You can modify the earnings cycle and the timing of payments.  It comes with high flexibility.
> 
> Any thoughts would be appreciated - I find the philosophy of valuation interesting to say the least.
> 
> edit:  I am away there are many more valuation models in existence, feel free to bring those into the mould too.   However,  I am not really talking from a systematic stand point, rather a stock picker's view point. I think that has a much different answer!




Multiples are fine – but you need a DCF type valuation mindset initially to determine what the multiple should be if you are interested in absolute valuation.  If you are interested in relative valuation then you can make comparisons for a grounding.

With the WOW example a couple of things that would be really important to me in selecting the appropriate  multiple  would be how much capital it can utilise at its consistent profitability and what that consistent profitability is compared to my required return.

If the profitability is changing fairly consistently then picking the multiple gets a lot tricker and I would be much more likely to be doing some trickier math.

If the profitability is all over the place - I give up - too tough for me.


----------



## Ves

craft said:


> Multiples are fine – but you need a DCF type valuation mindset initially to determine what the multiple should be if you are interested in absolute valuation.



I think this (and what follows it) sums up perfectly what I was thinking! All of these models rely on you intimately know the assumptions that you are making - there is no way around that.

No matter what you do, you still have to do all of the ground work (ie. hard work).


----------



## Ves

Question about ROIC.   Generally I take out goodwill (and most other intangibles from this equation - and adjust the EBIT for them if need be) from these calculations.

However, a lot of people businesses are not truly scalable. Advertising / marketing firms, compliance firms, some IT firms etc are good examples.  Organic growth is limited so you often find that they have large amounts of goodwill on the balance sheet and in most cases this will continue to grow.

SAI and SGN have been good examples of this over the last decade.   Excess capital and / or debt is generally used to fund acquisitions that will hopefully grow earnings.  Say ROIC was 25%   (EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities (creditors etc.)). This is not uncommon I have found.    However, if you leave historic Goodwill in this equation the result is closer to the cost of capital, somewhere around 8-12%.

To me it makes more sense that capital employed going forward in businesses with limited organic growth potential, that grow via acquisition, will achieve returns closer the 8-12% on any invested free cash flow.  Interesting to point out that a lot of acquisitions are made at EBIT multiples of 5-8 times.

_Implied growth  with ROIC 25% and 25% retained earnings is 6.25%.
Implied growth  with ROIC 10% and 25% retained earnings is 2.5%._

Certainly makes a big difference on a long-range DCF calculation!

What are other's thoughts?


----------



## craft

Ves said:


> Question about ROIC.   Generally I take out goodwill (and most other intangibles from this equation - and adjust the EBIT for them if need be) from these calculations.
> 
> However, a lot of people businesses are not truly scalable. Advertising / marketing firms, compliance firms, some IT firms etc are good examples.  Organic growth is limited so you often find that they have large amounts of goodwill on the balance sheet and in most cases this will continue to grow.
> 
> SAI and SGN have been good examples of this over the last decade.   Excess capital and / or debt is generally used to fund acquisitions that will hopefully grow earnings.  Say ROIC was 25%   (EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities (creditors etc.)). This is not uncommon I have found.    However, if you leave historic Goodwill in this equation the result is closer to the cost of capital, somewhere around 8-12%.
> 
> To me it makes more sense that capital employed going forward in businesses with limited organic growth potential, that grow via acquisition, will achieve returns closer the 8-12% on any invested free cash flow.  Interesting to point out that a lot of acquisitions are made at EBIT multiples of 5-8 times.
> 
> _Implied growth  with ROIC 25% and 25% retained earnings is 6.25%.
> Implied growth  with ROIC 10% and 25% retained earnings is 2.5%._
> 
> Certainly makes a big difference on a long-range DCF calculation!
> 
> What are other's thoughts?




PM sent.


----------



## McLovin

Ves said:


> What are other's thoughts?




I'm pretty simple with these sort of things and just leave the goodwill in. The way I see it, it's where the growth comes from. I guess the way I see it is goodwill on the balance sheet represents historic decisions but if the business plan is to grow through acquisition then the goodwill associated with those acquisitions should be included when measuring performance.

I actually think you could probably amortise goodwill associated with these sort of "people businesses". In many of the companies being acquired there is real key man risk and any moat is around a few individuals (usually the founders) rather than the company.


----------



## Ves

McLovin said:


> I'm pretty simple with these sort of things and just leave the goodwill in. The way I see it, it's where the growth comes from. I guess the way I see it is goodwill on the balance sheet represents historic decisions but if the business plan is to grow through acquisition then the goodwill associated with those acquisitions should be included when measuring performance.
> 
> I actually think you could probably amortise goodwill associated with these sort of "people businesses". In many of the companies being acquired there is real key man risk and any moat is around a few individuals (usually the founders) rather than the company.



Thanks McLovin -  I think it is a case of organic cashflow growth within a _franchise_ which has the potential for excessive returns of ROIC vs acquisitions for the sake of "profit growth" (which are either dilutive or value neutral) and should not be treated in in a DCF calculation as achieving anything but growth at a rate equal to the firm's cost of capital going forward.

In essence it becomes a question of whether the company and any of the businesses it has been acquiring are truly _scalable_ beyond the initial cashflow stream of their acquisition.   I think there is a big difference in the cashflow profile going forward of something like RFG and the two I mentioned SAI and SGN (at least as far as the historic trend evidence to this point in time would indicate).

Craft - I replied to your PM.


----------



## McLovin

Ves said:


> Thanks McLovin -  I think it is a case of organic cashflow growth within a _franchise_ which has the potential for excessive returns of ROIC vs acquisitions for the sake of "profit growth" (which are either dilutive or value neutral) and should not be treated in in a DCF calculation as achieving anything but growth at a rate equal to the firm's cost of capital going forward.
> 
> In essence it becomes a question of whether the company and any of the businesses it has been acquiring are truly _scalable_ beyond the initial cashflow stream of their acquisition.   I think there is a big difference in the cashflow profile going forward of something like RFG and the two I mentioned SAI and SGN (at least as far as the historic trend evidence to this point in time would indicate).
> 
> Craft - I replied to your PM.




I think we agree. On first glance SGN can look pretty good, but the nuts and bolts of it are fairly poor. I guess they might benefit from any cyclical upswing in advertising. I compared SGN to Interpublic, Lamar and Omnicom and found that those three also had the same strategy of buying growth. I think this probably comes down to the fact that if you're a good copywriter/PR person/marketing strategist you can earn a hell of a lot more working for yourself and the startup costs are minimal (computer and a desk, working from home), so the industry ends up very fractured. That's the reason I said you could make the argument for amortising the goodwill, because sooner or later the brains behind the business will probably up and leave and start again.

The scalability issue you bring up is a great point. My own perspective is that these "creative" industries are much, much harder to scale than people businesses that work from a documented process/system. So it is easier to scale a management consulting business where a few consultants use a tried and tested method versus an ad company where it's significantly hard to teach someone to come up with a jingle that will increase the sales of those scented things you stick in your toilet.


----------



## craft

Ves said:


> Question about ROIC.   Generally I take out goodwill (and most other intangibles from this equation - and adjust the EBIT for them if need be) from these calculations.
> 
> However, a lot of people businesses are not truly scalable. Advertising / marketing firms, compliance firms, some IT firms etc are good examples.  Organic growth is limited so you often find that they have large amounts of goodwill on the balance sheet and in most cases this will continue to grow.
> 
> SAI and SGN have been good examples of this over the last decade.   Excess capital and / or debt is generally used to fund acquisitions that will hopefully grow earnings.  Say ROIC was 25%   (EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities (creditors etc.)). This is not uncommon I have found.    However, if you leave historic Goodwill in this equation the result is closer to the cost of capital, somewhere around 8-12%.
> 
> To me it makes more sense that capital employed going forward in businesses with limited organic growth potential, that grow via acquisition, will achieve returns closer the 8-12% on any invested free cash flow.  Interesting to point out that a lot of acquisitions are made at EBIT multiples of 5-8 times.
> 
> _Implied growth  with ROIC 25% and 25% retained earnings is 6.25%.
> Implied growth  with ROIC 10% and 25% retained earnings is 2.5%._
> 
> Certainly makes a big difference on a long-range DCF calculation!
> 
> What are other's thoughts?




Using  SAI as an example.

For simplicity I’m making the assumption that depreciation approximates economic reality to come up with a free cash flow of 239 Million over the last 9 years.

In that last 9 years they have invested 524 Million – so first thing to do is throw out implied type growth calculation (unless of course you are going to sell valuation software based on it)

Of that 524 Million, 96 Million was invested at the level above Invested capital –ex good. 

The remaining 428 million was goodwill.

Funding was 213 million net debt, 239 million cash flow and 72 Million net additional equity (capital raising minus dividends)

For 2011 ROIC (ex goodwill ) was 64% ROE was 12.5% and ROA was 7.14%

This is the historical perspective of what you need to know to do a valuation

Now History is all well and good. It does show what precedents have been set if the management hasn’t changed – but it in no way dictates the future.

You need to make assumptions about the future – will it replicate the past?  Is their ROIC protected by a competitive advantage or will it decay under competitive forces. Will they stop acquiring new enterprises and instead only invest in the higher return but smaller pool of organic growth and pay down debt and/or make net distributions to equity holders?  Has the previous enterprise purchases increased the future organic growth opportunities. You need these assumptions about the future before you can allocate growth to the different return rates that apply to different ways of utilising discretionary cash flows.


----------



## Ves

Hi craft - thanks for all the effort you put into the calcs.  I calculated between 50-60% ROIC for SAI (without bothering to go into it in any depth) - which isn't too far off what you have come up.  



craft said:


> You need to make assumptions about the future – will it replicate the past?  Is their ROIC protected by a competitive advantage or will it decay under competitive forces. Will they stop acquiring new enterprises and instead only invest in the higher return but smaller pool of organic growth and pay down debt and/or make net distributions to equity holders?  Has the previous enterprise purchases increased the future organic growth opportunities. You need these assumptions about the future before you can allocate growth to the different return rates that apply to different ways of utilising discretionary cash flows.



This is gold - I tried to say something similar, but I lack some of the necessary understanding to successfully convey it into such fine words at this point! 

The implied growth at SAI's current cash flow retention rate of about 20% demonstrates the importance of the quoted text:

Implied growth with ROIC 60% and 20% retained earnings is 12%. 
Implied growth with ROIC 10% and 20% retained earnings is 2%.

Without detracting from the theoretical discussion too much:

Current EV is about 1 billlion  ($750 MC + $250 Debt).    It will generating around $70-80 mil EBIT in 2013.  Which is an EBIT multiple of about 13.   In my opinion, you would need to demonstrate that it can achieve close to historical returns on invested cashflow to justify such a multiple.


----------



## craft

Ves said:


> Hi craft - thanks for all the effort you put into the calcs.  I calculated between 50-60% ROIC for SAI (without bothering to go into it in any depth) - which isn't too far off what you have come up.




Hmmm -not much effort - just ripped the info off data supplier and didn't take much care either, I picked up the NOPLAT return (ignores interest and amortisation) to get 64%. The FCF return is more like 42% for 2011.




Ves said:


> Implied growth with ROIC 60% and 20% retained earnings is 12%.
> Implied growth with ROIC 10% and 20% retained earnings is 2%.




Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.


----------



## odds-on

Hi Craft and V,

The following links might be of interest.

http://aswathdamodaran.blogspot.co.nz/2012/05/how-much-are-you-paying-for-growth.html

http://aswathdamodaran.blogspot.co.nz/2012/05/how-much-is-growth-worth.html

…..plus there is a downloadable spreadsheet! 

Cheers


----------



## Ves

craft said:


> Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.



Are you talking about the calculation of the retention rate?  And yes,  I agree financial leverage that doesn't cost a cent is always desirable if it is backed by sustainable cashflow.

PS:   Thanks for clarifying how you arrived at 64% by the way - I was wondering what you had added back.


----------



## Ves

I think I can see what you are referring to craft - businesses that can afford to payout a very high proportion of their earnings because they source funding for new investment from constantly expanding negative working capital balances.

Wouldn't you pick this up though if you used Retention ratio as function of earnings / cashflow  _less_ maintenance capex and change in working capital funding  (obviously this is added back if negative)?


----------



## craft

Ves said:


> I think I can see what you are referring to craft - businesses that can afford to payout a very high proportion of their earnings because they source funding for new investment from constantly expanding negative working capital balances.
> 
> Wouldn't you pick this up though if you used Retention ratio as function of earnings / cashflow  _less_ maintenance capex and change in working capital funding  (obviously this is added back if negative)?




I’m easily bamboozled – you might need to spell out what you are saying with an example.

I’m trying to say that your implied growth rate calculation will lead to an incorrect assumption for companies like NVT which can pay out all Discretionary Cash Flow and still fund growth. 

Your formula would say ROIC  xx%  multiplied by 0% retained = zero growth.


----------



## Ves

craft said:


> I’m trying to say that your implied growth rate calculation will lead to an incorrect assumption for companies like NVT which can pay out all Discretionary Cash Flow and still fund growth.
> 
> Your formula would say ROIC  xx%  multiplied by 0% retained = zero growth.



I agreeing with you - but also saying that the "retention ratio" of these businesses needs to be modified - if a business such as NVT receives income in advance of earning it and can use this to fund growth - then their cashflow profile is telling me that there is some retention occuring, regardless of whether the earnings show it.

I'm sure Damodaran has a formula to calculate this somewhere.  It involves adjusting earnings for maintenance capex and working capital.

If a firm has negative working capital then their real earnings would increase over what is actually reported - so the payout ratio is less than 100% and the retention ratio is more than 0%.


----------



## craft

Ves said:


> I agreeing with you - but also saying that the "retention ratio" of these businesses needs to be modified - if a business such as NVT receives income in advance of earning it and can use this to fund growth - then their cashflow profile is telling me that there is some retention occuring, regardless of whether the earnings show it.
> 
> I'm sure Damodaran has a formula to calculate this somewhere.  It involves adjusting earnings for maintenance capex and working capital.
> 
> If a firm has negative working capital then their real earnings would increase over what is actually reported - so the payout ratio is less than 100% and the retention ratio is more than 0%.




I think we are on the same page.

There is no retention of _*earned*_ income and no retention of _*equity*_. 

However, on a _*cash*_ basis there is retention – the balance sheet expandeds with other peoples interest free money. 


Are we on the same page?


----------



## Ves

craft said:


> I think we are on the same page.
> 
> There is no retention of _*earned*_ income and no retention of _*equity*_.
> 
> However, on a _*cash*_ basis there is retention – the balance sheet expandeds with other peoples interest free money.
> 
> 
> Are we on the same page?




Correct.  If I have $100 of earnings, but I also received a further $20 in unearned income I have $120 real earnings if the assumption can be proven that my business model allows me to maintain this relationship between accounting earnings and real cashflow going forward. NVT is a really good example (so far).

Of course the reverse is also true.  Accounting earnings can be over-stated in businesses with strenuous working capital requirements and / or via under-stated depreciation.   Some businesses make an accounting profit year in year out, but any actual _economic profit_ is questionable. Airlines are often a good example.

$100 paid out divided by $120 real earnings is 83.333% payout. If ROIC is 40% then implied growth is 6.7% p.a.  The equity line hides this as you alluded to above.

Unfortunately this is much harder to work out in practice.


----------



## craft

Ves said:


> $100 paid out divided by $120 real earnings is 83.333% payout. If ROIC is 40% then implied growth is 6.7% p.a.  The equity line hides this as you alluded to above.




V

A question for you

What is NVT’s ROIC (ex goodwill)?

In case 'other acquired intangible assets' cloud the picture – What was NVT’s ROIC in any of the years prior to 2011?


----------



## Ves

craft said:


> What is NVT’s ROIC (ex goodwill)?



This one has always puzzled me - so I know why you ask.   The company presentations say 60% for 2010.   It isn't explicity stated any where, but I believe that this is in after-tax terms.

My personal calculation is higher as I use EBIT.  With some adjustments for amortisation and other minor items I get a ROIC of 85% for 2010.   Cash flow is lower than EBIT in 2010, but I believe that this was due to timing differences in the debtors uplift (the current assets look a little bloated on 30 June 2010). So potentially ROIC may be higher.

Now for the interesting part - this figure also does not offset the unearned income in the liabilities section.  If you substract this from the net assets employed the end result is that they have negative assets employed.  They are effectively borrowing assets off others interest-free and using them to generate very high rates of return.

I don't know of any other businesses like this.


----------



## craft

Ves said:


> Now for the interesting part - this figure also does not offset the unearned income in the liabilities section.  If you substract this from the net assets employed the end result is that they have negative assets employed.  They are effectively borrowing assets off others interest-free and using them to generate very high rates of return.





That’s the point. Any return on negative operational invested capital gives a negative ROIC.  How do you apply the implied growth formula to a negative ROIC?

Thats why I said



> Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.





ps 
Don't get me started with my full list of peeves about the calculation and how it is used and abused.


----------



## Ves

craft said:


> That’s the point. Any return on negative operational invested capital gives a negative ROIC.  How do you apply the implied growth formula to a negative ROIC?
> 
> Thats why I said
> 
> 
> 
> 
> ps
> Don't get me started with my full list of peeves about the calculation and how it is used and abused.



Point taken.  What metrics do you model for NVT then?   Revenue growth and margins as a product of student growth?

And please do list peeves.   It's a good way for others to learn.


----------



## Ves

craft said:


> I prefer to discount only the cash flow horizon I can have some certainty about and then calculate a terminal value based on the replacement cost of tangible assets and *possible some multiple* of that if the business has a true sustainable competitive advantage.



Sorry for grave-digging old posts, but would it be possible for you to elaborate on how you arrive at the multiple of tangible assets for perpetuity calculations that have a sustainable competitive advantage?

Is there a mathematical method involved? My thoughts are that the multiple must be higher when the business has higher ROIC compared to lower ROIC.


----------



## craft

Ves said:


> Sorry for grave-digging old posts, but would it be possible for you to elaborate on how you arrive at the multiple of tangible assets for perpetuity calculations that have a sustainable competitive advantage?
> 
> Is there a mathematical method involved? My thoughts are that the multiple must be higher when the business has higher ROIC compared to lower ROIC.




I consider the excess return [investment return – cost of capital] 
The amount of capital that can be invested at the excess return rates 
And how sustainable is the competitive advantage to maintain the excess return over time.

I then use my much beloved SWAG method to determine the multiple.

The maths is so sensitive to the variables that any precision is illusionary; nonetheless my guesses are grounded on the math.
As per usual my favourite source for valuation maths is Aswath Damodaran.


----------



## Ves

craft said:


> I consider the excess return [investment return – cost of capital]
> The amount of capital that can be invested at the excess return rates
> And how sustainable is the competitive advantage to maintain the excess return over time.
> 
> I then use my much beloved SWAG method to determine the multiple.
> 
> The maths is so sensitive to the variables that any precision is illusionary; nonetheless my guesses are grounded on the math.
> As per usual my favourite source for valuation maths is Aswath Damodaran.



Thanks I will have to start reading through his site some more - there is so much stuff on it that I can imagine one could use a lot of different methods to combine and shape their own principles and rules  (granted that they pass logic of course!).

edit:  your post shows me that I am at least somewhere in the ballpark, just need to start looking for the home plate now.


----------



## craft

Ves said:


> edit:  your post shows me that I am at least somewhere in the ballpark, just need to start looking for the home plate now.




V 

You will be knocking it out of the ball park one day, I have no doubt.


ps.




Time for a break

Cheers


----------



## Ves

Thanks mate - seeya soon!


----------



## chops_a_must

Really good thread guys.

I'm curious to know with whatever fundamental, value, cash flow method you use, how do you come to a price you are willing to buy at?

Are you able to give an example?

It just seems like a lot of analysis without reaching a final figure.

Cheers.


----------



## Ves

chops_a_must said:


> I'm curious to know with whatever fundamental, value, cash flow method you use, how do you come to a price you are willing to buy at?



I use a discounted cash flow model.  Like any valuation model it is only as good as the assumptions that you put in!  The model itself is simple.  Enter cashflows for each half year / year of your forecast range, pick a discount rate and discount all of the cashflows back to year zero (ie the present).  Then as we were discussing above you need to come up with a value for the cashflows outside of the forecast period or you at least a proxy for the net value of the assets of the company.

A model may look like:

http://www.stern.nyu.edu/~adamodar/pc/eqegs/Brahma.xls

This is from Aswath Damodaran.



> Are you able to give an example?



I'm afraid I wouldn't post my own as a) it would be useless to anyone who had not made the assumptions within (ie. probably everyone but me!) and  b) I don't want people relying on the figures. 



> It just seems like a lot of analysis without reaching a final figure.



It find it an enjoying challenge - most companies I look at I will never value.  The DCF model is the very last input, if I cannot find anything to get too excited about (which is the vast majority) then I move on in peace. Perhaps make a note for future review.

I usually only spend an hour (or two max) per night on research, so it's not too strenuous.


----------



## chops_a_must

Ves said:


> I use a discounted cash flow model.  Like any valuation model it is only as good as the assumptions that you put in!  The model itself is simple.  Enter cashflows for each half year / year of your forecast range, pick a discount rate and discount all of the cashflows back to year zero (ie the present).  Then as we were discussing above you need to come up with a value for the cashflows outside of the forecast period or you at least a proxy for the net value of the assets of the company.
> 
> A model may look like:
> 
> http://www.stern.nyu.edu/~adamodar/pc/eqegs/Brahma.xls
> 
> This is from Aswath Damodaran.
> 
> 
> I'm afraid I wouldn't post my own as a) it would be useless to anyone who had not made the assumptions within (ie. probably everyone but me!) and  b) I don't want people relying on the figures.
> 
> 
> It find it an enjoying challenge - most companies I look at I will never value.  The DCF model is the very last input, if I cannot find anything to get too excited about (which is the vast majority) then I move on in peace. Perhaps make a note for future review.
> 
> I usually only spend an hour (or two max) per night on research, so it's not too strenuous.




Very good.

That's what I was after - a spreadsheet that I could use or make myself with some inputs.

Probably a good starting point for me to learn, and find out more about what those inputs are.

Is there a preferred method for growth stocks? As I know that's what I have a bias towards, in my trading.


----------



## Ves

chops_a_must said:


> Is there a preferred method for growth stocks? As I know that's what I have a bias towards, in my trading.



Aswath Damodaran has some good papers on his site.  He covers all bases.  Just beware it isn't highly organised (well I don't think it is) but if you want to start from scratch it's a good free source.

He also has a book called "Little Book of Valuation" which covers the basics of this and other models / methods.  I picked it up for about $20 in store.  Probably cheaper online!

The best way to think of a model is merely a way of expressing the cash flows - there may be a growth period in the initial years, then a maturing period, then stable growth.... or the whole business could be very cyclical.  Learn the maths (or how to program MS Excel) and you can build your own easily.  The NPV function in Excel is great.


----------



## chops_a_must

Ves said:


> Aswath Damodaran has some good papers on his site.  He covers all bases.  Just beware it isn't highly organised (well I don't think it is) but if you want to start from scratch it's a good free source.
> 
> He also has a book called "Little Book of Valuation" which covers the basics of this and other models / methods.  I picked it up for about $20 in store.  Probably cheaper online!
> 
> The best way to think of a model is merely a way of expressing the cash flows - there may be a growth period in the initial years, then a maturing period, then stable growth.... or the whole business could be very cyclical.  Learn the maths (or how to program MS Excel) and you can build your own easily.  The NPV function in Excel is great.




Thanks.

I'm handy with excel so looking for the maths and parameters to be able to get to what I want.

I find too much on the topic tells me about cash flow and earnings and all the rest, but never actually tells me about what that should mean for price.


----------



## craft

craft said:


> Here’s an Ironic post for a stock forum.
> 
> *The best way to think about investments is to be in a room with no one else and just think.*
> 
> 
> http://www.youtube.com/watch?v=aL766NK2ynw
> 
> 
> I think he’s trying to tell me something.





The first couple of minutes of that video have been my major lesson for the year. 

I developed my approach in relative isolation and it works best when I do lots of specific company research that result in few but important actions. To avoid overstimulation and the urge to DO more then I really should under my approach I have dialled the noise back and almost instantly refound the clarity and perspective that had slowly and silently slipped away as I indulged in other peoples thinking on forums.

So indulgence over again for this visit - Back under my rock again.

Happy Investing – catch you infrequently.


----------



## craft

Anybody been watching the Aus Bond Yields in the last few days?

We may like a lower $ but as a net importer of capital we can’t afford it at the expense of too high a bond yields.  Limiting factor for RBA in cutting rates to address domestic situation.


----------



## craft

skc said:


> The market got complacent at $18 which really was perfect-sunshine-forever valuation.





Easy in hindsight to say when the end will occur.

MMS has been pretty fully priced on and off for quite a while. But the price largely run in line with the underlying business results and without knowing a certain end date for novated leasing (which seemed de-risked with the implementation of the Henry recommendations) the overpricing never really amounted to enough to compensate for tax and give a MOS on the sell decision. (note: some were sold purely on max position size rules) 

Nothing is easy with this business now. The earnings stream potential is more variable as if FBT for cars doesn’t end the competition will be less and the margins fatter / the earnings down side remains the same (Bad but not out of business by any means) although time will help mitigate to some degree. The big unknown is that sentiment and hence earnings multiple is now in play.

A spooked market trying to find a suitable earnings multiple on an earnings stream that has a higher variability and visibility of probabilities.  *Yep things have changed*. But getting out to avoid this scenario was not a clear-cut decision prior to the announcement.  

Trade management to avoid this situation would have either seen you not enter or out at $4, $6, $8.... I don’t know exactly where but not perfectly at $18 or even well at $12, $14 or $16. Is complacency just a hindsight charge or is there more to it? 

I’ve reflected on this investment and am happy with the entry decision, position sizing and the trade management, however I’m a bit close for an unbiased POV so would be pleased to see you extend the complacency argument for MMS. If the charge of complacency is valid this is the damage I have needlessly incurred.  – The equity curve for the super account where this investment sits.  (the trading to mitigate is in another account) July drawdown basically = MMS.




Unavoidable in the larger picture I accept – Complacency, I can’t afford, so don’t hold back why was holding complacent ‘in real time’?


----------



## skc

Craft, 

I think there are two parts to your answer.



craft said:


> MMS has been pretty fully priced on and off for quite a while. But the price largely run in line with the underlying business results and without knowing a certain end date for novated leasing (which seemed de-risked with the implementation of the Henry recommendations) the overpricing never really amounted to enough to compensate for tax and give a MOS on the sell decision. (note: some were sold purely on max position size rules)




1. While I agree that post-Henry tax review one would quite reasonably assume MMS will be business as usual for a while (3-5 years?), the tail risk was still real. Yes the PE multiple was a function of the earnings growth, but market neglected the risk in the earning growth itself. I don't really know how to price the tail risk, but the way MMS was priced, the tail risk was probably priced close to zero. It is a known unknown so definitely knowable in real time - and you know that based on our exchanges on the MMS thread around Dec 12. This was Citi's analyst report on 1 July 



> There has, at times, been a disconnect between growth in revenue and EBIT, and stock price performance, with the primary reason for this being regulation. Given the risk of regulatory change is real and material, the MMS stock price is volatile when the issue of regulatory change arises. *UItimately, differentiation must be made between actual and perceived risk. We agree that perceived risk is very high, however our view is that actual risk is often materially overstated. *As time passes and the likelihood of certain perceived risks materializing into actual risks minimizes, the stock frequently re-rates or at worst, returns to its previous levels.




To me they forgot that the tail risk in MMS case exists in perpetuity, so there's an element of it that should never be discounted.



craft said:


> I’ve reflected on this investment and am happy with the entry decision, position sizing and the trade management, however I’m a bit close for an unbiased POV so would be pleased to see you extend the complacency argument for MMS. If the charge of complacency is valid this is the damage I have needlessly incurred.  – The equity curve for the super account where this investment sits.  (the trading to mitigate is in another account) July drawdown basically = MMS.




2. Complacency by the market in pricing MMS on a standalone basis does not necessarily mean you were complacent when it comes to holding MMS. You may be well aware of the risk, and choose to hold for the right reason. MMS is only a part of your portfolio and you have your own rules about buying/selling/sizing etc which you followed. Perhaps there could be improvements such as extra MOS on entry, reduced MOS on sell decision, limit position size or portfolio exposure etc, on positions subjected to known tail risks. These are some potential passive risk management options.

There's one thing that is most interesting with MMS. I can't remember at what time Rudd released the proposed FBT changes, but MMS traded until 11:01am before announcing a trading halt, with the share price having fallen ~15%. If a holder had kept the tail risk consideration in their mind, they would have envisioned the scenarios when such tail risk eventuates (it would be from sources external to the company), and they could have set up additional safeguards for this type of investment. Eg. real time news alert, excessive price move alert etc. The safeguards may or may not work everytime (MMS could have gone into the trading halt before open), but they should be in place nonetheless. This would be a more pro-active risk management approach.

So were you complacent in real time? The question is simply... did you mis-price the risk, or did you NOT price the risk. I don't have the answer... and I defenitely didn't do any better. 



skc said:


> I sold these back at ~$6 so I am not very good at pricing that risk (or the market is wrong)...


----------



## craft

Thanks SKC

I appreciate having your considered view to contemplate.


----------



## Ves

craft said:


> The companies I hold or are really interested in, I model their financial reports and project them forward based on my assumptions.  Those assumptions and how well I can make them is where earnings risk comes into play. My valuation is simply to run an IRR on the bottom line to determine the projected yield. The yield is determined without the sale of the asset, but a terminal valuation is included at the end of the cash flow projections, that terminal value is normally the replacement value of the physical assets unless I am absolutely convinced the company has a *sustainable* competitive advantage, in which case It will be some sort of multiple of replacement asset value.



Bumping this old post. Apologies for the grave-digging.

Perpetuity calculations are still giving me doubts for most of the reasons you have outlined in this thread.  

Statistics say that most companies arguably will not be around in 20 or 50 years and if they do make it that far it is unlikely that their competitive advantage will last that long.  Sustainable competitive advantage is very rare universally it would appear from the history books. In other words; librarians may not be rich, but they still have interesting things to say!

It is probably with my own laziness / having other priorities / lack of knowledge / insert other excuses here that I have no tried to approach the problem from a different angle until now.  The art is there and seems to function to an extent; but in my opinion it needs refining. 

So how else to approach this problem?

My reading efforts and my own thoughts, and a quick read through this thread and a couple of others offer a few solutions.   Generally in the form of an equity multiple  (which is relative to the market - possibly undesirable in itself) or a figure based on the replacement / entry costs of a new entrant / competitor to replicate the firm's assets and business model.

Greenwald discusses the concept of replacement value of assets + adjustments for entry costs  (marketing, sales knowledge, R & D and other things that make up the raft of intangible assets that centre around terms like "brand" and "intellectual property.")   It is a good starting point.  

A few quick questions whilst they are fresh on my mind, if I can?

When completing a DCF do you add the replacement cost of assets at their net present value  (since I assume they are based on current values from the most recent financials plus or minus the adjustments that you choose to make) or do you discount them from the period immediately following your last cash flow projection?

I read a bit of Damodaran occasionally too (at your kind recommendation!) - but no where have I found the concept of using a multiple for the replacement asset value.   I am guessing that you developed this in isolation yourself and refine it through experience and knowledge of other concepts that you have come across.  It makes sense as a concept;  but like any valuation the data input would be arbitrary in nature and I imagine the multiple used could dictate have a big effect on the terminal value.  Would like your comments on this, even if it is only a very, very gentle push in the right direction.


----------



## craft

I lost my reply to your post below with some error 520 (and it still wont let me reply to it) . - It was a very similar answer to my response to your PM - did that sort this one out a bit for you as well? If not I'll type up again tomorrow.

Cheers


----------



## Ves

craft said:


> I lost my reply to your post below with some error 520 (and it still wont let me reply to it) . - It was a very similar answer to my response to your PM - did that sort this one out a bit for you as well? If not I'll type up again tomorrow.
> 
> Cheers



Thank you for the explanation via PM - it does give me a starting point for my questions here and a bit of the reasoning that goes in behind it.

Part of the problem may be that I am making this more complicated in my own mind than it actually is - the simplicity will no doubt come out when the penny drops.  

It would appear that those three chapters on enterprise valuation in Greenwald are a lot closer to what I am looking at doing than I would have thought before skimming over them again last night.  Looks like you have put your own twist on them, but kept the basic framework and principles?


----------



## craft

Some more reflection on MMS investment.

MMS re-acquainted me with scalability issues in absolute dollar terms. Relevance, percentage thinking etc etc all fine until your bloody brain starts involuntarily obsessing on  volatility calculated in terms of  X number of years of average wages;  donation;  cars;  houses;  planes;  boats;  holidays whatever your measurement unit of meaningfulness may be. 

Final wash up I am only going to make 1 change to my approach which led MMS to appear and stay in my portfolio and that is to adjust maximum portfolio exposure for known tail risk.  Long term I expect this to be a compromise in total returns (just as any arbitrary capping of winners is likely to do)  but at this stage I’m willing to pay for a bit of emotional comfort and facilitate a more relaxed position from which to monitor developments. 

Always learning.


----------



## skc

craft said:


> Some more reflection on MMS investment.
> 
> MMS re-acquainted me with scalability issues in absolute dollar terms. Relevance, percentage thinking etc etc all fine until your bloody brain starts involuntarily obsessing on  volatility calculated in terms of  X number of years of average wages;  donation;  cars;  houses;  planes;  boats;  holidays whatever your measurement unit of meaningfulness may be.




I don't know how you can divorce that when you are talking about your own capital... afterall that's why you accumulate capital and build wealth... so you can turn it into donations, cars, houses,  planes,  boats,  holidays whatever.  

To feel is only normal... to be able to act rationally despite the feeling is what you achieved and that's all you could have asked for imo.



craft said:


> Final wash up I am only going to make 1 change to my approach which led MMS to appear and stay in my portfolio and that is to adjust maximum portfolio exposure for known tail risk.  *Long term I expect this to be a compromise in total returns* (just as any arbitrary capping of winners is likely to do)  but at this stage I’m willing to pay for a bit of emotional comfort and facilitate a more relaxed position from which to monitor developments.




It's only a compromise in return for that particular stock. If you deploy the released capital with the same efficiency then on average you are no worse off. You'd only be worse off if you believe, for some reason, that the average return for stocks with tail risks are greater than the return of all other stocks in your investment universe.


----------



## Ves

craft said:


> Some more reflection on MMS investment.



I don't know about you - but this is probably the worst "psychological" stock in my portfolio at the moment.

Every where you go that some relation to stocks, people, whether they are analysts or small investors or speculators, are talking about it.  Lots of noise,  and _will to action_.  Something always has to be done,  some small angle needs to be discussed like it is the most important thing in the world.  It is not that I don't agree with some of the discussion or have the ability to separate it from my own thinking patterns.... but the fact that it is there,  starts my own internal dialogue...  and promotes some kind of mental activity, whether it be active thought or an effort to move on for now.    Silence is a wonderful thing sometimes,  and very beneficial.  Doing nothing,  not even thinking,  until you need to again, should be cherished more often that it is.

Buffett's idea of only visiting Wall Street once a year resonates highly with me at times like these.   Clearer,  precise thinking, free of everyone else's emotions, plans, angles, yada yada.  The dark room sounds good to me at the moment.


----------



## McLovin

Ves said:


> Buffett's idea of only visiting Wall Street once a year resonates highly with me at times like these.   Clearer,  precise thinking, free of everyone else's emotions, plans, angles, yada yada.  The dark room sounds good to me at the moment.




I've made a conscious effort as part of my New Financial Year's resolution to try and reduce the amount of crowd sourced opinions I listen to. I've found that in the past even when my thinking may be correct, having a roomful of other opinions will wash out my own. To be honest, I've found it liberating. I can see things with much more clarity or at least the things I think are important. Now if only I could get myself a nice villa on the beach in the Carribbean to "think".


----------



## craft

McLovin said:


> I've made a conscious effort as part of my New Financial Year's resolution to try and reduce the amount of crowd sourced opinions I listen to.




I make the same vows i.e. stay clear of this forum.

I think I have even posted on here before the Buffett quote that resonates with me the most..



> The best way to think about investments is to be in a room with no one else and just think.




Problem Is I keep ignoring it because the likes of you three above/below keep posting insightful things to spark the mind and I keep coming back for a fix and then read a little bit more then post...... 

Oh for some balance....or is it discipline?

Try again.


----------



## Ves

McLovin said:


> I've made a conscious effort as part of my New Financial Year's resolution to try and reduce the amount of crowd sourced opinions I listen to. I've found that in the past even when my thinking may be correct, having a roomful of other opinions will wash out my own. To be honest, I've found it liberating. I can see things with much more clarity or at least the things I think are important. Now if only I could get myself a nice villa on the beach in the Carribbean to "think".



Starting to become less and less reliant on other's opinions myself too.  At least in saying that I mean it is easier to know when my own thinking is being influenced / persuaded by others.   Said in another way - it would be much easier to "go missing into a dark room" and not feel too uncomfortable compared to a year ago.

I think the biggest problem for me, as I probably poorly explained in my first post, is the buzz of activity that reading / participating in discussion can bring on.   With a lot of things in life - and the riddle of the media in particular - is that they only are perceived to become more important when there is more noise!

- - - Updated - - -




craft said:


> I make the same vows i.e. stay clear of this forum.
> 
> I think I have even posted on here before the Buffett quote that resonates with me the most..
> 
> 
> 
> Problem Is I keep ignoring it because the likes of you three above/below keep posting insightful things to spark the mind and I keep coming back for a fix and then read a little bit more then post......
> 
> Oh for some balance....or is it discipline?
> 
> Try again.



Sounds familiar.   Doesn't look like I'm the only one. The feeling of missing something!


----------



## odds-on

Hi V,

I found this book particularly helpful in improving my thought process when dealing with the "noise"-  http://www.amazon.com/The-Contrary-Thinking-Humphrey-Neill/dp/087004110X

Hope it helps.

Cheers


----------



## odds-on

I forgot to post...

After I read that book, I spent time reading old media articles/threads, the "opinion" of the "crowd" really shows, e.g. a year or so ago, everbody seemed to be negative about the future of JBH, excuse my language, but #%&*!#& h@ll, that has turned into one great investment over the last 12 months. The influence of the media and public opinion is not to be underestimated.

Cheers


----------



## galumay

craft said:


> Problem Is I keep ignoring it because the likes of you three above/below keep posting insightful things to spark the mind and I keep coming back for a fix and then read a little bit more then post......
> 
> Oh for some balance....or is it discipline?
> 
> Try again.




I agree, but i do think its balance, I believe my confidence and skill as an investor has been greatly enhanced by a number of posters on ASF, yourself, odds-on, vespuria, ROE, etc to name but a few.

The trick is to separate the decision making from the learning (at least thats true for me), so even when I hear 'noise' here, i go away and do my research and calculations separately, i then try to make final decisions about entry in a quiet, unemotional and clear space that is time separated from the research phase.


----------



## Ves

Posting here in case I forget about it:

http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall13.htm

Weekly podcast by Professor Damodaran based on his lecture course in valuation.

- - - Updated - - -



odds-on said:


> Hi V,
> 
> I found this book particularly helpful in improving my thought process when dealing with the "noise"-  http://www.amazon.com/The-Contrary-Thinking-Humphrey-Neill/dp/087004110X
> 
> Hope it helps.
> 
> Cheers



Will see if I can get around to reading this - been on my list for a while.

Thanks Oddson!


----------



## Ves

Might try and have a rest from here for a while.     Will check infrequently.     Lots of financial statements to dig through and I've become too distracted by the disruptive kinds that often lurk on forums such as this one for little more than their own gratification.


----------



## craft

Ves said:


> Might try and have a rest from here for a while.     Will check infrequently.     Lots of financial statements to dig through and I've become too distracted by the disruptive kinds that often lurk on forums such as this one for little more than their own gratification.




ASF's loss.

But boy I hear where you are coming from. 

Think I'll join you.


----------



## Ves

Two related issues:

1.   Property holdings vs lease /rent  
2.   Treatment of leases in DCF valuations

In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital  (ROIC).   

I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them),   whilst others exclusively rent.   The former may dilute ROIC  (with consideration for future capacity requirements being important), because you only need to buy a property once  (the rest should be picked up in depreciation / maintenance capex charges).    Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt.  This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.

Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation.  I have been thinking about this a lot recently - and have not been convinced that what  I am currently doing impacts on the accuracy of my valuation -  I am picking up the impact of the leases in my cash flow upfront,  rather than subtracting it from the NPV at the end (like you do with other debt).

Craft, McLovin, or any others that use DCF models,  what do you do in practice?


----------



## VSntchr

Ves said:


> Two related issues:
> 
> 1.   Property holdings vs lease /rent
> 2.   Treatment of leases in DCF valuations
> 
> In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital  (ROIC).
> 
> I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them),   whilst others exclusively rent.   The former may dilute ROIC  (with consideration for future capacity requirements being important), because you only need to buy a property once  (the rest should be picked up in depreciation / maintenance capex charges).    Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt.  This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.
> 
> Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation.  I have been thinking about this a lot recently - and have not been convinced that what  I am currently doing impacts on the accuracy of my valuation -  I am picking up the impact of the leases in my cash flow upfront,  rather than subtracting it from the NPV at the end (like you do with other debt).
> 
> Craft, McLovin, or any others that use DCF models,  what do you do in practice?




This was something I brought up a few months ago in a seperate stock thread.
I have found that in most cases altering the DCF model to incorporate the operating lease commitments as debt does not change the valuation significantly...however, its clear to me that in certain situations (where there is a large amount of operating lease expense and perhaps a high differential in the cost of equity vs debt) the difference will be notable.

I guess once you start getting into these issues it becomes more of a _fine_ art.
Some people just want a valuation to get the rough value of a company - after all we only want to invest if we have a substantial margin of safety so whats a few % here and there...
However, others would like to get the finer details correct in order to have a complete understanding of the company and to get as precise as possible. I think that I fall in this camp to a large extent as I feel that playing around with niche subjects like the treatment of operating leases allows me to spend more time on the company and hence form a deeper understanding.

Looking forward to reading the views of some of the more knowledgable valuation experts out there


----------



## Ves

VSntchr said:


> This was something I brought up a few months ago in a seperate stock thread.
> I have found that in most cases altering the DCF model to incorporate the operating lease commitments as debt does not change the valuation significantly...however, its clear to me that in certain situations (where there is a large amount of operating lease expense and perhaps a high differential in the cost of equity vs debt) the difference will be notable.
> 
> I guess once you start getting into these issues it becomes more of a _fine_ art.
> Some people just want a valuation to get the rough value of a company - after all we only want to invest if we have a substantial margin of safety so whats a few % here and there...
> However, others would like to get the finer details correct in order to have a complete understanding of the company and to get as precise as possible. I think that I fall in this camp to a large extent as I feel that playing around with niche subjects like the treatment of operating leases allows me to spend more time on the company and hence form a deeper understanding.
> 
> Looking forward to reading the views of some of the more knowledgable valuation experts out there



The stock thread was UGL.   I was reading my reply to your question a few days ago - I hope it didn't come across as dismissive at the time!

I pretty much agree with what you have said above. The imprecise nature of valuation,  the preconceived biases that are impossible to stop from getting assimilated into the information we do or not not include in calculations,  our mental processes to protect ourselves against ourselves yada yada....   you'd never survive if you came into it thinking it was a science and you'd have to be 100% right!

I would like to think that the more lines of thinking / different approaches that I can build up the more scope that I will have in various scenarios that I may come across in the future.   It never hurts to constantly refine your art form.  Anything that increases understanding is great to me.


----------



## craft

Ves said:


> Two related issues:
> 
> 1.   Property holdings vs lease /rent
> 2.   Treatment of leases in DCF valuations
> 
> In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital  (ROIC).
> 
> I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them),   whilst others exclusively rent.   The former may dilute ROIC  (with consideration for future capacity requirements being important), because you only need to buy a property once  (the rest should be picked up in depreciation / maintenance capex charges).    Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt.  This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.
> 
> Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation.  I have been thinking about this a lot recently - and have not been convinced that what  I am currently doing impacts on the accuracy of my valuation -  I am picking up the impact of the leases in my cash flow upfront,  rather than subtracting it from the NPV at the end (like you do with other debt).
> 
> Craft, McLovin, or any others that use DCF models,  what do you do in practice?




I don’t think you need to capitalise the lease payments for valuation purposes – Big picture, doing so lowers returns but increases funds employed and valuation wise those two movements just counteract each other.
At a more detailed level some valuation differences may arise depending on depreciation rates, capitalisation rates etc chosen but overall unless management aren’t being diligent with ongoing lease/buy analysis and/or capital management policy then it should be fairly immaterial.

Of course if you don’t capitalise the leases and put every company on an equal footing than you can’t just compare return ratio’s when you’re considering financial economics of a business – you have to think a little more holistic. 

For companies with high lease commitments I think it’s pretty important to consider their solvency metrics in terms of interest bearing debt PLUS lease liabilities.


----------



## doctorj

VSntchr said:


> Looking forward to reading the views of some of the more knowledgable valuation experts out there




I don’t think it is possible to be a valuation ‘expert’.  As you’ve said, it’s as much art as it is science, but one thing that is for sure is that whatever comes out is entirely theoretical and whether you get an answer of $100 million or $150 million, doesn’t really matter as that number exists nowhere but your meticulously crafted spread sheet.

My day job, amongst other things, involves valuing and investing in mostly unlisted companies.  Spending the hours and hours building a model is nearly always a valuable exercise, but for me, it’s not something that I would base a valuation on.  I find it  valuable because it helps me understand the drivers of value in a business and the challenges it might face. I also use it to triangulate with other valuation tools so I can identify problems or potential value.

For me, valuation is only as good as what someone else is willing to pay for my shares and what other people are paying for similar companies.  So I rely much more on a relative analysis of P/E, P/B and other sector-relevant multiples than I do on any other valuation tool.  Compare valuations to comparable companies, understand why there might be differences and understand if there are drivers that might result in convergence.


----------



## craft

doctorj said:


> For me, valuation is only as good as what someone else is willing to pay for my shares





For me it’s the exact opposite.

Valuation to me is determined by what the company can generate in free cash over time. (A cow for its milk etc – not what I can re-sell the cow for next week/month/year.)  

What someone else is willing to pay becomes an opportunity for extra return not a requirement to make a return – For me it’s a much simpler and stronger foundation to approach the market from.


----------



## Ves

craft said:


> I don’t think you need to capitalise the lease payments for valuation purposes – Big picture, doing so lowers returns but increases funds employed and valuation wise those two movements just counteract each other.
> At a more detailed level some valuation differences may arise depending on depreciation rates, capitalisation rates etc chosen but overall unless management aren’t being diligent with ongoing lease/buy analysis and/or capital management policy then it should be fairly immaterial.
> 
> Of course if you don’t capitalise the leases and put every company on an equal footing than you can’t just compare return ratio’s when you’re considering financial economics of a business – you have to think a little more holistic.
> 
> For companies with high lease commitments I think it’s pretty important to consider their solvency metrics in terms of interest bearing debt PLUS lease liabilities.




Thank you, craft -  my current thoughts are that capitalizing finance leases is probably more suited to DCF valuation of projects on a short to medium term basis by management or those who want a more detailed,  “precise” fix on the sensitivity of the variables.  Big picture – you are probably right,   it all evens out in the long run,   you add something to cash flow,  you need to add something to the capital required to support those cash flows and vice versa.  There is always equilibrium between both aspects.  Again,  it’s all about the viability of what management are presenting you in the numbers and the tales they are weaving into their accounting adjustments  -  the cash flow statement will eventually catch them out if they are trying to over-state reality.

The second part is more interesting – and in a sense I’m looking at it from the wrong side.  Whilst not the exact point that you made care should probably be taken with those companies that have vast amounts of property holdings.   Cash flow is important and the main focus…  but do you agree that the properties should be to some extent added to the bottom line of the NPV?   For instance  look at  HVN.  It has $1.7 billion of property holdings on its balance sheet.   Should the proportion of those that are being used in the operating business (as separate from those that are leased to third parties) be added to the NPV of the cash flows?  The current market multiple that HVN is trading on vs peers seems to indicate that this is the widely held view.

For example, I definitely add PMV's holding in BRG to the bottom line of the DCF valuation  (as long as it seems reasonably priced by the market,  I may knock some off the top if I'm not comfortable).

Great point about solvency metrics too – completely agree.   Leases are generally fixed obligations just like debt repayments.


----------



## Ves

craft said:


> For a no growth business flip your pre-tax required return.
> 
> ie if you want 15% return before tax then 1/15% gives a EV/EIBT of 6.6.
> 
> If the business is growing then you can pay a higher multiple where the return on incremental re-investments  is higher than your required return, if the return is lower than you will need to pay a lesser multiple to achieve your required return.  The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.
> 
> ps
> 
> Its understanding what happens between EBITDA and EBIT lines and how the accounts reflect or distort the economic reality that can really give you an analyse edge.




Quick question on this for anyone who can answer.

So  1/15%  as Craft said gives an EV/EBIT of 6.6.    

If the entity can achieve profitable growth  (ie.  ROIC  >  cost of capital)  can you use the following formula:

(1+ profitability growth rate) ^ length of growth phase   /  Hurdle Rate


Eg.   you estimate that 5% per annum growth can be achieved from excess returns on capital for a growth phase of 10 years before the company enters a no growth phase for perpuity.

((1 + 0.05)  ^  10)   / 0.15   =  10.86.

Am I correct in saying that an investor would achieve a return of 15% per annum if these conditions were met  and the stock was purchased at an EBIT multiple of 10.86 or less? or are the maths more complicated than this "short cut"?

Disclaimer:   I'm certainly not advocating that this should be used as a valuation method,  but more for making sense of market scans etc.


----------



## craft

Ves said:


> Quick question on this for anyone who can answer.
> 
> So  1/15%  as Craft said gives an EV/EBIT of 6.6.
> 
> If the entity can achieve profitable growth  (ie.  ROIC  >  cost of capital)  can you use the following formula:
> 
> (1+ profitability growth rate) ^ length of growth phase   /  Hurdle Rate
> 
> 
> Eg.   you estimate that 5% per annum growth can be achieved from excess returns on capital for a growth phase of 10 years before the company enters a no growth phase for perpuity.
> 
> ((1 + 0.05)  ^  10)   / 0.15   =  10.86.
> 
> Am I correct in saying that an investor would achieve a return of 15% per annum if these conditions were met  and the stock was purchased at an EBIT multiple of 10.86 or less? or are the maths more complicated than this "short cut"?
> 
> Disclaimer:   I'm certainly not advocating that this should be used as a valuation method,  but more for making sense of market scans etc.




For your example to achieve 15% return would require selling multiple to be maintained at purchase multiple plus entire EBIT to be paid out in addition to the 5% growth being achieved. 

I'm not sure whether you are meaning 5% is the growth rate or if 5% is the excess return above cost of capital. A shortcut that gets sorta close would need both as inputs.


----------



## Ves

craft said:


> For your example to achieve 15% return would require selling multiple to be maintained at purchase multiple plus entire EBIT to be paid out in addition to the 5% growth being achieved.



Hmm you're right I've made a mistake - it's not 15% per annum return....   it's simply growth rate at that purchase multiple that needs to occur to achieve a 15% earnings yield on EV at purchase (year 0) at the end of year 10.  

Something more realistic for that scenario would be....

Assuming you paid an EBIT multiple of 10.86 the EBIT yield at year 0 is 1/10.86 = 9.2%

If the company pays 50% of their EBIT as a fully franked dividend (which grows at 5% per annum) and you held for 10 years the cash flows look like this (assuming the EBIT multiple is still 10.86 at time of sale).

Year 0	-$1.000 			
Year 1	 $0.069 			
Year 2	 $0.073 			
Year 3	 $0.076 			
Year 4	 $0.080 			
Year 5	 $0.084 			
Year 6	 $0.088 			
Year 7	 $0.093 			
Year 8	 $0.097 			
Year 9	 $0.102 			
Year 10	 $1.735 	(F/F Div $0.107 + Sale $1.628)		

IRR	11.90%			




craft said:


> I'm not sure whether you are meaning 5% is the growth rate or if 5% is the excess return above cost of capital. A shortcut that gets sorta close would need both as inputs.




Scratch that idea.  By the time you chew through a lot of these numbers (which let's face it,  is fairly hard to do on an extensive list of companies that come up in a market scan without wasting copious amounts of time) you may as well start working out proper long-term assumptions and plug them into a DCF.

Thanks for responding to my somewhat silly question.


----------



## craft

Ves said:


> Something more realistic for that scenario would be....
> 
> Assuming you paid an EBIT multiple of 10.86 the EBIT yield at year 0 is 1/10.86 = 9.2%
> 
> If the company pays 50% of their EBIT as a fully franked dividend (which grows at 5% per annum) and you held for 10 years the cash flows look like this (assuming the EBIT multiple is still 10.86 at time of sale).
> 
> Year 0	-$1.000
> Year 1	 $0.069
> Year 2	 $0.073
> Year 3	 $0.076
> Year 4	 $0.080
> Year 5	 $0.084
> Year 6	 $0.088
> Year 7	 $0.093
> Year 8	 $0.097
> Year 9	 $0.102
> Year 10	 $1.735 	(F/F Div $0.107 + Sale $1.628)
> 
> IRR	11.90%




Hi V

With those cash flows you can't gross up the dividends if you don't subtract the tax payment from the EBIT 



Ves said:


> Scratch that idea.  By the time you chew through a lot of these numbers (which let's face it,  is fairly hard to do on an extensive list of companies that come up in a market scan without wasting copious amounts of time) you may as well start working out proper long-term assumptions and plug them into a DCF.
> 
> 
> Thanks for responding to my somewhat silly question.




I'm not so sure you should scratch the idea - I regard a short cut valuation method that I use as probably the most useful tool in my bag.


----------



## Ves

craft said:


> Hi V
> 
> With those cash flows you can't gross up the dividends if you don't subtract the tax payment from the EBIT
> 
> 
> 
> I'm not so sure you should scratch the idea - I regard a short cut valuation method that I use as probably the most useful tool in my bag.




I was actually thinking on the train on the way home....   something that I did not mention was the impact of debt on both the purchase and the sale cash flow.   I assume that the figures that I used in my example are probably only technically correct if the company had zero debt as they assume that 100% of the EBIT flows to equity.   In which case my thinking would be that you could then add back the franking credits?

If you believe that a short-cut valuation tool would be useful then I will continue exploring whilst things are a little more subdued on the market.


----------



## Value Hunter

I think one kind of back of the envelope calculation that is useful in *some* situations (I use it sometimes) is payback period. Payback period is sometimes also used in small business valuations. Depending upon interest rates and the riskiness and quality of the business the payback period your willing to accept varies. 

There are 2 methods to calculating payback period. 

If you think the company can in the long term generate a return on equity equal to or above your required rate of return on future retained earnings (i.e. if your happy with a 12% return and you think the company can retain earnings at a 15-20% return) then you calculate payback period based on earnings/maintainable cash flow (operating cash flow minus maintenance capex).

For example if a company's shares (a good company as per the paragraph above) are trading at $9 and you estimate over the next 8 years the company will generate $9 of maintainable cash flow/earnings then your payback period is 8 years.  

If you think the company is a low quality business and will reinvest earnings below your required rate of return (e.g. you want a 10% return and think the company will only generate 6-8% returns on retained earnings) then you calculate payback period based purely on the dividends you think the company will pay you and ignore retained earnings (because they are worth far less than $1 to you). This approach is conservative and rightly penalizes the valuation of inferior companies.

I think in the current interest rate environment a payback period of 3-6 years for high risk companies (e.g. onthehouse, Icar asia, AHZ, Quickflix, etc) is fair, a payback period of 7-10 years for medium risk companies (e.g. Credit Corp, Thorn Group, Data 3, etc) and a payback period of 12-15 years for lower risk companies (e.g. Woolworths, Dominos Pizza, Seek, etc). I think as a rule of thumb in the current environment they can be a reasonable guideline. 

I don't like EV/EBIT or EV/EBITDA type calculations (I understand their comparison value) because I'm an equity investor I'm only buying the equity in the company not the equity and the debt. If I was buying both the equity and debt of a company I might use it but usually I'm not. 

Besides valuing a business from a control perspective when you don't control the assets or the company (i.e. minority shareholder) is not always wise. e.g. if you buy a small business below liquidation value in a distressed sale you have the power to liquidate the assets, however as a minority shareholder in a listed company if you buy below liquidation value the management might keep running the company and rack up further losses, so in reality you have to form an opinion of the likelihood of liquidation, asset sales, or a takeover. Same idea with EV/EBIT and debt how likely is the company to pay off the debt? 

In my opinion debt does affect the valuation of a company (from the perspective of a minority shareholder) by changing the equity risk premium (i.e. you would want a higher return for buying the equity of a highly geared company compared to the buying the equity of an otherwise identical but un-geared company due to higher earnings and solvency risk.) If you buy shares as a minority shareholder in a geared company the management may choose to never pay off the debt so using a control based EV/EBIT valuation doesn't make sense unless you are buying a controlling/influential stake in the company. Control valuation does have its uses e.g. calculating the takeover/strategic value of a company you think may get taken over, when an activist investor gets on board and shakes things up, etc

I remember Steve Keen in one of his presentations once talked about how payback period is a conservative valuation methodology compared to other things like DCF because it focuses you on nearer term cash flows (i.e. you focus on getting your money back sooner as for most businesses the longer the time horizon the more likely the business will stuff up, go into stagnation or decline, or go broke (how many companies you buy today would survive the next 30 years?). The further into the future the more uncertain/risky the cash flow. Also its more sophisticated than a simple p.e. because it looks at future growth/decline in earnings.


----------



## craft

Thanks for your post Value Hunter.

I think all the models are attempting to do basically the same thing – determine what a share is worth based on what the business can produce.  And that’s the big pig picture..... the models are just tools and it’s really the model input assumptions we make in light of the big picture, that informs us – not the model or its output.

To me investing is the foregoing of purchasing power now in order to obtain more at a later date.

That definition drives how I think about so many things: Inflation; Taxation; Transaction Costs; Earnings Risk; Competitive Advantage to protect Margin; Growth Potential; Valuation Model........

I suspect most, who find any value in this thread will share the big picture concepts on investing, but we will all probably address the detailed questions with different and varied tools and perspectives and that’s a good thing.

Look forward to some more post from you.


----------



## Value Hunter

One valuation formula which I useful in *some* situations is Brian Mcniven's valuation formula as set out in the book 'a concise guide to value investing" and his other book "market wise":

-IV = Intrinsic Value
-E = Equity Per Share
-ROE = Return on Average Equity (the average amount of shareholders equity throughout the financial year)
-RI = Reinvestment Ratio (this is equals one minus the dividend payout ratio) i.e. if the dividend payout ratio is 60% the reinvestment ratio is 40%
-D = Dividend Payout Ratio 
-RR = your required rate of return for the particular investment

Formula: [(ROE/RR)*RI] + D
            -------------------------
                     RR*E 
Note: All the figures (inputs) are based on your long-term future estimates for each variable (the only figure which is a current figure and not a future estimate is the Equity per share)

So If a company has a future forecast ROE of 20% and pays out three quarters of earnings and you want to get 12% return the valuation would be as follows
        [(20/12)(5) + 15]/12 =  1.944 times the equity per share 

This valuation is appropriate for stable relatively non-cycle companies where earnings growth is correlated to retained earnings and incremental return on equity is relatively stable and predictable and similar to past return on equity e.g. Woolworths (WOW). 

It does not work well for companies where earnings are not really related to the amount shareholder's equity e.g. Platinum Asset Management (PTM). 

It also does not work well for companies whose incremental return on future equity will be markedly different from return on existing equity. 

It also does not work particularly well for highly cyclical companies.

To be honest valuation formula's are to me at least sometimes an academic exercise when something is a screaming bargain it will be obvious you won't need to use a valuation formula as such, as the value will hit you in the face. If you need to fiddle around with formula's its not an obvious bargain.


----------



## craft

Value Hunter said:


> One valuation formula which I useful in *some* situations is Brian Mcniven's valuation formula as set out in the book 'a concise guide to value investing" and his other book "market wise":
> 
> -IV = Intrinsic Value
> -E = Equity Per Share
> -ROE = Return on Average Equity (the average amount of shareholders equity throughout the financial year)
> -RI = Reinvestment Ratio (this is equals one minus the dividend payout ratio) i.e. if the dividend payout ratio is 60% the reinvestment ratio is 40%
> -D = Dividend Payout Ratio
> -RR = your required rate of return for the particular investment
> 
> Formula: [(ROE/RR)*RI] + D
> -------------------------
> RR*E




Brian Mcniven’s model is a restatement of the Walter Dividend Model.  Roger Montgomery’s first foray into stock valuation software at Clime used this formula and credited it to McNiven. His second foray also uses the same formula except now he claims credit, because he has disguised it in a table and applied a 10% reduction to the valuation of the retained component.

It’s great to see you accommodating the limitations of the formula.

Here’s the limitations that Walter was very upfront about when he formulated the model in an attempt to assess the question of dividend policy.    

https://www.aussiestockforums.com/forums/showthread.php?t=20847&p=762415&viewfull=1#post762415



Value Hunter said:


> To be honest valuation formula's are to me at least sometimes an academic exercise when something is a screaming bargain it will be obvious you won't need to use a valuation formula as such, as the value will hit you in the face. If you need to fiddle around with formula's its not an obvious bargain.




The herd does not leave obvious screaming bargains - by definition you will only find screaming bargains if you see things differently to the majority. An understanding of valuation can help you stay grounded in the face of current popular trends and see things a little different.


----------



## Ves

Sorry guys... I've been a bit aloof on this thread since my last few posts.   Your thoughts are very appreciated and whilst I have thought long and hard on them,  I don't really have anything useful to add at this very point in time.    Valuation,  as craft and a few others often say,  is more art than science,  and I have come to totally respect that point of view over time.

At the moment my main concern is risk management.... valuation is part of that (of course I'm still refining my full valuation and "short cut" valuation methods),  but it is only a cog in the bigger picture as things currently stand in my mind.   Earnings hits to companies such as FGE have really opened my mind  to my prior consideration of proper process and critera before investing in a company and I'm really trying to hone in on my own process at the moment in respect to this.


----------



## VSntchr

Ves said:


> I've been playing around with a few options in the last few months.
> 
> Basically I take the FCFF (or whichever you use) from the last period of your cash flow analysis and divide it by some sort of risk-adjusted cost of capital for the firm  (usually between 11% and 15%).
> 
> So say at year 10 you had cash flow of $1 a share and I thought the cost of capital should be 12% for UGL.  TV at year 10 would be $8.33.  Discounted back to year 0 at 15% (my required rate of return before tax) this'd be $2.06.   as I said I would personally adjust this based on my confidence in the enduring competitive advantage of the business.   So for instance....  $2.06 x 50% =  $1.03.    It's pretty arbitrary as all valuation is, but it makes you think about the competitive advantage and how far above the replacement cost of assets you are willing to pay for it in today's dollars.
> 
> Here's a comparison of the same for 5 different scenarios using $1 as the base earnings at year 10. Discount rate from year 10 to year 0 is always 15% in all scenarios.
> 
> Scenario	A 	 B	  C	   D	   E
> TV Disc	11%	12%	13%	14%	15%
> TV      	 $9.09 	 $8.33 	 $7.69 	 $7.14 	 $6.67
> Year 0 	 $2.25 	 $2.06 	 $1.90 	 $1.77 	 $1.65
> 
> Scenario A is 36% higher than scenario E.   B is 25%,  C 15% and D 7%....  which demonstrates that discount rates impact the result pretty quickly.




We were off-topic from UGL, so perhaps better to discuss here...

Your approach is interesting and in many ways similar to mine.
Is your 15% discount rate universal amongst all stocks? Or does it differ based on your perception of company risk? I ask only because you appear to be adjusting for risk in other parts of your valuation - so accounting for it again in the discount rate may be over-punishing the company? 
However, if you are only discounting the *excess* terminal value based upon the competitive advantage that you feel applicable then my point may not be worthy..

I don't have my head 100% around your approach so I'm sorry if I'm off the mark here...


----------



## Ves

VSntchr said:


> We were off-topic from UGL, so perhaps better to discuss here...
> 
> Your approach is interesting and in many ways similar to mine.
> Is your 15% discount rate universal amongst all stocks? Or does it differ based on your perception of company risk? I ask only because you appear to be adjusting for risk in other parts of your valuation - so accounting for it again in the discount rate may be over-punishing the company?
> However, if you are only discounting the *excess* terminal value based upon the competitive advantage that you feel applicable then my point may not be worthy..
> 
> I don't have my head 100% around your approach so I'm sorry if I'm off the mark here...



It's a universal discount rate of 15%pa.

It's basically saying that if the company passes all of my risk management tests in the first place, I will value it based on a set of assumptions about the future, perhaps make some further risk adjustments.   Once I've got a valuation the company needs to trade at such a level that I think I will be able to get 15%pa before tax (hence the discount rate) before I would consider buying it.

Each month I usually just sort through my valuations and pick the one offering the biggest return / discount to it's value.  If there's none I just stay in cash.   Obviously there's position sizing requirements on top of that... I won't go higher than 10-12% of my portfolio in one company.  I try to average in, rather than time my entries. Set day each month - if I miss out I miss out,  but I'd rather not snatch at entries randomly.


----------



## VSntchr

> It's a universal discount rate of 15%pa.



Yep, this makes sense to me.



> It's basically saying that if the company passes all of my risk management tests in the first place, I will value it based on a set of assumptions about the future, perhaps make some further risk adjustments.   Once I've got a valuation the company needs to trade at such a level that I think I will be able to get 15%pa before tax (hence the discount rate) before I would consider buying it.



Yep, I have spreadsheet that provides me with my own IRR based on my modelling and current price.



> Each month I usually just sort through my valuations and pick the one offering the biggest return / discount to it's value.  If there's none I just stay in cash.   Obviously there's position sizing requirements on top of that... I won't go higher than 10-12% of my portfolio in one company.  I try to average in, rather than time my entries. Set day each month - if I miss out I miss out,  but I'd rather not snatch at entries randomly.




Seems like a pretty good method. 
I'm far more aggressive in my approach. I am not too worried about approaching 30% in one company. I understand the additional risk but at a young age I am in a situation that allows me to take it on.


----------



## Ves

VSntchr said:


> I'm far more aggressive in my approach. I am not too worried about approaching 30% in one company. I understand the additional risk but at a young age I am in a situation that allows me to take it on.



I was thinking along those lines too - but then I did the maths,   if I can get 10-12% per annum returns at my current savings rate (which is pretty high) I'll have a very tidy sum of money after 10-15 years.   Hence why I'm pretty conservative in general


----------



## VSntchr

Ves said:


> I was thinking along those lines too - but then I did the maths,   if I can get 10-12% per annum returns at my current savings rate (which is pretty high) I'll have a very tidy sum of money after 10-15 years.   Hence why I'm pretty conservative in general




and thats what it's all about isn't it - personalising your plan for YOUR situation!


----------



## Ves

VSntchr said:


> and thats what it's all about isn't it - personalising your plan for YOUR situation!



Spot on!


----------



## TheUnknown

Has anyone been successful to build cash flow from shares and an income from shares that produces them a wage per week?


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## craft

TheUnknown said:


> Has anyone been successful to build cash flow from shares and an income from shares that produces them a wage per week?




Now there's a question just begging the respondents to make themselves look like egotistical fools - but that's probably the perception of me already and it’s probably a common query - so tosser mode on – here goes.

Current dividend stream is greater then I imagine I could be making now in any other career. (Aged early 40’s) The initial capital was savings from pretty average sort of employment up until about age 30. Some of the increases in capital has been from trading (especially early on) but the majority in $ terms has grown by investing with a cash flow focus.

The aim now is to try and not blow it whilst continuing to invest in the style I do – because investing turns out to be more about doing something I enjoy rather then something I do to make money.


now - don't ask again - its rude.


----------



## craft

VSntchr said:


> It's funny that the market is pushing new recent highs, yet a few of the stocks I follow closely are near recent lows.




VSntchr made this comment in the DTL thread. I’m just going to make some random thoughts that jumped into my head when I read it. 

The market seems driven at least in the short term by current earnings.
I’m a long term investor – my job really is to arbitrage over time the difference between current earnings and true economic earning potential.

I think about how the market is currently pricing for example DTL compared to GXL and market price seems defensible on current earnings and analyst extrapolated forecasts but to me both prices seem wrong in relation to the long term economics of the businesses.

My disagreement with some market pricing is opportunity that will be realised over the long term.  If I’m right its opportunity that will be translated into profit, if I’m wrong it its opportunity that will be translated into loss.  If you think you’ve got an edge in evaluating long term performance of business’s then celebrate the markets appetite for earnings momentum and instant gratification. 

What about the opportunity costs of not going with the market momentum to make shorter term wins and compound them yourself?  Its zero sum for outperformance – It’s extremely crowded – It incurs lots of transaction costs, it requires more screen time & monitoring. I don't have the hunger anymore to compete consistently in a very competitive/time consuming game which is zero sum and has the drag stacked against you. 

Outperformance by picking quality at a sensible price and avoiding crap at expensive prices seems much simpler to me and far easier to scale.  You just have to worry about the correct allocation of your initial capital and dividend stream. Good businesses take care of some of the compounding for you.


----------



## skc

craft said:


> I think about how the market is currently pricing for example DTL compared to GXL and market price seems defensible on current earnings and analyst extrapolated forecasts but to me both prices seem wrong in relation to the long term economics of the businesses.






craft said:


> If you think you’ve got an edge in evaluating long term performance of business’s then celebrate the markets appetite for earnings momentum and instant gratification.




I think Buffet is an advocate of "extrapolation" of earnings and performance. However, his overarching premise is about predictable earning streams and sustainable competitive advantage. It feels like analysts there days simply adopted the "extrapolate" mantra yet failed to improve their skills in assessing the actual business.

Oh yeah and they get their performance assessed on a short term basis anyway so there's little reason to focus on the long term.

One thing on my to-do list is to run a NPV analysis on TCL. All their assets have finite lives. Some are to be returned back to the government on a debt free basis. I struggle to see how there's much value in today's term. My guess is that the analysis forecast only goes 3-5 years out so they literally can't see the end of the tunnel (pun intended).



craft said:


> What about the opportunity costs of not going with the market momentum to make shorter term wins and compound them yourself?  Its zero sum for outperformance – It’s extremely crowded – It incurs lots of transaction costs, it requires more screen time & monitoring. I don't have the hunger anymore to compete consistently in a very competitive/time consuming game which is zero sum and has the drag stacked against you.
> 
> Outperformance by picking quality at a sensible price and avoiding crap at expensive prices seems much simpler to me and far easier to scale.  You just have to worry about the correct allocation of your initial capital and dividend stream. Good businesses take care of some of the compounding for you.




The short term and long term are actually pretty symbiotic. Without short term sellers driving down the price (of DTL for instance), you won't have as many opportunities to acquire assets on the cheap.


----------



## craft

skc said:


> I think Buffet is an advocate of "extrapolation" of earnings and performance. However, his overarching premise is about predictable earning streams and *sustainable competitive advantage*. It feels like analysts there days simply adopted the "extrapolate" mantra yet failed to improve their skills in assessing the actual business.




On Buffett - if a person fails to comprehend the significance he puts on "sustainable competitive advantage" - especially the sustainable part then the majority of the story will be missed. he's tended towards predictable (as in smooth) because he's leveraged through the insurance float, otherwise from what I have read he would favour maximising return over minimising volatility.   



skc said:


> Oh yeah and they get their performance assessed on a short term basis anyway so there's little reason to focus on the long term.




That short term performance is a logical pursuit for so many market players is probably the very thing that keeps long term investing viable.




skc said:


> The short term and long term are actually pretty symbiotic. Without short term sellers driving down the price (of DTL for instance), you won't have as many opportunities to acquire assets on the cheap.




That says better what I was trying to say. Celebrate the opportunities because without the opportunities it doesn't matter how good you are - an efficient market with no opportunities means no scope to outperform.

Celebrating the opportunities is sometimes hard when you have become attached to the paper profits from much earlier buying. Holding good companies for the long term can incur 50% drawdowns from peak even when nothing has changed with the competitive advantage. You have got to be able to see it for what it is not what your emotions are screaming at you - temperament is so important especially when earnings have a cyclical nature.


----------



## craft

For those interested Buffett's 2013 annual Letter is out.

http://www.berkshirehathaway.com/letters/2013ltr.pdf


----------



## skc

Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill. 




So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.

IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.

So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.

Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!


----------



## craft

skc said:


> Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill.
> 
> View attachment 57050
> 
> 
> So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.
> 
> IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.
> 
> So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.
> 
> Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!




Interesting post.

I don’t understand how Broking houses get their price targets either and care factor for me is zero - though I do like it when I disagree with them.

2016 forecast earnings for ASL in this environment to a decimal place no less – righto.


----------



## odds-on

skc said:


> Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill.
> 
> View attachment 57050
> 
> 
> So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.
> 
> IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.
> 
> So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.
> 
> Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!




Are there any academic papers on the accuracy rate of the EPS and Price forecasts produced by Brokers/Research houses? I wonder if they are more accurate than TAB punters? If they are less accurate, how can they justify their salary?

Or is the stockmarket really  that difficult...
http://www.afr.com/p/national/how_alan_woods_beat_the_odds_1WYIMYctxSivusBw06fcJJ - How can one be so good at forecasting horse races yet so bad at forecasting the stockmarket?


----------



## skc

odds-on said:


> Are there any academic papers on the accuracy rate of the EPS and Price forecasts produced by Brokers/Research houses? I wonder if they are more accurate than TAB punters? If they are less accurate, how can they justify their salary?




Forecasting is quite an art so I've never expected them to be correct most of the time. The accuracy will depends largely on the industry (is it relatively steady or cyclical? Predicting the top and bottom of cyclical industries are difficult) as well as how far out the forecast is projected. 

The current period consensus (i.e. average or median amongst several analysts) can sometimes be useful... if nothing else, you expect a large company to make some sort of market guidance announcement when they discover that their earnings will vary significantly from current range of analyst forecasts. 



craft said:


> Interesting post.
> 
> I don’t understand how Broking houses get their price targets either and care factor for me is zero - though I do like it when I disagree with them.
> 
> 2016 forecast earnings for ASL in this environment to a decimal place no less – righto.




What is interesting in this case is that the forecast and the price objective seems completely incongruent. Their forecast may or may not be right but at least they should apply those input consistently. May be they simply said too much risk therefore assume price target of 30% of NPV or something like that. Which again means all the forecast is a complete waste of time if the analyst simply ignores the answer it gives him/her.


----------



## odds-on

skc said:


> Forecasting is quite an art so I've never expected them to be correct most of the time. The accuracy will depends largely on the industry (is it relatively steady or cyclical? Predicting the top and bottom of cyclical industries are difficult) as well as how far out the forecast is projected.
> 
> The current period consensus (i.e. average or median amongst several analysts) can sometimes be useful... if nothing else, you expect a large company to make some sort of market guidance announcement when they discover that their earnings will vary significantly from current range of analyst forecasts.
> 
> 
> 
> What is interesting in this case is that the forecast and the price objective seems completely incongruent. Their forecast may or may not be right but at least they should apply those input consistently. May be they simply said too much risk therefore assume price target of 30% of NPV or something like that. Which again means all the forecast is a complete waste of time if the analyst simply ignores the answer it gives him/her.




I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision? 

In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a  medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this). 

If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management. 

Having said that, some people have obviously worked out how to accurately  forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers? 

On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.

Cheers


----------



## craft

odds-on said:


> I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision?
> 
> In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a  medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this).
> 
> If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management.
> 
> Having said that, some people have obviously worked out how to accurately  forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers?



Hi Oddson

Probably a bit of an obscure response to your post – but

Any trading/investing success will ultimately be determined by your ability to take on risk when it is priced in favour of doing so.

Ability to take on risk is a circumstantial and personal attribute determined issue.

Seeing mispriced risk is a skill that can be achieved in a niche. (many different niches)

Specifically to your question about sustainable competitive advantage – You can estimate earnings and value companies that don’t have sustainable competitive advantages.  You can’t estimate earnings for companies outside of your area of understanding.



odds-on said:


> On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.
> 
> Cheers



What would surprise me is if they let a target price too far removed from consensus out the door.  It’s a business imperative for these guys to not stray too far from the pack. Regardless of how much faith they have in their forecasts it makes no business sense to isolate themselves with an outlier price target.  Being wrong in unison is not a business threat for these guys – being wrong in isolation is.
Their imperative to stay near consensus despite any inconsistency of valuation logic gives rise to opportunity for private investors who have the ability to be wrong in isolation because it also gives rise to the ability to be right in isolation.


----------



## KnowThePast

odds-on said:


> I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision?
> 
> In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a  medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this).
> 
> If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management.
> 
> Having said that, some people have obviously worked out how to accurately  forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers?
> 
> On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.
> 
> Cheers




Hi odds-on,

Thank you so much for that link. Just read the first chapters, seems to be awfully close to what I am trying to do.

Really looking forward to reading the rest of it.


----------



## Huskar

Just wanted to butt in and say also: some real thought-provoking posts (and links).

I should be less of a listener and get more involved but I can never say it better than has already been said!

Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?


----------



## craft

Huskar said:


> Just wanted to butt in and say also: some real thought-provoking posts (and links).
> 
> I should be less of a listener and get more involved but I can never say it better than has already been said!
> 
> Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?




Hesking

I don’t have in-depth understanding of ASL and I don’t pay much attention to broker reports or their immediate market impacts so I have nothing sensible to add. (my only observation is that there is lots of earnings risk with ASL which makes forecasting earnings difficult even if you are an expert in the area)  

One of SKC’s game plans seems to be around riding bow waves of big players in the market – perhaps he has some comments as to how to possibly profit from the ASL type research reports that seem contradictory between earnings and price targets. 

As for your involvement – As somebody who should post less but loves the thought provocation from reading diverse views, can I just selfishly say, please do.


----------



## skc

Huskar said:


> Just wanted to butt in and say also: some real thought-provoking posts (and links).
> 
> I should be less of a listener and get more involved but I can never say it better than has already been said!
> 
> Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?




Not long and short are very different.

When you buy something undervalued with substantial PV of future cash flow, you go long and you will profit if you are right. Even if the market NEVER price in a higher price, you will still profit from the growing future dividend stream that's above the cost of your capital.

When you short something that appears overvalued, you can lose even if you are right. The market can price shares at whatever price it wants, and when you short there isn't the future dividend stream (like the long case) that allows you to profit regardless of market price. So if you wanted to short something, not only do you need to be right, you need others to agree with you and act accordingly. Some examples may include UNS and Bitcoin(?).

BTW, I don't believe the uncertainty / incongruence in one broker house's valuation would create any shorting opportunity. Unless you can arbitrage against their insurance or something...


----------



## odds-on

craft said:


> Specifically to your question about sustainable competitive advantage – You can estimate earnings and value companies that don’t have sustainable competitive advantages.  You can’t estimate earnings for companies outside of your area of understanding.




Hi Craft,

I am in agreement that I can’t estimate earnings for companies outside of my area of understanding, but I struggle l to see how I can make an intrinsic value estimate for a company that does not have a sustainable competitive advantage – surely, the competitive advantage enables one to forecast to future earnings (cash flows) with confidence?

If the earnings are volatile then trying to figure out Year 2 to Year 10 earnings is pointless. If there is no sustainable competitive advantage then all I can hang my hat on is Liquidation Value/NCAV.....or….are you trying to tell me that if I am to trying to value a company without a competitive advantage then I have to take into account that the Return on Capital will mean revert to the industry (or sector or market) mean over a cycle?

Also, what % of listed businesses do you think have a sustainable competitive advantage?

Cheers


----------



## craft

odds-on said:


> Hi Craft,
> 
> I am in agreement that I can’t estimate earnings for companies outside of my area of understanding, but I struggle l to see how I can make an intrinsic value estimate for a company that does not have a sustainable competitive advantage – surely, the competitive advantage enables one to forecast to future earnings (cash flows) with confidence?
> 
> If the earnings are volatile then trying to figure out Year 2 to Year 10 earnings is pointless. If there is no sustainable competitive advantage then all I can hang my hat on is Liquidation Value/NCAV.....or….are you trying to tell me that if I am to trying to value a company without a competitive advantage then I have to take into account that the Return on Capital will mean revert to the industry (or sector or market) mean over a cycle?
> 
> Also, what % of listed businesses do you think have a sustainable competitive advantage?
> 
> Cheers




Can’t be specific enough to assign a single %  but it’s not many and if you interpret sustainable as infinite duration – then it’s none. 

Only companies that are at a competitive disadvantage need to be valued eventually at liquidation value (unless somebody is silly enough to keep giving them capital.)

Companies with a neutral competitive position can make their cost of capital and do it quite sustainably over time – actually it is more inherently stable then a company with competitive advantage which will be under constant scrutiny as competition tries to think up ways to get their hands on the attractive returns. 

Diminishing or increasing competitive positions mean you cannot get sensible valuations from static return valuation models.

Competitive advantage does not necessarily equate to smooth earnings – it equates to superior aggregate returns over a full cycle.


----------



## KnowThePast

craft said:


> Companies with a neutral competitive position can make their cost of capital and do it quite sustainably over time – actually it is more inherently stable then a company with competitive advantage which will be under constant scrutiny as competition tries to think up ways to get their hands on the attractive returns.




And this is an area that I usually play in.

A few studies have shown that for majority of companies, earnings in the long term tend to revert to mean. And so, using a PE ratio of average earnings over the last 5/10/20 years, may not be the worst way to value some companies. 

An even better way may be to average out ROC over many years, to see what average earnings would be with the current asset base. 

I don't think this kind of valuation would have a high accuracy rate (do any?), but using a scatter fire approach and buying companies with below average earnings should produce an above average result.


----------



## craft

Milestone are a good excuse to reflect.

I have noticed that I am about to come up on 1000 posts and in reflection I can’t justify that.

I’ve been a full time participant in the market in one form or another for nearly 15 years but the allocation of time is now more of a habit then a necessity.    A habit I wish to break because there are so many other things in life that I could better spend the time on and I have some big ideas that I want to get achieved.

All I really need to do for my approach to investing now is keep on top of developments in the companies within the portfolio and prospect for potentially better investments – the analogy that jumps to mind is akin to  a selector for the national cricket side.  The process requires very little transaction time but a fair bit of research time.

Controlling the amount of time spent on research is a challenge for me as weirdly I really enjoy this aspect.  I use the word prospecting for investments because I think I get the same buzz from uncovering something of value via business analysis as others might from uncovering a gold nugget.
I do know that I research best in isolation with candidates for closer examination picked up from my scans.  Other stimulation leads to less productive use of research time. 

With the aim of breaking established time use habits and using what time I do allocate to researching more productively I have decided to ensure I don’t make another 1000 posts. It is my intention to shortly delete my email and enter a scrambled password, effectively disabling my account and ensuring my actions follow through with my intent. 

Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.

Happy Journeys


----------



## skc

craft said:


> Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.
> 
> Happy Journeys




Hi Craft, sorry to hear your decision. Many here will miss your crafty insights.

All the best with your endeavours.


----------



## CanOz

skc said:


> Hi Craft, sorry to hear your decision. Many here will miss your crafty insights.
> 
> All the best with your endeavours.




+1 - will miss you around here Crafty...i think i'll be joining you soon though, with the prospect of fulltime work looming large again i know i won't have the time to post much...

Good luck Craft, drop in and say hi once in while will you!


----------



## Ves

Hi craft

There was a discussion on this forum at some point in time last year where you were trying to explain the need for a person to have the “inner mongrel” to succeed.

I have often reflected on this.    

Today I found the word that I am after.

Tranquility.

You will know what it means to be in this state in terms of your life, your actions and your core values and to be at peace with yourself when you look into the metaphorical mirror than life shoves in your face.

Without it there is only emotion, self-doubt and chaos amongst any attempts to be rational. 

It is somewhat an oddity that the day of your leaving coincided with this discovery.

Thank you for all of your thoughts,  and for answering many of my questions and providing lots of concepts and ideas to ponder.

All the best,
V


----------



## odds-on

craft said:


> Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.
> 
> Happy Journeys




Sad news for ASF. Let us know when you start teaching "The Art of Investment" at some University, I will sign up 

Cheers


----------



## nulla nulla

craft said:


> Milestone are a good excuse to reflect.
> 
> I have noticed that I am about to come up on 1000 posts and in reflection I can’t justify that.
> 
> I’ve been a full time participant in the market in one form or another for nearly 15 years but the allocation of time is now more of a habit then a necessity.    A habit I wish to break because there are so many other things in life that I could better spend the time on and I have some big ideas that I want to get achieved.
> 
> All I really need to do for my approach to investing now is keep on top of developments in the companies within the portfolio and prospect for potentially better investments – the analogy that jumps to mind is akin to  a selector for the national cricket side.  The process requires very little transaction time but a fair bit of research time.
> 
> Controlling the amount of time spent on research is a challenge for me as weirdly I really enjoy this aspect.  I use the word prospecting for investments because I think I get the same buzz from uncovering something of value via business analysis as others might from uncovering a gold nugget.
> I do know that I research best in isolation with candidates for closer examination picked up from my scans.  Other stimulation leads to less productive use of research time.
> 
> With the aim of breaking established time use habits and using what time I do allocate to researching more productively I have decided to ensure I don’t make another 1000 posts. It is my intention to shortly delete my email and enter a scrambled password, effectively disabling my account and ensuring my actions follow through with my intent.
> 
> Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.
> 
> Happy Journeys




Wisdom when imparted is often overlooked. And those providing that wisdom sometimes feel their contribution is of no import. Often their contributions are met with challenge and sometimes derision. However there is often a silent few that appreciate the merit of the contribution and more importantly the consistency of the quality of the contributions. 

As a poster, you have proven to be one of a handful of quality posters that I consider as being worth reading. Thoughtful and sometimes challenging, your posts have always deserved consideration. I hope you will reconsider your decision as a 1000 post tally over a period of six years is not excessive. I'm sure the forum would continue to benefit from the quality of your posts, even if you elected to scale it back to accommodate your future plans.

Best regards in your endeavors and many thanks, 

nulla


----------



## Newt

I hope you were just having a #@$! day Craft - don't do it - I'll miss the chance to learn from you and pretty sure many others would be dissapointed too.

Nothing wrong with rationing your future time though.  Anything's possible in life as long as you sacrifice the time your could have spent achieving something else....


----------



## VSntchr

Have been re-reading this thread and its making alot more sense then the first time ~2yrs back.

I like the concepts of ROIC and ROIIC and I decided the best way to learn more is to put it into practice.

I wanted to prove the fact that incremental returns will pull up the overall returns over a longer period (which is clearly logical).

I used Resmed for my example.

First I calculated EBIT(1-t). Then I calculated invested capital by taking total assets, subtracting excess cash (which is a subjective number based on what I think they need to retain for WC purposes), then subtracted goodwill - while leaving in all other intangibles with finite (amortisable) lives, finally I subtracted the all other non-interest bearing CL to finally arrive at a figure for invested capital.
I also compared the result of the above to the shortcut method of Equity + debt - cash, and found that the result is  within +/- 10%.

So for 2013 I arrived at a ROIC value for RMD of 25.5%. This compared to a ROIC in 2004 of 18.8%.
Taking a look at how RMD used their *incremental* capital over this period showed that they invested an additional ~$800m for an incremental EBIT(1-t) of $223m. This is a return on incremental capital of 28%. Pretty snazzy to be deploying additional funds over a 10 year period at that kind of rate  and  with the long run incremental rate higher than the overall rates of return - one might assume that the uplift will continue (enter here all assumptions about ability to deploy capital).
One factor that might need to be normalised is the fact that at the start of the period the company was paying a 32% effective tax rate, while most recently this was close to 20%.

Another area that this exercise has opened up for me is that RMD's invested capital base basically begun to stagnate over the last 4 years. This, however does not appear to be a lack of investment (capex is largely in-line with historical trends), but rather the company accelerating its capital return mechanisms.

As always, please critique as necessary


----------



## craft

So post 1000

Thanks to those above that posted some kind words and thanks to you VS for that last post – that somebody is working through some of the thoughts in this thread to see if they are of any use to them means  a lot. (my critique )

So let’s try this with an in-moderation approach - a somewhat unusual concept for me. [please tell me if I’m not achieving this objective] If I ever make it to 2000 posts that mile stone will have be equitable with my investing time frame - long term.

Infrequent visits probably means disjointed discussions and missed question/posts –So I’ll just apologise now if it appears that I am being ignorant or snubbing anybody.

Seems there is some interesting posting occurring on the site at the moment – maybe that just means I listen better when not talking.


----------



## Ves

VSntchr said:


> As always, please critique as necessary



Hey VS,

Companies that can employ excess capital generated into a franchise are obviously good long term plays (at the right price).

Often you will find that ROIC will grow in these types of companies because they are benefiting from increased scale and better asset utilisation (obviously revenue growth on a cost base that is somewhat fixed with do this).   Most of the fixed capital is in place...  so to add more capacity you might need to add less incremental capital to ramp up returns?   I guess it would help to know what the incremental capital was used for as well.  

With companies like Resmed that need to constantly innovate and create new products / features,  it would be interesting to try to identify how much of the change in ROIC over this period was due to a changing product mix from new innovation etc. and how much, if any, was due to increase in scale / operational leverage?  Were there any cyclical or structural factors within the industry that drove returns? Will these continue or is there risk of change?  In other words  we can see that the returns have increased,  but what are the drivers?   I think that will tell a story,  and from that,  you will most likely have a better idea of how sustainable it is and what assumptions need to be made for it to continue long-term.

You've hit the nail on the head.   You know what to look for - now that you can find it,  you can start asking new questions in your analysis.  The more you know,   well the more it turns out that you realise the less you know.  Which helps you expand your base further again. The paradox of knowledge / espistemology.


----------



## craft

Stranded Franking credits

Currently a company whose long term FCF is equivalent to its NPAT has the ability to distribute all its franking credits.  But under a 28.5% tax and 1.5% PPL levy arrangement we will have the situation where a company with 100M pre-tax profit will end up crediting the franking account with 28.5M but because they still only have 70M cash flow they can only distribute 27.9M of franking credits.

What’s the implications for valuation?

What companies are best placed to mitigate this absurdity?

Will something get legislated to overcome the situation? or does it exist already - can they frank above the tax rate etc?


----------



## Ves

craft said:


> Stranded Franking credits
> 
> Currently a company whose long term FCF is equivalent to its NPAT has the ability to distribute all its franking credits.  But under a 28.5% tax and 1.5% PPL levy arrangement we will have the situation where a company with 100M pre-tax profit will end up crediting the franking account with 28.5M but because they still only have 70M cash flow they can only distribute 27.9M of franking credits.



Can't they also pay out of previous retained profits or similar?  But you could be right... not all companies will have retained profits as not all companies have been historically profitable.  

I would need to do some further research,  took me until this morning to click with how you came up with your calculations.



> What’s the implications for valuation?
> 
> What companies are best placed to mitigate this absurdity?
> 
> Will something get legislated to overcome the situation? or does it exist already - can they frank above the tax rate etc?



Some companies have very large franking account balances,  such as PMV, which we have discussed before.   It would obviously restrict investors access to this pool in less can be paid at any one time.

I do my valuations pre-tax,  so I am not sure if there is any direct impact.   But you could argue that you may need to adjust the hurdle rate to reflect the fact that more tax will eventually be paid by investors.

EDIT:   Here is a link to an article that was written in 2012 when the ATO released their latest ruling on the franking and payment of company dividends.

The ruling number is mentioned in here.

http://www.mallesons.com/publicatio...dividends-final-Taxation-Ruling-released.aspx


----------



## DeepState

craft said:


> Stranded Franking credits
> 
> 1. Currently a company whose long term FCF is equivalent to its NPAT has the ability to distribute all its franking credits.  But under a 28.5% tax and 1.5% PPL levy arrangement we will have the situation where a company with 100M pre-tax profit will end up crediting the franking account with 28.5M but because they still only have 70M cash flow they can only distribute 27.9M of franking credits.
> 
> 2. What’s the implications for valuation?
> 
> 3. What companies are best placed to mitigate this absurdity?
> 
> 4. Will something get legislated to overcome the situation? or does it exist already - can they frank above the tax rate etc?




1. Get your point, but 70/100*28.5 = 19.95?  Hence, if the company can only distribute $19.95 million if the Net free cashflow before dividend payments are $70m.  This assumes all financing activity has been considered (ie. repurchase plans etc).  This also assumes that there are retained profits or unrealized capital gains availalable on balance sheet.

2. If you are doing DCF, you will get more cash due to lower tax rate.  This may or may not lead to capital drain due to increase in acquisitions, capex, working capital etc. that may result from a reduction in tax rate leading to more business activity.  You also need to make a separate assumption about franking being released with FCF which does not have to equal that which would be attached if the full dividend amount equaled FCF.  If you are using EVA style analysis, for example, FCF is calculated as if the whole company was financed using equity and thus FCF in reality for a the levered alternative will differ from this style of valuation. 

If you are using DDM, you can assume an attaching franking credit to each dividend and discount this.  You would possibly expect an increase in dividends as there is more cashflow as a result of lower tax.  If the payout ratio is less than 100%, then any business changes emanating from the tax reduction ought not impact on the ability to pay the dividends and, if the pay-out policy of the company is unchanged in dollar terms, all that changes is a reduced valuation for franking credits. In reality, there will be at least some firms that will increase the value of dividends distributed as a result of the increased FCF due to lower tax rate.  

For PE style valuation approaches, E will rise but attaching franking will decline. You will need to make assumptions regarding distributions, changes in ROE and cash requirements. It probably won't change the P/E materially in absolute or relative terms. 

Now, if you are in a marginal position where the retained profit is marginal or earnings exceed cashflow, the right thing to do is use option based valuation scenarios.  Good luck with that.

Overall, it's not a game changer.

3. Those with a clear delineation between their ability to pay franking credits (ie.profitable and FCF sufficient to meet their ideal dividend policy) and those that can't.  They are easiest to value.  Everything else is full of wobbles and you'd just have to pull a number out of someplace where the sun doesn't shine...much.

4. You cannot attach more franking credits to a distribution than the franking rate associated with the dividend as implied by the tax rate.  You cannot over distribute.  However, there are funky-called-medina methods for extracting more franking credits than might be implied from continuing a standard dividend policy, but that requires various unusual steps that manipulate the balance sheet quite a bit.  However, it can be done.

Cheers


----------



## craft

DeepState said:


> 1. Get your point, *but 70/100*28.5 = 19.95?* [1/.715*70-70=27.9 The net dividend will be 70K; grossed up will be 97.9K; Franking credit and hence debit to the company’s franking account will be 27.9K] Hence, if the company can only distribute $19.95 million if the Net free cashflow before dividend payments are $70m.  This assumes all financing activity has been considered (ie. repurchase plans etc).  This also assumes that there are retained profits or unrealized capital gains availalable on balance sheet.
> 
> 2. *If you are doing DCF, you will get more cash due to lower tax rate*.  This may or may not lead to capital drain due to increase in acquisitions, capex, working capital etc. that may result from a reduction in tax rate leading to more business activity.  You also need to make a separate assumption about franking being released with FCF which does not have to equal that which would be attached if the full dividend amount equaled FCF.  If you are using EVA style analysis, for example, FCF is calculated as if the whole company was financed using equity and thus FCF in reality for a the levered alternative will differ from this style of valuation.
> 
> If you are using DDM, you can assume an attaching franking credit to each dividend and discount this.  You would possibly expect an increase in dividends as there is more cashflow as a result of lower tax.  If the payout ratio is less than 100%, then any business changes emanating from the tax reduction ought not impact on the ability to pay the dividends and, if the pay-out policy of the company is unchanged in dollar terms, all that changes is a reduced valuation for franking credits. In reality, there will be at least some firms that will increase the value of dividends distributed as a *result of the increased FCF due to lower tax rate*.
> The majority if not all ASX listed company’s paying dividends will be subject to the PPL levy. Despite the lower tax rate of 28.5% the cash flow doesn’t change because they have to pay the 1.5% levy. Changes in FCF only applies to companies with a sub 5M NPAT.
> 
> For PE style valuation approaches, E will rise but attaching franking will decline. You will need to make assumptions regarding distributions, changes in ROE and cash requirements. It probably won't change the P/E materially in absolute or relative terms.
> 
> Now, if you are in a marginal position where the retained profit is marginal or earnings exceed cashflow, the right thing to do is use option based valuation scenarios.  Good luck with that.
> 
> Overall, it's not a game changer.
> 
> 3. Those with a clear delineation between their ability to pay franking credits (ie.profitable and FCF sufficient to meet their ideal dividend policy) and those that can't.  They are easiest to value.  Everything else is full of wobbles and you'd just have to pull a number out of someplace where the sun doesn't shine...much.
> 
> 4. You cannot attach more franking credits to a distribution than the franking rate associated with the dividend as implied by the tax rate.  You cannot over distribute.  However, there are funky-called-medina methods for extracting more franking credits than might be implied from continuing a standard dividend policy, but that requires various unusual steps that manipulate the balance sheet quite a bit.  However, it can be done.
> 
> I'm wondering if they will amend legislation to allow the franking at a higher rate when the rate drops to 28.5% to avoid this stranding effect.
> 
> If nothing is done legislatively, things like existing size of retained earnings account, excess FCF to NPAT etc  come into play to provide flexibility to release all franking credits.  Game changer - probably not - opportunity before the market fully reacts - maybe
> Cheers




....


----------



## DeepState

.... Get your point, but 70/100*28.5 = 19.95? [1/.715*70-70=27.9 The net dividend will be 70K; grossed up will be 97.9K; Franking credit and hence debit to the company’s franking account will be 27.9K]

Now I actually get your point.  I was just kidding before.. Misread your statement.

Ran some figures using your scenario comparing the former and proposed tax regime for 100 Before Tax with full payout of FCF. New regime includes PPL levy for reasons you have mentioned.

Tried different (zero and positive 2% and 5%) growth rates and used a discount rate of 10% via gross-up dividend discount model.

Basically the difference caused by the new regime is -2% relative to pre-change valuation.  This is essentially the effect of reduced franking credits (28.5% vs 30%) attaching to any dividend.  If a company is growing or at zero growth rate, it is paying out all of the franking it can.  Although stranded franking exists, this component is not worth anything under these scenarios because they get pushed out to infinity...they simply can't be paid under normal circumstances.  There are ways, as you have noted, that FCF might be engineered to be higher than NPAT, but distributions must be from retained profit and unrealized capital gains which imposes a limitation to the concept.


.....I'm wondering if they will amend legislation to allow the franking at a higher rate when the rate drops to 28.5% to avoid this stranding effect.

Don't know, but I personally doubt it.  Franking does not exist in other jurisdictions of note.  It is regarded as an anachronism.  The direction of movement is towards removal of franking in favour of a low company tax rate to make the company tax system competitive in a world sense.  At present the Budget papers have indicated that all future dividends will have franking at 28.5% and all existing franking balances will also be amended to that figure.  The recent developments here can be seen in the light of movement to international competitiveness, albeit that the corporate tax rates plus levy for large companies did not move down, although smaller companies did benefit in net terms. 


....opportunity before the market fully reacts - maybe 

Could be, I guess.  30% of the market assigns no value to franking at all (overseas).  A further 30-40% are in the professional market but compete largely on pre-tax terms or simply index  Maybe retail and HNW will move it to some degree, but it will be balanced off by others.  Ultimately, the full adjustment as calculated above will likely not be realized.


Cheers


----------



## McLovin

DeepState said:


> Don't know, but I personally doubt it.  Franking does not exist in other jurisdictions of note.  It is regarded as an anachronism.




I agree it's unlikely. This always looked to me like a neat back handed dividend tax that would (and has) largely go un-noticed. There is a fairly strong argument to move away from imputation. If personal tax rates keep rising and the company tax rate keep falling it's going to increase the already large motivation to corporatise personal income. The current system is extremely generous by global standards, especially around super funds.


----------



## Ves

DCF Question for Craft / RY and others.   I could be having a silly moment, so feel free to slap me. 

I was wondering how others are factoring the cost of growth into their DCF valuations.    Obviously growth is not free,  and only increases the net present value of the company if future profitability (ie. return on invested capital) is in excess of the cost of capital required for that growth.

I am ignoring that growth can also come from improving efficiency on already owned assets for this example.   And a lot of other things (ie. debt finance, share dilution).

Here are two valuations  A & B.  Exactly the same assumptions (as listed below) for each valuation.

Hopefully calculations are mathematically sound.

Both Companies (same assumptions)								

Net Invested Assets - $500.00						
Return on Invested Capital - 20% pre-tax					
Reinvestment Rate - 50%						
Cost of Capital - 11%    -   used for the discount rate						

*Valuation A	* 

Year 	Before Tax FCF	  Growth
1	$100.00	
2	$110.00	           10.00%
3	$121.00	           10.00%
4	$133.10	           10.00%
5	$146.41	           10.00%
TV	$1,331.00	

Discount Rate	11.00%

NPV	$1,232.29

*Valuation B	* 

Sorry about the messy columns, pasting from Excel was not kind to me... hope you can read them  (FCF  / Growth Rate / Reinvestment / Dividend)


Year 	Before Tax FCF	Growth	Reinvestment 	Dividend
1	$100.00		                $50.00	        $50.00
2	$110.00	       10.00%	$55.00	        $55.00
3	$121.00	       10.00%	$60.50	        $60.50
4	$133.10	       10.00%	$66.55	        $66.55
5	$146.41	       10.00%	$73.21	        $73.21
TV	$1,331.00		

Discount Rate	11.00%		

NPV	$1,011.09	

In Valuation A -   the NPV is calculated based on the Before Tax FCF.     

The Terminal Value is the 5th year Before Tax FCF /  the discount rate.       After year five the company is not expected to grow.  ROIC will revert to the cost of capital. It is a perpetuity.  A perpetuity obviously has it's own embedded assumptions (assume a company will never fold at your own peril) but that is most likely a different conversation unless you think there is something relevant to the cost of growth that I am missing. Used simply for the sake of comparison.

In Valuation B - the NPV is calculated based on the dividends paid (or distributed cash flow, no reinvested cash flows are included).

The Terminal value is the same as Valuation B. Same assumptions. Company will be stable.

Which valuation do you believe is most suitable?

If my example needs more complication, feel free to add it.   I've made it as simple as possible.


----------



## craft

Ves said:


> DCF Question for Craft / RY and others.   I could be having a silly moment, so feel free to slap me.
> 
> I was wondering how others are factoring the cost of growth into their DCF valuations.    Obviously growth is not free,  and only increases the net present value of the company if future profitability (ie. return on invested capital) is in excess of the cost of capital required for that growth.
> 
> I am ignoring that growth can also come from improving efficiency on already owned assets for this example.   And a lot of other things (ie. debt finance, share dilution).
> 
> Here are two valuations  A & B.  Exactly the same assumptions (as listed below) for each valuation.
> 
> Hopefully calculations are mathematically sound.
> 
> Both Companies (same assumptions)
> 
> Net Invested Assets - $500.00
> Return on Invested Capital - 20% pre-tax
> Reinvestment Rate - 50%
> Cost of Capital - 11%    -   used for the discount rate
> 
> *Valuation A	*
> 
> Year 	Before Tax FCF	  Growth
> 1	$100.00
> 2	$110.00	           10.00%
> 3	$121.00	           10.00%
> 4	$133.10	           10.00%
> 5	$146.41	           10.00%
> TV	$1,331.00
> 
> Discount Rate	11.00%
> 
> NPV	$1,232.29
> 
> *Valuation B	*
> 
> Sorry about the messy columns, pasting from Excel was not kind to me... hope you can read them  (FCF  / Growth Rate / Reinvestment / Dividend)
> 
> 
> Year 	Before Tax FCF	Growth	Reinvestment 	Dividend
> 1	$100.00		                $50.00	        $50.00
> 2	$110.00	       10.00%	$55.00	        $55.00
> 3	$121.00	       10.00%	$60.50	        $60.50
> 4	$133.10	       10.00%	$66.55	        $66.55
> 5	$146.41	       10.00%	$73.21	        $73.21
> TV	$1,331.00
> 
> Discount Rate	11.00%
> 
> NPV	$1,011.09
> 
> In Valuation A -   the NPV is calculated based on the Before Tax FCF.
> 
> The Terminal Value is the 5th year Before Tax FCF /  the discount rate.       After year five the company is not expected to grow.  ROIC will revert to the cost of capital. It is a perpetuity.  A perpetuity obviously has it's own embedded assumptions (assume a company will never fold at your own peril) but that is most likely a different conversation unless you think there is something relevant to the cost of growth that I am missing. Used simply for the sake of comparison.
> 
> In Valuation B - the NPV is calculated based on the dividends paid (or distributed cash flow, no reinvested cash flows are included).
> 
> The Terminal value is the same as Valuation B. Same assumptions. Company will be stable.
> 
> Which valuation do you believe is most suitable?
> 
> If my example needs more complication, feel free to add it.   I've made it as simple as possible.




I think your NPV calc is a bit wonky so couldn't recreate exactly  – but I think I still get what you are asking and my answer is defiantly B.

Valuation A counts the growth in the first 5 years twice as your terminal value calculation includes that growth and doesn’t acknowledge the cash flow distributed after paying for growth.

Do you see it or do you want me to expand.


----------



## McLovin

Hi V

There's two streams you need to worry about...

a) the dividends being paid and their present value

b) the ending cash flow, and it's terminal value.

In your valuation A, it doesn't look like you've included the value of the dividends being paid to you, which of course do have value! ETA: I'm actually a little confused how you've reached NPV for both, although it looks like you might not have discounted TV, which occurs at the end of year 5.


Here's a quick example I just put together. Maybe it will help...


----------



## luutzu

McLovin said:


> Hi V
> 
> There's two streams you need to worry about...
> 
> a) the dividends being paid and their present value
> 
> b) the ending cash flow, and it's terminal value.
> 
> In your valuation A, it doesn't look like you've included the value of the dividends being paid to you, which of course do have value! ETA: I'm actually a little confused how you've reached NPV for both, although it looks like you might not have discounted TV, which occurs at the end of year 5.
> 
> 
> Here's a quick example I just put together. Maybe it will help...
> 
> View attachment 58048





I think you guys are being too clever.. I don't mean that as an insult, but I think your approach is a bit fanciful and extreme.

I understand it's precise and scientific or whatever "proper" finance is... but you are applying a precise value to something that cannot be predicted with any precision.

How do you know the company will grow at g? then at g2?

How do you know it will pay dividends, and its dividends will be at x growing at g in the future? That it could earn and pay dividends from net profit and not borrowed cash to keep you guys happy?

And why do you separate dividends from total net earnings: the company actually earn both the dividends and also what it kept back, right?  And if its dividend policy is reasonable, intelligent: that it does try to keep the institutionals and some investors happy so have to pay dividends, but not just pay even when it can't afford it or when it could clearly invested it at a higher rate thereby profit the owners more etc etc...

Why are you setting the terminal value at 2 or 5 or 10 years? Will that be when you plan to sell the stock?

Anyway, if any of your estimates on the variables above are a slight fraction off, the value of the company will be off.


----------



## craft

luutzu said:


> I think you guys are being too clever.. I don't mean that as an insult, but I think your approach is a bit fanciful and extreme. There is a learning curve, but eventually it's simple and profitable.
> 
> I understand it's precise and scientific or whatever "proper" finance is... but you are applying a precise value to something that cannot be predicted with any precision. Nobody here after precision.
> 
> How do you know the company will grow at g? then at g2? If you can't make assumptions about future growth and whether that growth will be profitable or not - walk away.
> 
> How do you know it will pay dividends, and its dividends will be at x growing at g in the future? That it could earn and pay dividends from net profit and not borrowed cash to keep you guys happy? Not interested in dividends per say- interested in discretionary free cash flow - if you think we are just interested in dividends you have misunderstood
> 
> And why do you separate dividends from total net earnings: the company actually earn both the dividends and also what it kept back, right?  And if its dividend policy is reasonable, intelligent: that it does try to keep the institutionals and some investors happy so have to pay dividends, but not just pay even when it can't afford it or when it could clearly invested it at a higher rate thereby profit the owners more etc etc... Um ??? see above.
> 
> Why are you setting the terminal value at 2 or 5 or 10 years? Will that be when you plan to sell the stock? We don't - Ves stated perpetual (with all the disclaimers about doing so) in his exercise.
> 
> Anyway, if any of your estimates on the variables above are a slight fraction off, the value of the company will be off. What do you suggest other than making assumptions about the variables that drive valuation?



....


----------



## Ves

craft said:


> I think your NPV calc is a bit wonky so couldn't recreate exactly  – but I think I still get what you are asking and my answer is defiantly B.






McLovin said:


> In your valuation A, it doesn't look like you've included the value of the dividends being paid to you, which of course do have value! ETA: I'm actually a little confused how you've reached NPV for both, although it looks like you might not have discounted TV, which occurs at the end of year 5.
> 
> 
> Here's a quick example I just put together. Maybe it will help...
> 
> View attachment 58048



Hi guys,   thanks for the replies.

My apologies but it looks like the formatting of my original post has caused a bit of confusion.   McLovin,  how do you take a screenshot of the Excel cells like that?   Would be very helpful by the looks of it. I'm using Excel 2010 here at work,  think it's 2007 at home.

I'll try again with the table function on the forum (which is time consuming, and hard to use if you're not used to it!).    Here is valuation B again,  since it is, we agree,  the most suitable for the exercise.


YearFCFGrowthReinvestmentDividend1$100.00$50.00$50.002$110.0010.00%$55.00$55.003$121.0010.00%$60.50$60.504$133.1010.00%$66.55$66.555$146.4110.00%$73.21$73.21TV$1,331.00

The Terminal Value is just the 5th year cash flow of $146.41  divided by the discount rate of 11%.

Discounting back the dividends paid in years 1 to 5, and the terminal value from year 5,   I get an NPV of $1,011.09.

Looks like we have different dividends and that is the reason for a different NPV.   To achieve 10% growth at 20% ROIC they would need to reinvest 50%  (10% growth / 20% ROIC) of FCF (assuming that they are not using any other source of funds).  Therefore the payout ratio is 100% - 50% = 50%. 

Hopefully my calculations are correct,   and it was just the way that I presented the information that caused the confusion.

I will post some more later in the day,  but thank you both for clarifying that it is Valuation B.  Yes I do see that valuation A is double counting the growth.  There are a lot more considerations that I would like to explore if that is OK.


----------



## Ves

PS: In my original post I said pre-tax FCFF,   and it turns out my calculations ignore tax,  so they're obviously based on after-tax FCFF.   An oversight that probably does not detract from the exercise,   but a very important one in practice.

I am still a bit torn on whether to do valuations based in before tax or after tax dollars,   and confused how franking credits would come into the valuation?  What impact does this have on the valuation?   Surely the discount rate would need to be adjusted to take the tax into account as well.

Other things to consider -  as craft mentioned it's the amount of discretionary FCFF that needs to be considered.  You need to value the whole enterprise,  so the impact of any debt needs to be included.

Discretionary FCFF in my opinion should include any cash flow that is a) paid as a dividend b) used to repay debt principle c) is retained as cash reserves (ie. it is not used for growth and may be distributed in later years).  The dividend probably only tells part of the story in some cases.

I guess what I am saying is that FCFF _less_ funding required for any forecast growth (working capital impacts need to be also considered too) is discretionary cash flow and this is what you include in your valuation at NPV?


----------



## McLovin

Ves said:


> Looks like we have different dividends and that is the reason for a different NPV.   To achieve 10% growth at 20% ROIC they would need to reinvest 50%  (10% growth / 20% ROIC) of FCF (assuming that they are not using any other source of funds).  Therefore the payout ratio is 100% - 50% = 50%.




Sorry, ignore my dividends, they're wrong! For some reason I did FCF*0.2*0.5=Dividend. Based on the simplicity of the assumptions in your example, it would seem the easiest way to approach it is to think of it like a savings account; in order to grow tomorrow's interest income you have to reinvest some of that interest today.

I used a Mac to create that sheet. I like the screeenshot simplicity but hate everything else about their spreadsheet program! FWIW, if I'm using Windows then Snagit is pretty good.


----------



## luutzu

craft said:


> ....





I've seen CFO and Finance Managers struggling to get enough data from their own company to know their company's income and expense each quarter... and it's just one division. For an outsider to try and predict profit, growth.... not saying it can't be done, but saying maybe that brainpower should be put to better use.

Maybe i'm just too simple but I just assumes that companies will have to pay taxes, pay interests, their properties will depreciate... and the future, given where they are in the industry, they are most likely to do business in the next few years as they have been the past few years... that with their financial and competitive position, they'll grow, and maybe grow at a faster and slower rate than previous given general business cycle, given initial costs in certain r and d etc... 

So, in not being smart enough, i'll ignore future positions.. .just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on. 

And next year or next two years, i'll take another look and see how the business is doing, then repeat.

I think you might be putting too much faith in accounting and finance and not enough in the business.


I built a house frame once. You should've seen how precise my roof pitch was. The angles and struts were placed with computer guided, laser measured precision... then a real pro turned up and knock the whole roof together using a tape measure and couple of sticks at each end... not as pretty as mine but you know, holds the roof up and done in a couple of days.


----------



## craft

luutzu said:


> I've seen CFO and Finance Managers struggling to get enough data from their own company to know their company's income and expense each quarter... and it's just one division. For an outsider to try and predict profit, growth.... not saying it can't be done, but saying maybe that brainpower should be put to better use.
> 
> Maybe i'm just too simple but I just assumes that companies will have to pay taxes, pay interests, their properties will depreciate... and the future, given where they are in the industry, they are most likely to do business in the next few years as they have been the past few years... that with their financial and competitive position, they'll grow, and maybe grow at a faster and slower rate than previous given general business cycle, given initial costs in certain r and d etc...
> 
> So, in not being smart enough, i'll ignore future positions.. .just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on.
> 
> And next year or next two years, i'll take another look and see how the business is doing, then repeat.
> 
> I think you might be putting too much faith in accounting and finance and not enough in the business.
> 
> 
> I built a house frame once. You should've seen how precise my roof pitch was. The angles and struts were placed with computer guided, laser measured precision... then a real pro turned up and knock the whole roof together using a tape measure and couple of sticks at each end... not as pretty as mine but you know, holds the roof up and done in a couple of days.




You are asserting things about us that are not correct to launch your attack on how we overcomplicate things. We are not interested in quarterly detail etc just the divers of long term valuation.

That nothing will change is in itself an assumption - Do you realise how many of those nothing will change assumptions are imbedded in a static earnings power calculation and how few companies such a valuation method is suitable for? How many of those price is 'approximately good enough' are a result of true under valuation or mis-valuation by you? 

Accounting is just the language - estimating a valuation is a small end of process part of the picture. The entire focus is the business, despite what you may assert about our approach.


----------



## Ves

Ves said:


> I am still a bit torn on whether to do valuations based in before tax or after tax dollars,   and confused how franking credits would come into the valuation?  What impact does this have on the valuation?   Surely the discount rate would need to be adjusted to take the tax into account as well.




OK,  another example to demonstrate what I mean by this. Here is how _I think_ it works.  Would be happy to see what others think.   One valuation is based on pre tax cash flows,  one is post tax cash flows.  Say I want a 15% return before tax.   If I am on 30% marginal tax rate in my own name that is 10.5% after tax.

Assumptions 

Company tax rate is 30%  (this includes 28.5% tax + 1.5% PPL Levy).
Net Invested Assets - $1.00	
Return on Invested Capital	- 28.57% pre-tax
Return on Invested Capital	-20%	 after-tax
Growth years 1-5 - 10%
Reinvestment Rate - 50%	

Same as my last example.  The company becomes stable after year 5.  All free cash flow is paid out as dividends.

Valuation


YearBefore Tax FCFTaxFCF After TaxGrowthReinvestmentDividendFranking Credits 28.5%Total Dividend1$0.286$0.086$0.20$0.10$0.10$0.041$0.1412$0.314$0.094$0.2210.00%$0.11$0.11$0.045$0.1553$0.346$0.104$0.24210.00%$0.121$0.121$0.049$0.1704$0.380$0.114$0.26610.00%$0.133$0.133$0.054$0.1875$0.418$0.125$0.29310.00%$0.146$0.146$0.06$0.206TV$0.42$0.171$0.591TV$4.00$3.94

Before Tax NPV  $2.78   (discount rate 15.00%)
After Tax NPV $2.88    (discount rate 10.50%)

As I expected the valuations should either be exactly the same or at least very close.   

I am not sure why the After Tax NPV is 3.6% or $0.10 higher.  I assume that it has to do with the difference between 28.5% and 30% and the effect on the discount rate....


----------



## McLovin

luutzu said:


> just* look at the current earning power, projected into infinity* at my cost of capital... and if the price is approximately good enough, i'll take it else move on.




(my bolds)

This is a pretty absurd statement given what you seem to be saying about forecasting anything

Projecting to infiinity at any point in the earning cycle other than dead centre will produce useless results. Take a look at mining services for a real world example.


----------



## craft

Ves said:


> OK,  another example to demonstrate what I mean by this. Here is how _I think_ it works.  Would be happy to see what others think.   One valuation is based on pre tax cash flows,  one is post tax cash flows.  Say I want a 15% return before tax.   If I am on 30% marginal tax rate in my own name that is 10.5% after tax.
> 
> Assumptions
> 
> Company tax rate is 30%  (this includes 28.5% tax + 1.5% PPL Levy).
> Net Invested Assets - $1.00
> Return on Invested Capital	- 28.57% pre-tax
> Return on Invested Capital	-20%	 after-tax
> Growth years 1-5 - 10%
> Reinvestment Rate - 50%
> 
> Same as my last example.  The company becomes stable after year 5.  All free cash flow is paid out as dividends.
> 
> Valuation
> 
> 
> YearBefore Tax FCFTaxFCF After TaxGrowthReinvestmentDividendFranking Credits 28.5%Total Dividend1$0.286$0.086$0.20$0.10$0.10$0.041$0.1412$0.314$0.094$0.2210.00%$0.11$0.11$0.045$0.1553$0.346$0.104$0.24210.00%$0.121$0.121$0.049$0.1704$0.380$0.114$0.26610.00%$0.133$0.133$0.054$0.1875$0.418$0.125$0.29310.00%$0.146$0.146$0.06$0.206TV$0.42$0.171$0.591TV$4.00$3.94
> 
> Before Tax NPV  $2.78   (discount rate 15.00%)
> After Tax NPV $2.88    (discount rate 10.50%)
> 
> As I expected the valuations should either be exactly the same or at least very close.
> 
> I am not sure why the After Tax NPV is 3.6% or $0.10 higher.  I assume that it has to do with the difference between 28.5% and 30% and the effect on the discount rate....




V your franking credits look weird. 28.5% should be 1/.715xdividend-dividend.
Where you have the div of $0.42 shouldn’t that be the after tax amount of .293?

Anyways , using your assumptions I get FV$2.79 by using Pre tax FCF  and FV$2.73 by using the gross dividend flow. The difference is entirely the franking credit/levy issue.

I always use before tax and interest (i.e. eliminate the financial structure) to compare. I want to establish the best business not who's got the best tweaked financial structure - that's a minor(unless its tweaked to aggressively)  and later consideration.

The question to me is whether because of the PPL levy I should push up my pretax hurdle rate as less will now stick to my ribs and more to the governments. 

End of the day my decision was to stick with my current figure because the change is not that big and the hurdle really only comes into play for me if there is only one available investment and it’s just over the hurdle rate. Normally there is quite a few competing options all well above the hurdle rate.


----------



## Ves

craft said:


> V your franking credits look weird. 28.5% should be 1/.715xdividend-dividend.
> Where you have the div of $0.42 shouldn’t that be the after tax amount of .293?
> 
> Anyways , using your assumptions I get $2.79 by using Pre tax FCF  and $2.73 by using after tax dividend flow and the lower discount rate. The difference is entirely the franking credit/levy issue.




Agree with both - I divided by 0.7 out of habit,   and you are correct I forgot to take out the company tax on the terminal value. 



> I always use before tax and interest (i.e. eliminate the financial structure) to compare. I want to establish the best business not who's got the best tweaked financial structure - that's a minor(unless its tweaked to aggressively)  and later consideration.



I am (un)happy to admit that I have been using a model closer to Valuation A in my first post than Valuation B.

It makes some quite incorrect assumptions,  and if I'm not happy with it at all.   It's an on-going process to improve,  and obviously the more I contribute to my portfolio the bigger an issue it becomes.   So I'm dedicated to improving my technique.

I have been using EBIT as a starting point,  and working from there, making adjustments for certain non-cash items,  looking at cyclicality as best as I know how....  after reading a lot of "crap" valuations on blogs and forums,  and then comparing them to the work of authors like Damodaran, I decided that I definitely need to pay more attention to cost of growth (and factor that into my valuations) and considerations like  adjustments for working capital  (in some cases this offsets some or if you are really lucky a lot of the cost of growth,  in other it adds to it).

Obviously it is important to distinguish between growth from additional investments and growth from better operational efficiency / improvement from cyclical lows etc.



> The question to me is whether because of the PPL levy I should push up my pretax hurdle rate as less will now stick to my ribs and more to the governments.
> 
> End of the day my decision was to stick with my current figure because the change is not that big and the hurdle really only comes into play for me if there is only one available investment and it’s just over the hurdle rate. Normally there is quite a few competing options all well above the hurdle rate.



I agree that it looks fairly minor in its impact after playing around with some spread sheet calculations over the past few days.

Does your hurdle rate change over time? In particular,  for interest rate changes?


----------



## luutzu

McLovin said:


> (my bolds)
> 
> This is a pretty absurd statement given what you seem to be saying about forecasting anything
> 
> Projecting to infiinity at any point in the earning cycle other than dead centre will produce useless results. Take a look at mining services for a real world example.




It's just a mathematical representation of a known factor [earnings], and assuming it will do pretty similarly in the future... not literally saying it will be like so forever. 

If you do that, and revised your earnings, not revising your growth rate assumptions and kept the same earnings results, but earning stream only then when you see high probability of that earning changing for the company. It will be more accurate, and much simpler, than all the other assumptions about growth rate/s.


There's a 101 factors that could affect a company's growth rate... from inflation to changing climate to new political leaderships to interest rates to capital structure to customer tastes, new competition, management being bored... how anyone could think they can know the first stage, then the second stage of growth is quite amazing.

I mean, i can't even predict how my bank account will be like in next 3 or 5 years with any precision, let alone a multi million billion dollar enterprise. 


A business is not a dead asset. It's a living organism, operating in a constantly changing economic environment. And just because your estimates came true, it might not even came true because of the reasons and factors and weighing you use anyway.

Anyway, a matter of approach and capability i guess.

All i know, and can guess at, is that ey, i don't owe people money... i have and earn enough to pay the bills... i work hard, try to also build something i think will sell, and might sell well because i think it's quite valuable to people's needs... and so over the next few years, my bank account will be at least this much, could be a bit more... but when it will be that, not too certain.

I probably could draw you my account's growth rate, but that will depends on my mood... I might be depressed and assume it's all going to end... or be optimistic and say i'll take over the world. And i honestly can't tell you what mood i was in when i make those projections.


----------



## McLovin

luutzu said:


> It's just a mathematical representation of a known factor [earnings], and assuming it will do pretty similarly in the future... not literally saying it will be like so forever.




It's a completely rubbish representation that neither looks in the rear view mirror or the road ahead. It's just a static scenario that assumes the world stands still, and goes against virtually everything else you have said in your posts. If you can't at least make some base case assumptions then you're playing the wrong sport.

How well would your extrapolate to infinity approach have worked if you were buying in 2007?

There's so many snake oil salesmen out there who push these kind of holy grail formulas.


----------



## DeepState

luutzu said:


> So, in not being smart enough, i'll ignore future positions.. .just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on.




Presumably your cost of capital is something north of 8% or so.  Projected to infinity, that company and all others that you value which have positive earnings, individually, will dominate the world economy and eventually become indistinguishable from the world economy itself.  

Although estimation of value is not precise, this assumption is somewhat - shall we say - imprecise and not very smart.  Yet, it will dominate your entire valuation.  These are not firm foundations from which to pitch the arguments you have made.


----------



## luutzu

craft said:


> You are asserting things about us that are not correct to launch your attack on how we overcomplicate things. We are not interested in quarterly detail etc just the divers of long term valuation.
> 
> That nothing will change is in itself an assumption - Do you realise how many of those nothing will change assumptions are imbedded in a static earnings power calculation and how few companies such a valuation method is suitable for? How many of those price is 'approximately good enough' are a result of true under valuation or mis-valuation by you?
> 
> Accounting is just the language - estimating a valuation is a small end of process part of the picture. The entire focus is the business, despite what you may assert about our approach.




I'm not trying to attack you, i like you guys   We might even be friends one day.

And true, I haven't read all the to and fro so will not know the details... BUT

But i know what you guys are doing, and i wouldn't say wrong, but the benefit it brings isn't... isn't economical.


----------



## luutzu

McLovin said:


> It's a completely rubbish representation that neither looks in the rear view mirror or the road ahead. It's just a static scenario that assumes the world stands still, and goes against virtually everything else you have said in your posts. If you can't at least make some base case assumptions then you're playing the wrong sport.
> 
> How well would your extrapolate to infinity approach have worked if you were buying in 2007?
> 
> There's so many snake oil salesmen out there who push these kind of holy grail formulas.




The formula, the approach, is a simple ordinary annuity, extended to perpetuity... or  Ordinary Perpetuity. 

It's not snake oil salesmanship, it's taught in my finance and investment textbooks... ok, take that back 

The calculation is to find the value of an expected cashflow [ie Earnings], at a required interest rate, extending that to infinity [or a couple hundred years, depend on how precise you want]

ie. PV = lim(n to infinity) C/i   x [1 -  (1/(1+i)to n ]     (i checked with a textbook)

When you extend n far enough into the future,  (1/(1+i)to n  approaches zero... leaving you with PV = C/i

----------

Yes, the formula is static... But as i've said, you review and reappraise it when changes require you to... and when you reappraise, a static formula, applied as and when needed, is no longer static but adaptive.

What are we revising?

The C [the earning power]... and the i [our required rate of return].


You expect the company's C to grow, in general... if next year it doesn't grow by your i, you look at the business and see if that's just part of business... new investments that you are quite certain will add higher earning soon enough etc.

You look at your i... if you find a better opportunity, if your cost goes up...

and you adjust and reappraise your valuation accordingly.

---

So with PV = C/i.... your i is pretty static, relatively... but a company's earnings might not, and so it is really the only thing you look at.

If new products, new services, new market, better asset utlisation etc... If these and other factors have show signs of better earnings, higher C... your PV will change to a higher value accordingly... if C looks to be down for a foreseeable future, will this be the new normal, if so, what value would that be... and you make your buy/sell/hold decision accordingly


No one is suggesting you use this approach and go to sleep.

----

What the Discounted Cashflow, dividend and all the combinations are doing is trying to do the same thing, but trying to be smarter.

If you can do it, if you can accurately predict the impact of higher interest rates, impact of industry A impacting your company, impact of this and that... If you can predict these factors, and these factors' impact on your company's earnings, then yea, it's the best way and the right way to go about it.

I just don't think i could, so what i do is look at the company's financial position, competitive position, its ranges of earnings... and assume that with a strong structure and good product, it's going to be alright and earn me what it has... and if it were to earn me higher next year, i'll value it higher.

In other words, I can guess possible influence and impact of some variables, but i won't use them until they appear on the PL, balance sheet.

I could be wrong and too late of course... but it's better that i don't discount future losses or future gains when that future hasn't yet happen, or if happen, hasn't affect my holdings to a degree the world thought it will.

And to be safer, i'll pay at a lower price than my worst case scenario...

Could still be wrong, could be sitting outside forever... but this approach is no more or less accurate than your detailed discount approach, it's much simpler and force people to really know what it is they're owning, not be moved by the wind.


----------



## luutzu

DeepState said:


> Presumably your cost of capital is something north of 8% or so.  Projected to infinity, that company and all others that you value which have positive earnings, individually, will dominate the world economy and eventually become indistinguishable from the world economy itself.
> 
> Although estimation of value is not precise, this assumption is somewhat - shall we say - imprecise and not very smart.  Yet, it will dominate your entire valuation.  These are not firm foundations from which to pitch the arguments you have made.





7 or 8%, depends... could be 6 or 9...

But no, that's where i think there's a misconception about required rate of return and growth.

A required rate of return is return on capital, on equity, not growth in sales or growth in earnings by 8pc into infinity.

So if the company earn 8% next year... and kept it back, i expect it will reinvest that 8% and compound it at 8 or higher... if not, return to me, its owner in terms of dividends or whatnot so i can find other opportunities.

No company can grow sales, let alone earnings, by 8% or 10 or 20... and i don't expect companies i look at to do so.

So as long as the company keep its original equity [capital] base, its sales can be stagnant or grow with inflation and i get my required rate... and we're both happy.


It's insane to me that some analysts and fund managers expect a "growth" company to grow at 30% or 20% year on year and cut them when their industry is generally declining and they "only" grow by 18% in earnings, return only 40% on equity.

---

Maybe it's because the smart monies are paid to look and produce smart reports, maybe they're paid by the hour, or maybe they have too much data they think it's useful information.

I've done those long complicated calculations, I could even code and program it and be so precise it won't even round the decimals until the final result... that kind of precision is good to impress, but useless because the inputs are best guesses.


----------



## craft

luutzu said:


> But i know what you guys are doing, and i wouldn't say wrong, but the benefit it brings isn't... *isn't economical*.




You had me rolling round the floor in stiches with this one- you are so funny (but you probably don't even realise it)


----------



## craft

Ves said:


> Does your hurdle rate change over time? In particular,  for interest rate changes?



 Not really its been 15% pre tax for ages - but I don't use it as a discount rate - just the hurdle rate at which I would stay in cash rather then take a position.

Interest rates don't impact P/E's as much as I at least initially thought - most of the interest rate change is taken up in ERP's so have never needed to lower the 15% because of interest rates - If interest rates went high enough (like early 90"s) I would probably start ratcheting the hurdle up then.


----------



## Ves

craft said:


> Not really its been 15% pre tax for ages - but I don't use it as a discount rate - just the hurdle rate at which I would stay in cash rather then take a position.



OK,  this statement actually makes a lot of other things that you have previously said make sense to me.  I initially assumed (or misread) that your hurdle rate and discount rate were the same.

But what I do not understand is how you can have a different hurdle rate and discount rate in your valuation?   I am thinking that it possibly has to do with the IRR you complete on the cash flows.   Can you provide a little bit more information?   It's probably really obvious - sorry if I'm a bit slow.


----------



## craft

Ves said:


> OK,  this statement actually makes a lot of other things that you have previously said make sense to me.  I initially assumed (or misread) that your hurdle rate and discount rate were the same.
> 
> But what I do not understand is how you can have a different hurdle rate and discount rate in your valuation?   I am thinking that it possibly has to do with the IRR you complete on the cash flows.   Can you provide a little bit more information?   It's probably really obvious - sorry if I'm a bit slow.





So I Calculate an IRR for my potential investments [IRR is just the interest rate where the NPV for a series of cash flows including the initial outlay = zero] if say there is only two opportunities that I understand well enough to be comfortable making assumptions about and they came out at an IRR of 14% and 12%, I would take neither because they are both below my hurdle rate of 15% - back to the drawing board to look for a better opportunity or wait for a better price.

If however the two returns were 18% and 23% - I take the 23% - I don't take both just because they are both above my hurdle rate - Investments are always competing for a spot in my team - I only want the best of what I have looked into *and* they have to be above 15% otherwise I will stay liquid and do more searching or wait for better opportunity.

Have I helped explain it at all?

I just evolved using different terminology and approach but its no different then using a *fixed* discount rate and taking the biggest Margin of safety.


----------



## Ves

craft said:


> Have I helped explain it at all?
> 
> I just evolved using different terminology and approach but its no different then using a *fixed* discount rate and taking the biggest Margin of safety.




Yes,  that does make sense - the maths says that it is just a different way of completing the same calculation.   

The only "grey area",   and one that I am stilling working through myself is the terminal value.   

If you are using a perpetuity (or a number based on a proportion of a perpetuity) that includes a discount rate which is equal to the cost of capital,   wouldn't this effect the IRR?  Should the discount rate on the perpetuity be the hurdle rate?  There's a big difference for example  1  / 0.11  and 1 / 0.15 even if it is a far dated cash flow at the end of the calculations.

I guess what I am saying is that if your discount and hurdle rate are the same thing, then perhaps this isn't an issue?

Perhaps I am misinterpreting this part... please tell me if this is the case.


----------



## craft

Ves said:


> Yes,  that does make sense - the maths says that it is just a different way of completing the same calculation.
> 
> The only "grey area",   and one that I am stilling working through myself is the terminal value.
> 
> If you are using a perpetuity (or a number based on a proportion of a perpetuity) that includes a discount rate which is equal to the cost of capital,   wouldn't this effect the IRR?  Should the discount rate on the perpetuity be the hurdle rate?  There's a big difference for example  1  / 0.11  and 1 / 0.15 even if it is a far dated cash flow at the end of the calculations.
> 
> I guess what I am saying is that if your discount and hurdle rate are the same thing, then perhaps this isn't an issue?
> 
> Perhaps I am misinterpreting this part... please tell me if this is the case.




Seem to remember this discussion a few times now. 




craft said:


> Does post 21 or 40 in this thread help at all with your thinking?
> 
> You have to be incredibly careful with terminal values. You only have to change the inputs by small margins to produce any number you like. Consider that if future perpetual growth is 5% and future cost of capital is 9% then the terminal value multiple is 25. Changing those two variables by just one 1% can produce multiples from 16 to 50 times.
> 
> I prefer to discount only the cash flow horizon I can have some certainty about and then *calculate a terminal value based on the (then) replacement cost of tangible assets and possible some multiple of that if the business has a true sustainable competitive advantage*.


----------



## Ves

I understand that bit (or maybe I don't as well as I think I do - we will see).

Let's say as an example you decide that the net replacement costs of the assets is $200.

Let's say that at the end of the forecast period you calculate that the entity have $100 discretionary free cash flow per annum.

Then say you do not want to factor in any growth.   The range of your terminal value would between the net replacement cost of assets $200  and a perpetuity based on the cost of capital of 10%, which is $1,000.      However,  if the perpetuity is calculated at the hurdle rate of 15% it is $666.67.

If the company has a robust competitive advantage, and you believe it will out hold up for a long time,  the TV, as you said will be closer to the perpetuity than the net replacement cost of assets  (at least that is what I remember from our discussion via PM, that you alluded to in post 274).   I can find the wording if it helps?

Maybe it is a matter of technicality,  but wouldn't it have an impact on your thinking if the perpetuity was calculated on 10% vs 15%?  Like anything else is this just a judgment call?  Am I over-thinking this?


----------



## craft

Ves said:


> I understand that bit (or maybe I don't as well as I think I do - we will see).
> 
> Let's say as an example you decide that the net replacement costs of the assets is $200.
> 
> Let's say that at the end of the forecast period you calculate that the entity have $100 discretionary free cash flow per annum.
> 
> Then say you do not want to factor in any growth.   The range of your terminal value would between the net replacement cost of assets $200  and a perpetuity based on the cost of capital of 10%, which is $1,000.      However,  if the perpetuity is calculated at the hurdle rate of 15% it is $666.67.
> 
> If the company has a robust competitive advantage, and you believe it will out hold up for a long time,  the TV, as you said will be closer to the perpetuity than the net replacement cost of assets  (at least that is what I remember from our discussion via PM, that you alluded to in post 274).   I can find the wording if it helps?
> 
> Maybe it is a matter of technicality,  but wouldn't it have an impact on your thinking if the perpetuity was calculated on 10% vs 15%?  Like anything else is this just a judgment call?  Am I over-thinking this?




Yep your overthinking it and Yep it's judgement. Yet here's the ironic part, the judgement that simplifies everything and makes it all click into place will come from your current overthinking process.


----------



## luutzu

craft said:


> You had me rolling round the floor in stiches with this one- you are so funny (but you probably don't even realise it)




Na i know... i'm pretty good that way, haha

Anyway, from the notes in my finance textbook next to annuities, i wrote "Buffett's formula?"... then i went on ignoring it, got pretty close to full marks in the midterm, then my only HD at uni from this subject doing all these discounted cash flows.


----------



## Ves

craft said:


> Yep your overthinking it and Yep it's judgement. Yet here's the ironic part, the judgement that simplifies everything and makes it all click into place will come from your current overthinking process.



Maybe I am trying to make something, that in reality is fairly nebulous, situational,  and mostly entirely arbitrarily defined (ie.  it is more of an art) into something which can be distilled into a systematic application (scientific).   

That's probably a stupid idea -  because the more "unknown" it is the more I have to actively think about it each time I sit down and do a valuation,  whereas the more systematic it becomes,  the less thinking I will probably do.

Hmm.


----------



## craft

Ves said:


> Maybe I am trying to make something, that in reality is fairly nebulous, situational,  and mostly entirely arbitrarily defined (ie.  it is more of an art) into something which can be distilled into a systematic application (scientific).
> 
> That's probably a stupid idea -  because the more "unknown" it is the more I have to actively think about it each time I sit down and do a valuation,  whereas the more systematic it becomes,  the less thinking I will probably do.
> 
> Hmm.




V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic  - I just reckon you should ask how much money they have made *from the markets *before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.


----------



## craft

luutzu said:


> Na i know... i'm pretty good that way, haha
> 
> Anyway, from the notes in my finance textbook next to annuities, i wrote "Buffett's formula?"... then i went on ignoring it, got pretty close to full marks in the midterm, then my only HD at uni from this subject doing all these discounted cash flows.




So an assumption about Buffett and a Uni subject - Is that all you bring to the table? I reckon you have at least read RM's book? What else?


----------



## Ves

craft said:


> V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic  - I just reckon you should ask how much money they have made *from the markets *before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.



The thing that starts most of these dialogues (in my mind) and makes me pose questions (of myself and, then finally others) is because I get to the point where my natural tendency is to do just that _make things easier_ and I start making decisions by either routine or auto-pilot (they just are because that is how I do it).

Eventually it gets to the point where I realise that this is happening,  and I try to force myself to throw everything out the window and the start the thinking process all over again (which is much easier said than done if you have read anything about bias).   Usually the first sign of this is boredom - if you are bored, your mind is probably somewhere else,  and if it is somewhere else you are not thinking about what you are doing.

My natural mental tendency is law and order  (system / science), and everything progresses towards this, probably because that is how we are taught from a young age in the modern Western society...  but there is something else inside me that occasionally reminds me to actually _think_ and _question everything._  It is the creative side that can get easily suppressed.

You once posted that people should read widely,   and at the time I may have misinterpreted that,  but I find that I read more non-investment books than investment books these days.   And oddly enough, sometimes I will find things  (to do with mindset and actually thinking) that really help with investing.


----------



## McLovin

craft said:


> V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic  - I just reckon you should ask how much money they have made *from the markets *before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.




I actually used to think you had a very systematic approach, and would worry that my own "get a little wood on the ball" approach was too simple.


----------



## craft

McLovin said:


> I actually used to think you had a very systematic approach, and would worry that my own "get a little wood on the ball" approach was too simple.




Probably because I have spent a lot of time talking about the foundations rather then what I specifically do now.



> The Don also benefited from a regime of regular practice as shown by the famous exercise in developing ball-sense he undertook with the golf ball and cricket stump against the water tank. Bradman stressed that  “there is no substitute for hard work and practice if you want to be successful” in his own coaching manual.




Going out to get a "little wood on the ball" can result in either a century or a first ball duck. somewhat random from innings to innings but the career average is based on skill and preparation.


----------



## luutzu

craft said:


> So an assumption about Buffett and a Uni subject - Is that all you bring to the table? I reckon you have at least read RM's book? What else?




Buffett is on TV, and you have to trust people on TV, haven't you seen the Lego Movie? 

It's easy to fall in love with complicated formulae, and maybe it was just me but I was quite proud to be able to work out a beta result for CAPM. And with all these cash flows, how good it was to plug in a whole bunch of numbers and get a nice and neat "value"... and if I had stayed with the Masters degree, I would actually come to know what alpha is and how to model all these nonsense too. 

Like i said, if you're certain of the accuracy of all the factors in your model, it's the way to go. 
Just I doubt anyone could accurately estimate a company's CURRENT earning power, let alone know that and able to  predict other influences on the business.


----------



## craft

luutzu said:


> Buffett is on TV, and you have to trust people on TV, haven't you seen the Lego Movie?
> 
> It's easy to fall in love with complicated formulae, and maybe it was just me but I was quite proud to be able to work out a beta result for CAPM. And with all these cash flows, how good it was to plug in a whole bunch of numbers and get a nice and neat "value"... and if I had stayed with the Masters degree, I would actually come to know what alpha is and how to model all these nonsense too.
> 
> Like i said, if you're certain of the accuracy of all the factors in your model, it's the way to go.
> Just I doubt anyone could accurately estimate a company's CURRENT earning power, let alone know that and able to  predict other influences on the business.




Now you have lost me - are you making some assertion now about us using beta and CAPM? and whatis the reference to Buffett meant to mean?


----------



## luutzu

craft said:


> Now you have lost me - are you making some assertion now about us using beta and CAPM? and whatis the reference to Buffett meant to mean?




What i am saying is that Buffett is a very smart man, and as far as I can see, sounds like a very decent man too. 
When a person that smart, and that successful, tells you this is how he value a company... maybe there's something to it.

The guy doesn't use a computer, doesn't even have a calculator... and he's able to decide within a few minutes the value or businesses worth billions. 

How could he or anyone do that?

By having a computerised brain that can do your calculations, predict growth rates and forecast the future? That he's a "six sigma event" or take over companies and run its management?


These models you guys are using is based on the assumption that you could accurately predict the future... and by using a couple growth assumptions, a few scenarios, you get a few nice rounded figures and congratulate yourselves for knowing how this and that will impact this and that.

That's nice but that's no more simplistic than a "simple" perpetual annuity approach. 

But unlike the simple model of valuing a financial asset, your models are more dangerous because, among other things, you might not be aware that your growth forecasts and assumptions are influenced by general market or economic sentiments.. that and you seem to think that the reported earnings, averaged out or whatever, is the earnings and all you need to do to get an edge is to accurately predict the future and its impact on your company.

Me, i preferred to pay for what i see now... and if the future is brilliant, i'll pay an appropriate price for that brilliance when it happen... and if what i see now is pretty good but the world is saying it's going to end, well i don't know if that's the case so let's not bet on it.


And it could be just me again, but I find it pretty hard to know a business well enough to even have a reasonably confident idea of its earning power.

-----------

And yes, beta and CAPM is rubbish.
It's a bunch of complicated maths built on false foundation.

It's insane to say that in order to make more money, you have to take on more risk.

That's like telling a person that to make money, they have to go to the casinos, and bet all on black or something.

It occurs to a lot of ordinary people that gamblers lose money because they took on more risks by playing against the casino, and those who doesn't take risks gambling get to keep their money.. and those that put more thought into their work, take a few a risk as possible, actually make money out of it - at least more often than a risky gambler.

But let say CAPM is right on this risk-reward assumption. They're wrong in how they define risk.

An average person like myself would have thought that a risky business is one that doesn't make money, not ones whose market price fluctuate more than the averages of other businesses in a representative index.


----------



## craft

luutzu said:


> What i am saying is that Buffett is a very smart man, and as far as I can see, sounds like a very decent man too.



Yes he is - you should listen to him carefully. 

Everything written by Buffett in the Berkshire Hathaway Annual reports indicates that he simply uses the Present Value of Future Cash Flows to estimate Intrinsic Value.

Also see this link for some more information.

https://www.aussiestockforums.com/forums/showthread.php?t=20847&p=670773&viewfull=1#post670773



luutzu said:


> When a person that smart, and that successful, tells you this is how he value a company... maybe there's something to it.
> 
> ...............




Actually I'm wondering if a person who mis-asserts and mis-represents as the basis for telling us how to suck eggs warrants a point by point response (maybe somebody else has the patience) or if it would just be an exercise in futility.




luutzu said:


> And yes, beta and CAPM is rubbish.
> It's a bunch of complicated maths built on false foundation.
> 
> It's insane to say that in order to make more money, you have to take on more risk.
> 
> That's like telling a person that to make money, they have to go to the casinos, and bet all on black or something.
> 
> It occurs to a lot of ordinary people that gamblers lose money because they took on more risks by playing against the casino, and those who doesn't take risks gambling get to keep their money.. and those that put more thought into their work, take a few a risk as possible, actually make money out of it - at least more often than a risky gambler.
> 
> But let say CAPM is right on this risk-reward assumption. They're wrong in how they define risk.
> 
> An average person like myself would have thought that a risky business is one that doesn't make money, not ones whose market price fluctuate more than the averages of other businesses in a representative index.




Where in the world did we use or defend CAPM and Beta?


----------



## DeepState

Ves said:


> 1. Before Tax NPV  $2.78   (discount rate 15.00%)
> After Tax NPV $2.88    (discount rate 10.50%)
> 
> As I expected the valuations should either be exactly the same or at least very close.
> 
> I am not sure why the After Tax NPV is 3.6% or $0.10 higher.  I assume that it has to do with the difference between 28.5% and 30% and the effect on the discount rate....
> 
> 2. The only "grey area", and one that I am stilling working through myself is the terminal value.
> 
> If you are using a perpetuity (or a number based on a proportion of a perpetuity) that includes a discount rate which is equal to the cost of capital, wouldn't this effect the IRR? Should the discount rate on the perpetuity be the hurdle rate? There's a big difference for example 1 / 0.11 and 1 / 0.15 even if it is a far dated cash flow at the end of the calculations.
> 
> I guess what I am saying is that if your discount and hurdle rate are the same thing, then perhaps this isn't an issue?




_*From Craft: *_

_I always use before tax and interest (i.e. eliminate the financial structure) to compare. I want to establish the best business not who's got the best tweaked financial structure - that's a minor(unless its tweaked to aggressively) and later consideration.

 The question to me is whether because of the PPL levy I should push up my pretax hurdle rate as less will now stick to my ribs and more to the governments_


1. Although post-tax FCF is 0.7 x pre-Tax FCF, it is not the same thing as discounting post-tax FCF by an interest rate which is 0.7x the pre-tax interest rate.  Compounding effects do surprising things.  To see the fuller effect, do not assume the company stabilizes after five years and watch the valuations diverge materially.  The discount rates required to make these NPVs have the anticipated relationship changes depending on your reinvestment assumption.

One small wrinkle, I think Craft produced a valuation using pre-tax FCF and gross dividends using the pre-tax discount rate as is appropriate.  He found the ratio of valuations differed by a ratio of 1.5% attributable entirely to the value of the PPL.  The gross dividends in the growth phase, however, are not distributing full franking credits that accrued.  Allowing for this, the after tax valuation would then be a little further lower than the pre-tax valuation to allow for franking not distributed (and never will be distributed under these assumptions).

2. In the ultimate extension of valuation theory, you can vary your interest rate assumptions as things get more distant.  This is sometimes justified by observing that the bond yield curve, for example, has a non-linear shape.  Given the discount rate applicable to cashflows from bonds varies depending on the time they are expected to be received varies...why not equity valuations?  Errr.

If you apply a lower rate of capitalization to residual income than your hurdle rate, what you are saying is that, at terminal date, the market will value it as you have assumed...using a different discount rate than you want.  Nothing stops you from doing that, but I'm sure it's obvious to you that it is less conservative than just discounting all cashflow at your higher discount rate.  Changing this terminal discount rate will definitely impact your IRR as the terminal value will change with all else constant.

If you are using residual assets as terminal value, this might disfavor low capital businesses depending on how you might otherwise value their ongoing cashflow.  Again, in theory, the right thing to do is to figure out return on capital and fade it in to some cost of capital figure over some time frame.  Except, in low capital businesses, your assets are largely your people.  Hence, you need to...get this...convert your people into capital-like assets and account for them as such in ROIC type calculations.  In reality, terminal growth rates of 2-3% are used and you just test it to see if it is in your zone of cheapness.

Craft:  This is a problem with using pre-tax DCF.  On a net of tax basis, no adjustment would be required for your discount rate as the impact of the PPL is just an item that reduces discretionary FCF.  The switch between the tax mix worsens your after tax NPV as you would expect if the discount rate is held constant.  On a pre-tax basis, you continue to have the same FCF and, if you are thinking in pre-tax terms, this should just stay the same....but you know it isn't when it comes down to it. So I guess you should add some sort of 'fudge factor' to make allowance for it.

The general practice that I have seen is that these calcs are done on a full equity basis.  That is, you need to reorganize the company accounts to produce the after tax FCF as if the company had no leverage. Mostly, that involves adding back the cost of interest payments and adjusting tax paid accordingly. This accounts for differences in capital structure across companies. You then discount that figure with what you would like the company to return if you owned the entire share base which can include considerations of your own capital structure - ie. you can factor in your own leverage etc.  Because franking is a factor in Australia, you would also discount the value of franking to whatever degree you think is right for you (usually it is 60-100% to allow for the fact that not everyone values franking).


Cheers


----------



## luutzu

Sorry to say, but you're wrong. And if Buffett does what you are doing, he too is wrong.
And just to name drop, I remember reading/hearing an interview where Charles Munger said he never saw Buffett do a discounted cash flow model like the ones you guys are into.

I agree that yes, a company's value is the discounted present value of future earnings [net op. cash flow]... but that does not  mean I, and I bet you not Buffett or anyone who's a bit sensible, would take that to mean going ahead and predict what that future cash flow will precisely be, from now until eternity.

And if you can't possibly predict what that growth or earning to be over 5 or ten years, why in the world would you find it more precise to plug in assumed growths and impact of this and other policies and factors.

I'm no mathematician but i'm pretty sure that the more variables you use, the greater the IMprecision will be. Unless, of course, you get all those variables correct.

And we are talking about variables that depends on other variables, most of which the company has no control over, most of which no politicians or treasurer or Nostrodamus could foresee let alone estimate its ultimate impact on a company's growth.

Maybe you guys can predict the future, I know I can't.

---

I thought in your reply you believe in beta and CAPM.


----------



## McLovin

luutzu said:


> I agree that yes, a company's value is the discounted present value of future earnings [net op. cash flow]...




Given your vast repository of knowledge, I'm surprised you think earnings = net operating cash flow. Crack open those text books again, my friend. 

I really think you should read up on what you're saying because you have made a lot of very simple mistakes. Nothing wrong with that of course, I make them all the time, but you're on here telling everyone else they're wrong.

You never answered my question about how you're system would have fared in 2007, or with mining services stocks a couple of years back. The idea of jusy accepting today's earning at face value and extrapolating them to the end of time, and checking back in a couple of years if things don't work out would have had you shuffling down the footpath in your bathrobe and slippers.


----------



## DeepState

luutzu said:


> 1. When a person that smart, and that successful, tells you this is how he value a company... maybe there's something to it.
> 
> The guy doesn't use a computer, doesn't even have a calculator... and he's able to decide within a few minutes the value or businesses worth billions.
> 
> How could he or anyone do that?
> 
> 
> 2. These models you guys are using is based on the assumption that you could accurately predict the future... and by using a couple growth assumptions, a few scenarios, you get a few nice rounded figures and congratulate yourselves for knowing how this and that will impact this and that.
> 
> That's nice but that's no more simplistic than a "simple" perpetual annuity approach.
> 
> But unlike the simple model of valuing a financial asset, your models are more dangerous because, among other things, you might not be aware that your growth forecasts and assumptions are influenced by general market or economic sentiments..
> 
> ... that and you seem to think that the reported earnings, averaged out or whatever, is the earnings and all you need to do to get an edge is to accurately predict the future and its impact on your company.
> 
> 
> 3. Me, i preferred to pay for what i see now... and if the future is brilliant, i'll pay an appropriate price for that brilliance when it happen... and if what i see now is pretty good but the world is saying it's going to end, well i don't know if that's the case so let's not bet on it.
> 
> 
> 4. And it could be just me again, but I find it pretty hard to know a business well enough to even have a reasonably confident idea of its earning power.
> 
> 
> 5. An average person like myself would have thought that a risky business is one that doesn't make money, not ones whose market price fluctuate more than the averages of other businesses in a representative index.




Hi Luu


Here are my views on your comments:


1. He is able to make quick decisions because he knows several industries intimately and knows the characteristics of the companies he is looking for.  Then...he values them.  For him, price is very important.  Valuation relative to price is a measure of his safety margin.  So valuation is important.

Let's take a look at Page 17 of his latest annual report (Source: BRK-US)




Notice how he: 
+ normalizes earnings
+ forecasts productivity and crop prices
+ produced expectations for the future which were realized, but where earnings are definitely different to current, let alone normalized earnings.
+ uses a dcf approach.


2. No-one claims to be able to predict with extreme accuracy.  But if you happen to know that the forward curve for iron ore is going through the floor, wouldn't it be vaguely sensible to make even some allowance for it in your valuation of FMG-AU?  Anything would be more accurate than doing nothing.

Or, to make the point clearer, let's say FMG-AU was within 2 years of mine life left before it is moth-balled.  And you'd like to capitalize a perpetuity?

Or CSL-AU just licensed Gardasil a vaccine for HPV, something that every girl and now, pretty much every boy will need to take.  It had not achieved sales but has been approved for sale by the FDA, received CE mark and also TGA approval.  We are to make no allowance for this?

DCFs do not need to be complicated.  They permit the flexibility to take such things as above into account.  A perpetuity requires few assumptions.  Sometimes, where earnings are stable and growth is steady, a perpetuity type valuation might be appropriate.  However, only in extreme situations would an assumption of the same earnings being generated in perpetuity be any decent sort of representation for the company.  DCFs require more assumptions, but you'll find only a few matter and people focus on those.  

If you are going to run an annuity or run a DCF, a good place to start is some form of normalized earnings.  Hence the assumption load is pretty much identical for both practices.  Thereafter the assumptions differ.  If your future earnings stream is anything other than some form of simple compounding, then a DCF is superior to PE etc.

It is reasonably argued that any of those assumptions are hard to derive accurately.  But to suggest there is no better predictive ability than perpetuating a zero growth rate is unreasonable.  That zero growth rate assumption, simple and innocent as it may seem, will be wildly inaccurate for almost all companies.

It will lead you into situations like expensive depleting mines and prevent you from buying cheap rockets at their take-off point. That would not seem like a useful tool to apply to the task of investment.

While a DCF will be wrong, on average, it will be less wrong than a perpetuity calculated as you have done.

DCF is just a tool. It may, for some, be an edge.  Or it may support other decision processes to ensure that there is at least some measure of valuation support.  In either case, we would want the best tools available.  Perpetuity at zero growth would not form part of that tool kit.


3. The market is forward looking.  By the time you have revalued the firm using historical figures, the price has already moved to largely reflect it although some residual exists.  Of all the fundamentals you can think of, companies move most on the basis of near term changes in forecast earnings. You will not participate.


4. You need to do more research until you get comfortable, or otherwise realize you have no idea what this thing is worth and try to make money in ways other than knowing what a company's fundamental value is.  This is, actually, not entirely unreasonable.  But this point is besides the issue to hand which is the relative worth of valuations using annuities or DCF.  If you have no idea what earnings is, neither approach is likely to be of much use.  Most people do have some idea. And some idea is usually better than no idea.


5. Enron, Merrill Lynch, Lehman...all made money.  Whoops.

Watsapp...no earnings...USD 19bn...Whoops.

Risk is buying/holding a company for more than it is worth.  In order to assess this risk, you need to have a reasonable shot at figuring out what it might be worth.  Perpetuity and zero growth almost gives you zero chance of achieving this.  It's underlying assumptions are significantly flawed from the outset, which is made worse because there are so few assumptions available to be made in this approach.


Overall, valuation is hard and seeing the future is hard.  The difference in effort between producing an annuity style valuation and DCF is usually not that large in practice given sensitivities are concentrated into a small number of variables.  Yet an annuity which simply perpetuates a current earnings stream to infinity is approximating virtually no company on the market at all.  Flawed as this practice may be given uncertainty, a DCF can make at least some allowance for what is known in the market and adjust the earnings/FCF streams accordingly.  Such a valuation approach is unlikely to be inferior to a perpetuity at zero growth.


----------



## craft

DeepState said:


> 1. Although post-tax FCF is 0.7 x pre-Tax FCF, it is not the same thing as discounting post-tax FCF by an interest rate which is 0.7x the pre-tax interest rate.  Compounding effects do surprising things.  To see the fuller effect, do not assume the company stabilizes after five years and watch the valuations diverge materially.  The discount rates required to make these NPVs have the anticipated relationship changes depending on your reinvestment assumption. If the dividend is fully franked I don't see this - care to make the point with an example so I can grasp what you are getting at?
> 
> One small wrinkle, I think Craft produced a valuation using pre-tax FCF and gross dividends using the pre-tax discount rate as is appropriate.  He found the ratio of valuations differed by a ratio of 1.5% attributable entirely to the value of the PPL.  The gross dividends in the growth phase, however, are not distributing full franking credits that accrued.  Allowing for this, the after tax valuation would then be a little further lower than the pre-tax valuation to allow for franking not distributed (and never will be distributed under these assumptions). Agree with this - its basically the same as the levy issue.
> 
> Craft:  This is a problem with using pre-tax DCF.  On a net of tax basis, no adjustment would be required for your discount rate as the impact of the PPL is just an item that reduces discretionary FCF.  The switch between the tax mix worsens your after tax NPV as you would expect if the discount rate is held constant.  On a pre-tax basis, you continue to have the same FCF and, if you are thinking in pre-tax terms, this should just stay the same....but you know it isn't when it comes down to it. So I guess you should add some sort of 'fudge factor' to make allowance for it.
> 
> The general practice that I have seen is that these calcs are done on a full equity basis.  That is, you need to reorganize the company accounts to produce the after tax FCF as if the company had no leverage. Mostly, that involves adding back the cost of interest payments and adjusting tax paid accordingly. This accounts for differences in capital structure across companies. You then discount that figure with what you would like the company to return if you owned the entire share base which can include considerations of your own capital structure - ie. you can factor in your own leverage etc.  Because franking is a factor in Australia, you would also discount the value of franking to whatever degree you think is right for you (usually it is 60-100% to allow for the fact that not everyone values franking).
> 
> 
> Cheers




Yep agree that eliminating the interest and adjusting for the tax shield (NOPLAT) is a purer valuation of equity. Personally I'm still more happy to do most of my work at the EBIT level as I'm first and foremost interested in business analysis and I hadn't felt the need to continue to NOPLAT.  The PPL levy issue made me consider this again though as did your point above about franking credits that May not be distributed during a growth phase. 

Thanks for your post - always thought provoking.


----------



## luutzu

McLovin said:


> Given your vast repository of knowledge, I'm surprised you think earnings = net operating cash flow. Crack open those text books again, my friend.
> 
> I really think you should read up on what you're saying because you have made a lot of very simple mistakes. Nothing wrong with that of course, I make them all the time, but you're on here telling everyone else they're wrong.
> 
> You never answered my question about how you're system would have fared in 2007, or with mining services stocks a couple of years back. The idea of jusy accepting today's earning at face value and extrapolating them to the end of time, and checking back in a couple of years if things don't work out would have had you shuffling down the footpath in your bathrobe and slippers.




I have just recently read the textbook actually. And over time, a company's net operating cash flow should approximate its reported net earnings.   Do you want me to quote the textbook and page number?

I started investing around 2004, did OK but didn't really know what i was doing although any fool could have done well during those years... though 4 of my 5 stocks were taken over - Colorado, Coles, PHG [scaffolding company], Rio Tinto, but BHP weren't allowed by the European Union... so maybe i might have known a little of what i was doing.

and got completely smacked with the GFC while fully invested but my excuse was I was building a house, got a job to pay the loans... I know I wouldn't have seen it anyway if i were in the market.

----

I never said accepting today's earnings at face value and project it.
I'm saying that I would try to understand the company's business, its financial position, performance etc.. and from these try to see what its current earning power is... this could be the current year's, it could be what it had earned a few years' back before the boom... from these, I then discount into infinity... then repeat this next time there are material changes I can see happening to the company.

 Give you an example:





I don't need crazy forecasts to tell you in two seconds that company will either go broke or raise more equity in 2008-2009.


----------



## McLovin

luutzu said:


> I have just recently read the textbook actually. And over time, a company's net operating cash flow should approximate its reported net earnings.   Do you want me to quote the textbook and page number?




Net operating cash flow excludes non-cash items (like depreciation and amortisation) that net earnings do not. Your text book is wrong if it's saying the net ocf will approximate net earnings over time.

Anyway, you've got your system. Good luck with it. 

I'm taking a break for a while.


----------



## DeepState

luutzu said:


> I have just recently read the textbook actually. And over time, a company's net operating cash flow should approximate its reported net earnings.   Do you want me to quote the textbook and page number?




Luu

Although net earnings will converge to operating cashflow as reinvestment in the business ceases and the asset base is fully depreciated, that doesn't happen for businesses which are growing/shrinking their capital base for at least part of the forecast period.  Using the same discount rate, the discounted value of FCF will not equal that of net earnings.

McLovin was correct to say you can't just substitute one for the other. It only becomes right under a very special condition of zero reinvestment through the entire forecast horizon.

Cheers


----------



## DeepState

luutzu said:


> I have just recently read the textbook actually. And over time, a company's net operating cash flow should approximate its reported net earnings.   Do you want me to quote the textbook and page number?




Luu

Although net earnings will converge to operating cashflow as reinvestment in the business ceases and the asset base is fully depreciated, that doesn't happen for businesses which are growing/shrinking their capital base for at least part of the forecast period.  Using the same discount rate, the discounted value of FCF will not equal that of net earnings.

McLovin was correct to say you can't just substitute one for the other. It only becomes right under a very special condition of zero reinvestment commencing from a fully depreciated asset base through the entire forecast horizon.  Alternatively, it occurs when reinvestment matches depreciation over the horizon.

Cheers


----------



## luutzu

DeepState said:


> Luu
> 
> Although net earnings will converge to operating cashflow as reinvestment in the business ceases and the asset base is fully depreciated, that doesn't happen for businesses which are growing/shrinking their capital base for at least part of the forecast period.  Using the same discount rate, the discounted value of FCF will not equal that of net earnings.
> 
> McLovin was correct to say you can't just substitute one for the other. It only becomes right under a very special condition of zero reinvestment through the entire forecast horizon.
> 
> Cheers




Thanks. 

Yea, i don't mean that op cf will equal earnings, but i expect it to converge close to earnings but delayed. How many years behind earnings i guess will depends on the company i'm looking at. 

I'm not quite sure what i'll do with net op cf figures just yet. Intention was that it be one of the few factors to see if management is playing around with reported earnings... could also have some predictive use of future earnings.

-------

I don't think our approaches are that different.... just that you guys try to put a more concrete estimates on growth etc while i simply approximate and already include it in the C [earnings]. 

I think you've misunderstood that I make a zero growth assumption. Growth is already implied in the C/i... that I expect it to grow at least by i. And if next year or there about it grows i+x, or if its growth is i-x... that growth has nothing to do with my expectations, it's just what the business does.


Then there's the pure asset play, or dividend play and has little to do with earnings or growth.
Say a historically well run company, with strong and conservative capital structure, able management, doing great business but its industry is stablising [not booming]... if i feel its future is relatively good considering, that it won't go broke as far as i can tell, that it's still making sales and have enough cash... and paying a dividends yield of 8 or 9% on the market price. I wouldn't see much wrong with buying it and hope for the best.

Your farm example there agrees with my understanding more than you think.


----------



## luutzu

McLovin said:


> Net operating cash flow excludes non-cash items (like depreciation and amortisation) that net earnings do not. Your text book is wrong if it's saying the net ocf will approximate net earnings over time.
> 
> Anyway, you've got your system. Good luck with it.
> 
> I'm taking a break for a while.




Bruce Lee to Young Grasshopper:
"Don't think! Feeeeelll... It is like a finger pointing away to the Moon. [pag!] Don't con.cent.trate on the fing.ger or you will miss all that heavenly glor...rryyyy. Do you understand? [Grasshopper bow... pag!] Don't ever take your eyes off your opponent, even when you bowwwww..."

thanks man. You guys are alright.


----------



## DJG

8-9% dividend yield - you obviously don't expect much..


----------



## DeepState

luutzu said:


> Thanks.
> 
> 
> I think you've misunderstood that I make a zero growth assumption. Growth is already implied in the C/i... that I expect it to grow at least by i. And if next year or there about it grows i+x, or if its growth is i-x... that growth has nothing to do with my expectations, it's just what the business does.
> 
> Your farm example there agrees with my understanding more than you think.
> 
> 
> Post #364
> 
> The calculation is to find the value of an expected cashflow [ie Earnings], at a required interest rate, extending that to infinity [or a couple hundred years, depend on how precise you want]
> 
> ie. PV = lim(n to infinity) C/i x [1 - (1/(1+i)to n ] (i checked with a textbook)
> 
> When you extend n far enough into the future, (1/(1+i)to n approaches zero... leaving you with PV = C/i
> 
> 
> Post #365
> 
> But no, that's where i think there's a misconception about required rate of return and growth.
> 
> A required rate of return is return on capital, on equity, not growth in sales or growth in earnings by 8pc into infinity.
> 
> 7 or 8%, depends... could be 6 or 9...
> 
> But no, that's where i think there's a misconception about required rate of return and growth.
> 
> A required rate of return is return on capital, on equity, not growth in sales or growth in earnings by 8pc into infinity.
> 
> So if the company earn 8% next year... and kept it back, i expect it will reinvest that 8% and compound it at 8 or higher... if not, return to me, its owner in terms of dividends or whatnot so i can find other opportunities.
> 
> No company can grow sales, let alone earnings, by 8% or 10 or 20... and i don't expect companies i look at to do so
> 
> Post #386
> 
> I remember reading/hearing an interview where Charles Munger said he never saw Buffett do a discounted cash flow model like the ones you guys are into




Luu

Your understanding of required rate of return and growth are misconceived.

If you expect growth to equal your discount rate (" Growth is already implied in the C/i... that I expect it to grow at least by i") and discount it by the same discount rate and are using a discount rate like 8%, your company is worth infinity.  Your earnings will become the world economy as I said before.

You have misunderstood and misapplied a perpetuity model.  C/i  Is the present value of C into perpetuity if C does not change...zero growth. Check your text book and read it again. ("PV = lim(n to infinity) C/i x [1 - (1/(1+i)to n ] (i checked with a textbook)")

Buffett allows for growth.  Your model does not.  That's about the biggest difference imaginable for valuation purposes.  There is no more important factor than the assumed difference between perpetuity growth and discount rate.  "Your farm example there agrees with my understanding more than you think."...but your understanding is fundamentally inaccurate, he forecasts path ways that fade as opposed to extrapolates forever, allows for growth rates different to discount rates....each of these violates your understanding as documented in your posts and actions as similarly detailed.

If you want to persist with perpetuities for all companies despite the fact that this is far more inaccurate than even simple allowances for known factors that will effect earnings in the coming period, what you actually need is the Gordon Growth Model. PV = c x (g/(i-g)) where g is the growth rate.  *When g = 0, meaning no growth, the Gordon Growth model collapses into what you have been using to justify your valuations.  That's a pretty big error*.  *If you think that the rate of growth equals your discount rate ("Growth is already implied in the C/i... that I expect it to grow at least by i. " and where i is your "required interest rate") then if i=g and the present value goes to infinity.*

"No company can grow sales, let alone earnings, by 8".  Yet when you are using an required interest rate of "7 or 8%, depends... could be 6 or 9..."  it basically tells you that the growth rate that you assume must be different to the required discount rate and, yet, your current formulation makes no allowance for differences between your assumed growth rate and required discount rate.  Didn't this occur to you?

Luu...these are big errors. One possible reason your valuations make no sense to you and why you find no worth in pursuing more expansive approaches is that your approach is built from fundamental misconceptions from the outset.

Cheers


----------



## Ves

DeepState said:


> 1. Although post-tax FCF is 0.7 x pre-Tax FCF, it is not the same thing as discounting post-tax FCF by an interest rate which is 0.7x the pre-tax interest rate.  Compounding effects do surprising things.  To see the fuller effect, do not assume the company stabilizes after five years and watch the valuations diverge materially.  The discount rates required to make these NPVs have the anticipated relationship changes depending on your reinvestment assumption.
> 
> One small wrinkle, I think Craft produced a valuation using pre-tax FCF and gross dividends using the pre-tax discount rate as is appropriate.  He found the ratio of valuations differed by a ratio of 1.5% attributable entirely to the value of the PPL.  The gross dividends in the growth phase, however, are not distributing full franking credits that accrued.  Allowing for this, the after tax valuation would then be a little further lower than the pre-tax valuation to allow for franking not distributed (and never will be distributed under these assumptions).



Hi RY

Thank you for all of your posts.   I have read them, but so far haven't consumed them fully enough to warrant me to respond to a lot of the content.

However,  this part quoted above interests me.   So I experimented with the model in one of my previous posts (the one you quoted the results of with the pre-tax and post-tax calculations and franking credits, with the two discount rates).

And it appears that you are right,   the higher the amount of earnings reinvested that produces returns above the cost of capital / discount rate,  the bottom line after-tax NPV was higher than the before tax NPV.   However,  there is a point where if the payout ratio of dividends is increased the Before-tax NPV is higher than the After-Tax NPV.

It is possible that my model is based on an erroneous assumption  (ie.  the discount rates of 15% pre tax and 10.% after tax are not suitable) and that is the main cause of the differences in the observed results.

But what you say about compounding does make sense too.   Although,  I have not admittedly got my head around the whole thing yet.


----------



## craft

DeepState said:


> 1. Although post-tax FCF is 0.7 x pre-Tax FCF, it is not the same thing as discounting post-tax FCF by an interest rate which is 0.7x the pre-tax interest rate.  Compounding effects do surprising things.  To see the fuller effect, do not assume the company stabilizes after five years and watch the valuations diverge materially.  The discount rates required to make these NPVs have the anticipated relationship changes depending on your reinvestment assumption.




Hmmm You are right. Some sort of geometric thing going on with compounding maybe?

Do you know if there is a formula to calculate the right conversion given the reinvestment rate? My brain can't stretch far enough to work it out backwards.

Big thanks.


----------



## luutzu

DeepState said:


> Luu
> 
> Your understanding of required rate of return and growth are misconceived.
> 
> If you expect growth to equal your discount rate (" Growth is already implied in the C/i... that I expect it to grow at least by i") and discount it by the same discount rate and are using a discount rate like 8%, your company is worth infinity.  Your earnings will become the world economy as I said before.
> 
> You have misunderstood and misapplied a perpetuity model.  C/i  Is the present value of C into perpetuity if C does not change...zero growth. Check your text book and read it again. ("PV = lim(n to infinity) C/i x [1 - (1/(1+i)to n ] (i checked with a textbook)")
> 
> Buffett allows for growth.  Your model does not.  That's about the biggest difference imaginable for valuation purposes.  There is no more important factor than the assumed difference between perpetuity growth and discount rate.  "Your farm example there agrees with my understanding more than you think."...but your understanding is fundamentally inaccurate, he forecasts path ways that fade as opposed to extrapolates forever, allows for growth rates different to discount rates....each of these violates your understanding as documented in your posts and actions as similarly detailed.
> 
> If you want to persist with perpetuities for all companies despite the fact that this is far more inaccurate than even simple allowances for known factors that will effect earnings in the coming period, what you actually need is the Gordon Growth Model. PV = c x (g/(i-g)) where g is the growth rate.  *When g = 0, meaning no growth, the Gordon Growth model collapses into what you have been using to justify your valuations.  That's a pretty big error*.  *If you think that the rate of growth equals your discount rate ("Growth is already implied in the C/i... that I expect it to grow at least by i. " and where i is your "required interest rate") then if i=g and the present value goes to infinity.*
> 
> "No company can grow sales, let alone earnings, by 8".  Yet when you are using an required interest rate of "7 or 8%, depends... could be 6 or 9..."  it basically tells you that the growth rate that you assume must be different to the required discount rate and, yet, your current formulation makes no allowance for differences between your assumed growth rate and required discount rate.  Didn't this occur to you?
> 
> Luu...these are big errors. One possible reason your valuations make no sense to you and why you find no worth in pursuing more expansive approaches is that your approach is built from fundamental misconceptions from the outset.
> 
> Cheers




My required rate of return and the company's ability to meet or surpass it are independent.

If i am able to find investment opportunities that could return me that required rate, and keep on doing it, then yea, I might take over the world. But that's just what I planned to do, not what the companies i bought into could or would do.

Say I've done a great amount of work, know a very good amount about the company, its assets, position and all that... and figured it, right now or within a year or two, could earn $100 a year, very steadily, quite easily... and could continue to do that for a foreseeable future.

That means this company is paying its owner a coupon, an annuity, of $100 per year until the end of the world as far as i am concern.

My required rate, or my cost of capital or my opportunity costs etc... say that rate is 8% a year.

What would an asset that earns $100, return at my rate and do so for ever be worth?

100/0.08 = $1,250.


What is the current price its owners are asking?    the max i will go is around $1250, but depends on the strength and my best guesses, I could pay a bit higher [lowering my required rate because of more certainty or higher probability of real earning being more than $100]...

If it's asking at my value, I probably wouldn't pay for it, I'd preferred to pay lower [that's my margin of safety].

--------

Say I bought it... and over the next five years, there are no inflation etc... and the company pay all its earnings as dividend to me, the only owner. The company is then still valued by me to be $1250. 

It doesn't need to have its sales growth or its earnings growth by 8% to keep me happy... it just need to return at least that yield from the initial capital i put into it [the price i paid, or at least the initial value].

So the excess profit of 8% that i required, if returned to me, will become my problem and I will have to find another opportunity that could do 8% minimum.

If the company that i now own then earn 10% on its capital/equity, I hope it would keep the dividends and keep growing at that... and hope it continue to do so until its growth and its opportunities no longer able to do that... then return as dividends.


---

When you use the projected growth, stages of growth... It does not make sense to me because:

1. You are saying that the company's present value is from its earnings stream, and its earnings will grow at g rate up to 5 or 10 years, then at g2 until enternity... and by discounting these future earnings [growing at g, then g2]... and discount at rate r1, then r2... the present value of the company is X.


That, to me, is paying for a future that you cannot predict with any accuracy.

You guys are basically making assumptions about future earnings, then discount that future earnings growth assumptions back and value those assumptions.

What if your assumptions are too optimistic? What if it is right, but the timing is slightly off? 

------

So by me saying that growth is already implied in C, and growing at least by rate i.... I don't mean to say that C is to grow at rate i forever.

I mean that in the next couple of years, it could grow at i... then after that, I'll take a look again to see if it could still grow at i... and depends on my costs and greater expectations, depends on the company's earning capacity... if the C is bigger then, it will be more valuable... if lower, less valuable [assuming i is still the same]

--------

SUMMARY:

It makes no sense to me to say... this company is now earning $100... but this is to grow, given the industry, given its history, given inflation... will growth by 10% p.a.   So its prevent value is to discount $110 back one year at r1, plus discount [110x1.1] 2 years... and so on until the 10th year where it will grow at g2, but by then the costs of capital will be r2 and so you discount and so on...


It makes more sense to me, and probably make me richer, to ask this: from what i can figured, this company is earning $100 right now... i require 8%, is the present value [the price] being offered allow me to achieve that?

And again, I don't come to $100 earnings based on reported earnings.
That figure is where i will concentrate my efforts... the future can wait.

---

"The Warriors of old act only when it is profitable to do so;
"He only engage in battle when victory is all but guaranteed.
 - Sun Tzu.

You cannot make plans that says: I will whoop their hind if they first go to A, then act as B, then they will move to C then victory will be mine.  But if they move to A, then for strange reasons ignore B and move to B+1, then i'm wrong.

That's exactly what you guys are doing with detailed discounted cash flow modellings.


----------



## luutzu

DJG said:


> 8-9% dividend yield - you obviously don't expect much..




I actually found one    Think it was last October... probably was 7.5% dividend yield.
I put around 40% of my savings into it... don't want to go more in case the reports are wrong, or i might've missed something.


What are your plans with the website there?

A blog or newsletter/research service?


----------



## Ves

craft said:


> Hmmm You are right. Some sort of geometric thing going on with compounding maybe?
> 
> Do you know if there is a formula to calculate the right conversion given the reinvestment rate? My brain can't stretch far enough to work it out backwards.
> 
> Big thanks.



I've started some digging,  but most sources that I have found from the academic world seem to indicate that there is no reliable way of converting a post-tax discount rate into a pre-tax discount rate,  because there are too many variables to incorporate.

This paper is interesting,  written by Australians,  with some further resources in the bibliography that I haven't had the chance to locate.

http://kevindavis.com.au/secondpages/workinprogress/Pre and Post Tax Discount Rates.pdf

Damodaran seems to also stress post-tax cash flows in the writings that I have searched so far.


----------



## DeepState

luutzu said:


> My required rate of return and the company's ability to meet or surpass it are independent....
> 
> ....You cannot make plans that says: I will whoop their hind if they first go to A, then act as B, then they will move to C then victory will be mine.  But if they move to A, then for strange reasons ignore B and move to B+1, then i'm wrong.
> 
> "The Warriors of old act only when it is profitable to do so;
> "He only engage in battle when victory is all but guaranteed.
> - Sun Tzu.
> 
> That's exactly what you guys are doing with detailed discounted cash flow modellings.




All the best with that...err....I'm off this discussion thread too. Cheers.

"Very funny, Scotty. Now beam me down my clothes."
- Captain Kirk, Starship Enterprise

"He who laughs last thinks the slowest!"
- Anonymous discussant on ASF thread


----------



## craft

Ves said:


> I've started some digging,  but most sources that I have found from the academic world seem to indicate that there is no reliable way of converting a post-tax discount rate into a pre-tax discount rate,  because there are too many variables to incorporate.
> 
> This paper is interesting,  written by Australians,  with some further resources in the bibliography that I haven't had the chance to locate.
> 
> http://kevindavis.com.au/secondpages/workinprogress/Pre and Post Tax Discount Rates.pdf
> 
> Damodaran seems to also stress post-tax cash flows in the writings that I have searched so far.




Thanks for the link VES.


----------



## craft

DeepState said:


> All the best with that...err....I'm off this discussion thread too. Cheers.




I hope you are just knocking that discussion on the head and not the entire thread, Luutze is not representative of the normal discussion here. I and I'm sure others would like to see you stick around.


----------



## DeepState

craft said:


> I hope you are just knocking that discussion on the head




Just the discussion.

Let's consider the pre and post-tax valuation discount rates where there is no reinvestment.  In that circumstance the Pre-Tax cash flows will be 10/7 times Post-Tax flows and stay like that consistently.  The after tax PV (excluding franking here - as for an overseas company) is say, 70.  The pre-tax valuation = 10/7 x Post-tax valuation.  Now, what the heck interest rate gives you that effect? Now, the irony, let's say these two streams are perpetuities with zero growth. PV(AT FCF) = 70/i(after tax). PV (BT FCF) = 100/i(pre tax).  Then if PV(after tax)=PV(before tax) we get i(after tax) = 7/10 x i(pre-tax). Just as Ves expected.  

As soon as you add reinvestment, you have a problem.  If attempting a valuation under pre-tax terms, the valuation is mixed up.  You are discounting the pre-tax cashflow, but reinvestment occurs on post tax terms.  As a result of this, things get mushed and you begin to see how pre-tax DCF just cannot be made to equal post-tax DCF via some simple ratio between pre/post-tax discount rates.  This ratio will depend on the reinvestment rate through the forecast horizon, rate of growth and one one of the discount rates.  You can derive it from manipulation of the Gordon Growth Model.  If you have different rates of reinvestment through the horizon, get your Excel Solver out...because there is no good solution which can be derived using algebra.

Ultimately, source of truth is the post-tax DCF with NOPLAT adjustments and thus assuming it is fully equity financed and an allowance for distributed franking value. All companies will be free of finance chicanery when analysed on this basis.  In the insto market, the general allowance for franking is 60% as a reflection of the proportion of the market that actually derives value from it.  Given you value it, it is entirely fine and correct to assume 100% because that is the valuation that is right for you.

Another wrinkle...try discounting dividends.  I think you'll find that PV dividends (without franking) is below PV after tax FCF at the same discount rate.  The discount rate for dividends should actually be lower than applied to FCF unless you are fully paying out.  So if you are doing DDM, you need some arbitrarily lower discount rate than when using DCF on AT FCF.  How much arbitrarily lower will depend on payout rate, ROIC, the FCF discount rate....

James T Kirk
Captain, USS Enterprise


----------



## Ves

craft said:


> Thanks for the link VES.




The Lonergan paper that most of these other papers seem to reference can be accessed as a free PDF here.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1435128

Here is another paper on the same topic that shows some examples of how you may use a pre-tax discount rate. It strongly suggests NOT to simply divide the post-tax discount rate by the post-tax rate unless you are using a no-growth perpetuity.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1655691

In general,   not many websites / guides / books,  focus on this kind of thing.   It's mainly the academics from what I have seen and it seems that the prevalent view,  from my basic research agrees with RY's post above  (thank you by the way).  A lot of non-academics have just accepted that doing it on a post-tax basis is much easier?  Either most people who follow their lead don't understand the concept or haven't thought about it and they just do what they were taught  (with in most cases seems to be based on post-tax cash flow).

Australia is also fairly unique when compared to most other countries,  in that the franking credits need to somehow to be incorporated into the valuation.  This seems to muddy the pre-tax / post-tax argument compared to places such as the USA.


----------



## craft

So here is an example of the pre/post discount rate issue at @ 90% retention. The future value of the terminal value is not the issue (and you would logically discount both back at the same discount rate) but the PV of the stream does fluctuate.


----------



## craft

And @ 10% Retention


----------



## craft

Back to my gut reaction that it didn’t matter with fully franked dividends and the reason I thought I had isolated only the effect of the PPL in original response to VES.

My underlying logic is that I want my hurdle rate to be 15% before tax.  In other words what I want my hurdle rate to be is a grossed up return in my hands of 15% that I will then be liable for tax on. 

It seems to me that this hurdle rate in my hand can be transferred directly to Pre-tax cash flows from the business perspective. (In the case of full franking).   Less than full franking and the PPL  levy does have an impact.





No differences between pre tax rate in my hand and business pre-tax rate.


----------



## craft

Changing only the imputation rate to 28.5% to represent the impact of the PPL.  I should isolate only the impact of the levy impact and not be impacted by the Pre/Post issue RY raised

Or am I missing something?


----------



## Ves

For the NPV of the stream with the franking credits can you please try a discount rate of 12.6083% and post the excel screenshot?

PS:  Think we all crossed posts before above your Excel screenshots....   just in case you missed the posts.


----------



## craft

Ves said:


> For the NPV of the stream with the franking credits can you please try a discount rate of 12.6083% and post the excel screenshot?
> 
> PS:  Think we all crossed posts before above your Excel screenshots....   just in case you missed the posts.




Just looking at that now - thanks

12.6083? Is this what you want, what is your thinking


----------



## Ves

craft said:


> Just looking at that now - thanks
> 
> 12.6083? Is this what you want, what is your thinking
> 
> View attachment 58100



It only works for the cash flow at the end of year 1.   I was trying to reverse engineer it using algebra  (it won't show up properly in your spreadsheet because there are decimals missing).

Basically $1 of pre-tax FCF  is equivalent to $0.979021 after you take into account that it is franked at a tax rate of 28.5%.

I think I also screwed up the maths slightly.

1 / 0.15 = $0.869565.   So you need to find the post-tax discount rate to match this number.

$0.869565 = 0.979021/(1+x)
$0.869565 + $0.869565x  = 0.979021   (multiply both sides by (1+x))
$0.869565x = 0.109456   (take away $0.869565 from both sides)
x = 0.125874   (divide by sides by $0.869565)

If you apply this as the discount rate to $0.979021 you will get 0.869565 (the same 1 / 1.15 in the pre-tax equation).   

Do the same for your first post-tax cash flow of $0.179748 at year 1 of your spreadsheet.  The two amounts should match.

However, I believe that the equations for the later dated years probably have to take into account whatever the year is to the power of itself.

ie.    (1+x) ^2

I can't think of a short hand way of doing it at the moment.

You would have a different discount rate for each year to allow for the compounding....


----------



## craft

HI ves

There’s a couple of issues that we could probably get all crossed up here if we are not careful.

Personally I am attached to EBIT to isolate the business performance – I only look to valuing the ‘equity’ itself after I have decided on the business

My focus has been on whether the PPL levy should change my pre-tax profit approach or minimum hurdle. So suspect I could be going off on a tangent to the points RY is making as I am considering things mainly as they pertain to me. 

Some other mitigating factors for why I'm sticking with pre-tax, is that my hurdle target is actual set based on pre-tax in my hand that transfers across to the business level(under full franking)  without the problems of having an after tax figure that I try to impose on the pre-tax environment.   I also don’t use the hurdle rate as a discount rate, my risk is throwing a opportunity away that may come up higher on a full equity valuation that fails the 15% pre-tax hurdle - but it doesn't really matter if it isn't the best available opportunity pre-tax anyway.

I'm stuck in my ways

Now with my excuses for doing things differently than normal out of the way.

For valuing all aspects of equity most faithfully I fully agree with this and if you are reviewing your processes, post tax makes sense unless have some reason sorted in your head for doing something else.



DeepState said:


> Ultimately, source of truth is the post-tax DCF with NOPLAT adjustments and thus assuming it is fully equity financed and an allowance for distributed franking value. All companies will be free of finance chicanery when analysed on this basis.  In the insto market, the general allowance for franking is 60% as a reflection of the proportion of the market that actually derives value from it.  Given you value it, it is entirely fine and correct to assume 100% because that is the valuation that is right for you.




Unless you have a specific after tax discount rate that you want to achieve *and* you specifically want to use only pre-tax analysis – it’s probably better to side step the complexity. (anything to avoid algebra)


----------



## DeepState

Luu

I have screened the ASX for companies:
1. whose Last Reported EPS, capitalized at 9%, exceed the current stock price; and
2. whose dividends exceed 8% on an historical basis.

Here is the list for your further investigation:




Just be careful with how you use this, OK?  A lot of these companies are experiencing operating difficulties, declining expectations or otherwise have some risk to their underlying asset base as they are essentially investment holding companies whose reported earnings are not of the same kind as for operating companies.

RY


----------



## luutzu

DeepState said:


> Luu
> 
> I have screened the ASX for companies:
> 1. whose Last Reported EPS, capitalized at 9%, exceed the current stock price; and
> 2. whose dividends exceed 8% on an historical basis.
> 
> Here is the list for your further investigation:
> 
> View attachment 58111
> 
> 
> Just be careful with how you use this, OK?  A lot of these companies are experiencing operating difficulties, declining expectations or otherwise have some risk to their underlying asset base as they are essentially investment holding companies whose reported earnings are not of the same kind as for operating companies.
> 
> RY




Appreciate the patience RY... I'm not going to change anyone's mind, and I am definitely sure you guys aren't going to change mine either.

Not because i'm hardheaded, but because I know where you guys are coming from, what you guys are trying to do, and I just don't see the sense in it.

Out of respect, let me try to put what i'm saying another way.

Firstly, I don't look at a company's current or previous, or even average the previous few years' reported earnings then simply assume that's how it is into eternity.

I spent a great deal of effort to try and understand the business in its entirety... though I haven't done this to the extend i needed yet, I aim to understand the business financial, competitive position, operational performance etc etc... understand to the point where I can say... OK, this company could earn this much right now. BUT, but due to a couple of hick ups, due to this and that, last year, maybe this year and the next... it would most likely earn less than its true earning capacity... .But once these issues, which are relatively minor etc etc... got out of the way, this is how much this company actually earns, right now. 

Again, not what it has, not what it just reported, not what its current earnings will grow to be soon... it's current power to earn.

Once I am confident I know that, I do not use the banks' or the market's rate of return... I use my own required rate of return... this could be the same as the banks', it could be the rate at which another opportunity that I can take could return to me etc etc.


Why you guys think doing that is easy or simple I don't know. well, i do know, but that would just be me guessing.

--------

A good story that illustrates what I am trying to do:


During China's Three Kingdoms period, Zhuge Liang, the Prime Minister of Liu Pei's Shu Han Kingdom to the south west was at a small city on the frontier between his and Tsao Tsao's Wei Kingdom to the North. The young Wei King sent his top general, Sima Yen to take the city.

Liang, known throughout the world for his genius, his foresight... some even call him a God because they have seen him again and again predicting the future with almost absolute accuracy... hearing that Sima Yen was marching onto his city, and having just sent his generals and most of his troops elsewhere days ago.. .know he cannot hope to get out of the situation - that he cannot run, and know he cannot fight.

But he knows Sima Yen, he knows the political structure of Wei, the knows the history of Sima Yen and his position, he know the guy and his ambition.

Knowing this, he flung the city gates wide open, sat on the wall and play music.

Having march his soldiers to the gates, Sima Yen halted them, and listen to the music... trying to see from the tune if Zhuge Liang is setting up a trap or pulling a fast one. 

Wei's generals urge Sima to attack, they say their spies have reported no sizable troops in the city... that the other generals has gone here and there.. .if only they march in, they will take the city, take Zhuge and the Kingdom of Shu Han will be no more.

Sima says no... that Liang is very clever, he's setting a trap... this and that and ordered his troops back away from the city... running away from it in case the enemy attack from behind... then half a day later, thought otherwise and turned back but Liang and the city's civilians has escaped.

----
A simple look at this story and we just say that Sima is just a cautious coward, that Zhuge Liang is taking a great risk because he have no other choice.

That is not the case.

Zhuge Liang know that Sima does not want to take the city, does not want to capture him and end the war.
He know this because Sima is a brilliant man with great ambition, and Wei's founder, Tsao Tsao, would have told his son to not use or give Sima any power lest the Kingdom is lost to him. 

But without Sima, no one else have had a chance of defeating Zhuge Liang... no other generals had come close. And the only reason the Wei King gave Sima this commission was to end Zhuge, after which Sima will be forced to retired... and retired long before he have the chance to build up his army from his commands.

So as long as Zhuge is alive, the Wei King will eventually call on Sima Yen... and with time, he will gain the trust and influence from the army... without Zhuge Liang, Wei will take Liu Pei's, then will take the kingdom of Sun and Sima will have no chance of usurping Wei then eventually reunited China and establish the Jin Dynasty.

But how do you give a guy who doesn't want to fight a good reason to not fight and not be punished by his King? You play on your genius and fame to give the guy reasonable grounds to not fight... .after all Sima Yen did eventually "realised his mistakes" and return to take the city.

-----

What I am trying to tell you is that once you know your subject intimately - know its structure, its thinking, its management, its financial strength, its possible opportunities and possible downsides... you can make decisions in minutes and seconds without crazy forecasts of future cash flows or tax policies or dividend policies

So if you spend time and get to know a business well - and again i don't mean know every single manager or every dollar and cents and assets... but where you can say with good certainty that this business has been able to earn this under difficult circumstances, its product and services are in good demand... this is what it could normally earn, and being a financially strong, profitable business with an enviable position in its industry... chances are in the future it will do as well if not better.

But what that future earning and income stream is, I don't know... and so I won't include it in my valuation.

So by getting its current earning power, you are not simply looking at a reported EPS... and by eyeing the future, you are not trying to be the gods and guess it with accuracy... you simply say, after a lot of hard work and research, say this company currently earns this much, I require this percentage return to take over the world, is the offering price good enough to enable me to do that, good enough to compensate for my possible mistakes...

If yes, you just buy... if not, you go and watch X-Men: Days of Futures Past and try to forget you've just wasted $20 and a couple hours on Spiderman 2. 



But you guys obviously think Buffett is a genius because he could do discounted cashflow modelling on top of his head, could recall and forecast all growth rates and possibilities.. and do so with pen and paper while you guys are also geniuses but a bit better because you know how to use a computer and spreadsheets.

I have actually tried to do what you guys are doing just because I want to know how the real professionals would do it, but couldn't bring myself to finish the module because it's just nonsense to me. 
And just in case i say that because I can't programme it, I tried it on something else just as complicated and i'm not too bad.

anyway...


----------



## DeepState

luutzu said:


> Appreciate the patience RY... I'm not going to change anyone's mind, and I am definitely sure you guys aren't going to change mine either....
> 
> ...But you guys obviously think Buffett is a genius...
> 
> I have actually tried to do what you guys are doing just because I want to know how the real professionals would do it, but couldn't bring myself to finish the module because it's just nonsense to me.
> 
> anyway...




Luu

Some day, you are going to learn about the difference between a projection and a forecast.  That day will be a great one.

We all work off normalised earnings.  You seem to think it's just some regression.  It is not.  We can read financial statements, analyse industries and meet management / competitors / suppliers and customers...at least as well as you can to achieve such aims.

There is a reason why the professional industry - and Buffett - does things the way they do.  It is a big call for you to say that it is all nonsense and it might give you pause. But you are nonetheless free to meet them/us in the market and test your mettle.  The market is a test of beliefs.  The most successful combinations will win out over time.

So I guess we'll see.

Tread carefully alright?

RY


----------



## DJG

luutzu said:


> I actually found one    Think it was last October... probably was 7.5% dividend yield.
> I put around 40% of my savings into it... don't want to go more in case the reports are wrong, or i might've missed something.
> 
> 
> What are your plans with the website there?
> 
> A blog or newsletter/research service?




Without a doubt there would be a few around, would want to be critical of any capital loss outweighing the dividend though. Is the dividend sustainable? 

Um.. at the moment busy with other commitments but would eventually like to put my trades, trade journal, thoughts and insights on it. If people follow it, so be it but regardless will still post on it.


----------



## luutzu

DeepState said:


> Luu
> 
> Some day, you are going to learn about the difference between a projection and a forecast.  That day will be a great one.
> 
> We all work off normalised earnings.  You seem to think it's just some regression.  It is not.  We can read financial statements, analyse industries and meet management / competitors / suppliers and customers...at least as well as you can to achieve such aims.
> 
> There is a reason why the professional industry - and Buffett - does things the way they do.  It is a big call for you to say that it is all nonsense and it might give you pause. But you are nonetheless free to meet them/us in the market and test your mettle.  The market is a test of beliefs.  The most successful combinations will win out over time.
> 
> So I guess we'll see.
> 
> Tread carefully alright?
> 
> RY




I obviously have no economic or financial industry experience, so as far as i'm concerned, projections and forecasts is just a guy [myself if i were to do it] telling me something about the future.

And if I am being asked to pay for an asset at a PV where if growth were this in year 1, that in year 2... and if interest rates or the market's required returned can be assume r1, then maybe r2.. .and then after a few years of these growth figures, let's just assume it will be the same indefinitely... If all these ifs, which are based on other ifs I and the guy who's selling me might not be aware of...

What would a person say to that?
I'd asked, what if one or two of your forecasts are off?

If the future don't work out as we forecasts/projected, well you'd pay too high or too low, but we'll fine tune as we go along.

A more important question is: why is it that I have to put money out now, and will only get a return on it later, once, and if, the sun, the moon and the planets aligned?

I mean, i understand the need to wait, to be patient... but to do that and also to hope and pray that i have guessed the future right too?


---

You guys are obviously experienced and well educated in investments, finance and things... me, i'd like to make money on things that doesn't need me to get the future correct, and I'd like to think I have already made money the moment I bought the business - just need to wait for others to agree... 

I mean others could already be way ahead of me but i try to not do things I can't reason out. 

If corporations are people, I'd like to hang around good people. I can't quantify how beneficial it will be from year to year and if all that benefits will be worth my time, i just know it's not going to be too bad for me.


----------



## luutzu

DJG said:


> Without a doubt there would be a few around, would want to be critical of any capital loss outweighing the dividend though. Is the dividend sustainable?
> 
> Um.. at the moment busy with other commitments but would eventually like to put my trades, trade journal, thoughts and insights on it. If people follow it, so be it but regardless will still post on it.




I think it's sustainable. Have looked very closely at its capital structure, current assets, cash flows, payout ratio... its performance over past 10 years, its recent declines [still grow its earnings at 15 to 20% p.a. over past 5 years]. But who knows, I was only testing the data and found it too good to wait.

Good luck with the site. I'll check back now and then and will learn.

I find it really educational to write your ideas out. Forces us to confront it and structure our approach properly. That and pick fights with smart people on here


----------



## DJG

It does help, hopefully the odd person may learn a thing or two. Although I'm not even the slightest bit close to being as seasoned as some.


----------



## Ves

Hi craft



craft said:


> HI ves
> 
> There’s a couple of issues that we could probably get all crossed up here if we are not careful.




I agree - and we a crossing over a number of different purposes here.  

*My* focus seems to be in the same vein as your focus,  that is I am an investor and I am interested in the present value of the cash flows that I estimate that I will receive in the future (this also includes any compounding from reinvestment by the company).  For comparison,  it is easier if these are converted and discounted to NPV in pre-tax terms.

Granted,  that a hurdle rate and a discount rate can be different as we discussed,  it seems fine to me to use an arbitrary rate of 15% (or something else) in your IRR calculations.  If those cash flows actually occur... then that is the return that you will receive.   I am not sure how this could be mathematically incorrect.

As you have commented, the PPL levy changes to franking mean that the company FCF is slightly different by 1.5% than it would be in *your own hands.*

Therefore,  the main question is whether you want to change your own hurdle rate to compensate for any return lost due to this change.   (I believe that originally this discussion started because myself (maybe RY) confused this with another issue - ie. the effect of pre-tax cash flows on valuation in terms of compounding with pre-tax figures etc).

I'm not really in the business of comparing tax and debt structures across companies,  like you I prefer it easier to work on the EBIT level, as it feels more consistent.




> Unless you have a specific after tax discount rate that you want to achieve *and* you specifically want to use only pre-tax analysis – it’s probably better to side step the complexity. (anything to avoid algebra)



I screwed around with this for another hour before work this morning.   It would appear that it is much easier to go from post-tax discount rates to pre-tax discount rates.   The second paper in my previous post outlines how this is possible in a DCF valuation -  I have not been able to figure out how to go from a pre-tax discount rate to a post-tax discount rate,   and to be honest  it's not really worth spending any more time working out how until I actually have a reason to complete such a calculation....

My understanding of the issue from a theoretical stand point is that the main caveats in DCF valuation,  and as we are looking at cash flows to investors it is probably not an issue, is ensuring that the only difference between pre-tax and post-tax cash flows is the tax component. If there are other non-cash entries that do not include tax amounts then the discount rates used may be inaccurate and not readily comparable.  

I hope we are on the same page.   If not let me know.


----------



## Ves

Say a company has two operating segments.

One has a competitive advantage which I believe is well entrenched.

The other segment doesn't operate with a competitive advantage (or disadvantage).   It's worth the replacement cost of its assets.   (However,  as an added aside,  this segment does provide cross-selling opportunities into the more profitable segment).

In a valuation I would need to value both segments separately. 

I am currently running a DCF on the segment with a competitive advantage.  It can pay out most of its earnings, as it does not require much capital to grow.  I've factored in the cost of the growth for this segment into the DCF.

However -  some of the cash flow generated by this segment is reinvested into the second segment (that roughly earns its cost of capital over the cycle).

Should I exclude this from the "discretionary cash flow" of the first segment entirely as it is not contributing to profitable growth?  (ie.  it does not add any value to the company)


----------



## craft

Ves said:


> Say a company has two operating segments.
> 
> One has a competitive advantage which I believe is well entrenched.
> 
> The other segment doesn't operate with a competitive advantage (or disadvantage).   It's worth the replacement cost of its assets.   (However,  as an added aside,  this segment does provide cross-selling opportunities into the more profitable segment).
> 
> In a valuation I would need to value both segments separately.
> 
> I am currently running a DCF on the segment with a competitive advantage.  It can pay out most of its earnings, as it does not require much capital to grow.  I've factored in the cost of the growth for this segment into the DCF.
> 
> However -  some of the cash flow generated by this segment is reinvested into the second segment (that roughly earns its cost of capital over the cycle).
> 
> Should I exclude this from the "discretionary cash flow" of the first segment entirely as it is not contributing to profitable growth?  (ie.  it does not add any value to the company)




It shouldn't matter if you include the discretionary cash from the first segment going into your hand or into the second segment - so long as the 'cost of capital' is equal to the 'return' you can make from alternative investments.

One thing to note is that the second segment may have a competitive advantage by being associated with the first segment in that the first segment provides the cash flow certainty to leverage up (and at lower borrowing costs) the second and get a financial structure benefit, ie ROA at cost of capital because their is no competitive advantage but ROE is sustainably higher because of the debt servicing ability of the first segment.

MMS is an interesting case study on two segments as you have described with the above 'association' competitive advantages.


----------



## Ves

craft said:


> It shouldn't matter if you include the discretionary cash from the first segment going into your hand or into the second segment - so long as the 'cost of capital' is equal to the 'return' you can make from alternative investments.
> 
> One thing to note is that the second segment may have a competitive advantage by being associated with the first segment in that the first segment provides the cash flow certainty to leverage up (and at lower borrowing costs) the second and get a financial structure benefit, ie ROA at cost of capital because their is no competitive advantage but ROE is sustainably higher because of the debt servicing ability of the first segment.
> 
> MMS is an interesting case study on two segments as you have described with the above 'association' competitive advantages.



Hi craft,    thanks for that.   Handy to know - just have to be satisfied that the second segment does not fall into competitive disadvantage and destroy value in that case.

You have a good eye for detail in more ways than one.  MMS is one of the companies where I have been considering this very issue.

Your comments about the competitive advantage by association and the fact that this can mean access to cheaper financing I will consider   (TGA *might* fit under this category as well).

I think CAB probably does as well.

Highly relevant to MMS,   and would make sense to the context of their recent announcement on the conditions that they are experiencing in the UK and the opportunities that this presents.

I'm a bit reluctant to put much excess value on their asset management segment at this point,  more from conservatism,  but any upside would definitely be a bonus,  and the company does not look super expensive at the current prices   (there was beginning to be some buffer under $10 for regulatory risk in the medium to long-term too).


----------



## craft

In the latest GMO quartley,  I found the third section  “In Defense of Risk Aversion” by Ben Inker interesting. 



> Conclusion
> Believing that value matters is not quite the same thing as believing that valuations mean revert. If you believe that value matters but valuations do not necessarily mean revert, you should move your portfolio of risky assets around pretty aggressively as valuations shift among the various risky assets. But you should keep a fairly constant allocation to risky assets over time except in the rare instances where valuations are so extreme that risky assets are actually priced to lose out to lower-risk assets. That strategy will outperform a naÃ¯ve strategy over time, but if valuations do mean revert, it is substantially sub-optimal. If valuations mean revert, you can improve the risk/reward trade-offs of your portfolio substantially by adjusting how much risk you take through time, taking more risk when the return to risk is high, and less when it is low.




https://www.gmo.com/Asia-Pacific/CMSAttachmentDownload.aspx?target=JUBRxi51IIBfJXb8ASd8%2bVowJLvycx5qwpkOml5KFkvpvW%2bFH01T2tgNC6TBXFMfdUu3Sib0A6H1wXqswGANpVNDG7ycvtoaXx9pPFbuICtgm2NB7on9jjJqObH0znrt


----------



## Ves

Is that a fancy way of saying that they rebalance based on implied risk premiums?


----------



## Ves

I'll ask this here, because it's more related to my personal curiosity than it is to SBB



craft said:


> The point is that any 'conclusion' you reach with imperfect information could just as easily be explained by another plausible explanation.  Facts you don't have to question, but opinions, which is what we form when evaluating imperfect or insufficient information need inverting.




How long did it take you to internalise this process and make it more of a "reflex action"?  Or do you still find yourself falling into bad habits and not 'inverting' as much as you would like at times? Do you have a prompt to remind you?


----------



## craft

Ves said:


> I'll ask this here, because it's more related to my personal curiosity than it is to SBB
> 
> 
> 
> How long did it take you to internalise this process and make it more of a "reflex action"?  Or do you still find yourself falling into bad habits and not 'inverting' as much as you would like at times? Do you have a prompt to remind you?




I still don't do it enough but I'm getting better with experience (experience = learning the hard way)

The prompt is reality. The future keeps turning out different enough then I expect - especially at the detail level. That's enough for me to realise I really know squat and enough for me to keep challenging my own opinions and an open mind to other possibilities.

Sometimes I can catch myself being complacent and will be more diligent in inverting to try and identify the risks/opportunities I haven't comprehended yet but mostly its a different reality emerging that kicks my butt into gear.

Reviewing a diary (or even a forum post) of what you thought would unfold compared to what eventually evolves is really beneficial for learning that you don't know what you think you know.


----------



## DeepState

craft said:


> In the latest GMO quartley,  I found the third section  “In Defense of Risk Aversion” by Ben Inker interesting.
> 
> 
> 
> https://www.gmo.com/Asia-Pacific/CMSAttachmentDownload.aspx?target=JUBRxi51IIBfJXb8ASd8%2bVowJLvycx5qwpkOml5KFkvpvW%2bFH01T2tgNC6TBXFMfdUu3Sib0A6H1wXqswGANpVNDG7ycvtoaXx9pPFbuICtgm2NB7on9jjJqObH0znrt




In relation to stock selection, GMO believes the most mean-reverting variable is EBITDA margin.

In relation to the article, GMO have been very prescient on market return predictions over something like 7-10 year periods.  However, one lament which Jeremy Grantham makes is that those who start on the journey (in GMO multi-asset portfolios which use the concepts embedded in Inker's note) don't tend to be the same as those at the end. There are many ways someone can read that statement.


----------



## Ves

craft said:


> I still don't do it enough but I'm getting better with experience (experience = learning the hard way)
> 
> The prompt is reality. The future keeps turning out different enough then I expect - especially at the detail level. That's enough for me to realise I really know squat and enough for me to keep challenging my own opinions and an open mind to other possibilities.
> 
> Sometimes I can catch myself being complacent and will be more diligent in inverting to try and identify the risks/opportunities I haven't comprehended yet but mostly its a different reality emerging that kicks my butt into gear.
> 
> Reviewing a diary (or even a forum post) of what you thought would unfold compared to what eventually evolves is really beneficial for learning that you don't know what you think you know.



Thanks,  that's helpful.    The reality that you talk about is exactly what I have been facing in the past few months,  there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning.   It's a real eye opener,  and it makes me feel a bit sloppy (maybe lazy).  The more I think I know,  the less I really know.  Whilst my results are still OK,  I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then.  Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects).  It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful...   But I disgress,  thanks for the input.


----------



## craft

Ves said:


> Thanks,  that's helpful.    The reality that you talk about is exactly what I have been facing in the past few months,  there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning.   It's a real eye opener,  and it makes me feel a bit sloppy (maybe lazy).  The more I think I know,  the less I really know.  Whilst my results are still OK,  I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then.  Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects).  It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful...   But I disgress,  thanks for the input.




Ves – probably the most insightful post I have seen.

Here’s some things I know about you.

You can analyse earnings risk and understand competitive advantage.

You can analyse financial risk of a corporate structure and comprehend any economic advantages or disadvantages embedded. (ie capital intensity etc)

You can avoid valuation mistakes because you can form your own view on valuation using a raft of valuation tools.

That all means you can find quality businesses at a price that makes sense.

You convert your current excess capital to well priced quality assets on a regular and consistent basis. 

The long term score card is the cash you receive back from your assets but you won’t get your investor report card on that basis for a long time. If you are looking for the market to score your approach on an interim basis then expect its evaluation of your method to vary with its bull/flat/bear phases.

Taking on risk when it’s appropriately priced is the determinant of successful investing. Appropriate pricing requires a true and honest appreciation of what you don’t know about the future.

Reaching the stage where I lost all my false sense of certainty was a critical step for me – I had by that stage however, still enough faith in my judgement of identifying mispriced risk to be a strong hand in sizing and holding certain exposures and continuing on made all the difference.

All your work comes down to making good judgements. (the catch 22 is you can’t make good judgements without the background work) Continuing beyond random outcomes with bad judgement will ultimately results in failure, continuing on with good judgement results in success.


----------



## KnowThePast

Ves said:


> Thanks,  that's helpful.    The reality that you talk about is exactly what I have been facing in the past few months,  there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning.   It's a real eye opener,  and it makes me feel a bit sloppy (maybe lazy).  The more I think I know,  the less I really know.  Whilst my results are still OK,  I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then.  Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects).  It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful...   But I disgress,  thanks for the input.




Hi Ves,

This has really resonated with me, a great observation, I often feel the same.

I try to think of it as swimming with the current. My efforts may speed up or slow down the progress, but a large/most of the progress with determined by overall market movement. 

Continuing to invest using the same strategy, while my portfolio was falling, has been more difficult than I thought it would be.

In Giverny capital letters, they talk about Rule of 3, which I find comforting to remeber:
- One year out of three, the stock market will go down at least 10%.
- One stock out of three that we buy will be a disappointment.
- One year out of three, we will underperform the index.


----------



## KnowThePast

DeepState said:


> Luu
> 
> I have screened the ASX for companies:
> 1. whose Last Reported EPS, capitalized at 9%, exceed the current stock price; and
> 2. whose dividends exceed 8% on an historical basis.
> 
> Here is the list for your further investigation:
> 
> View attachment 58111
> 
> 
> Just be careful with how you use this, OK?  A lot of these companies are experiencing operating difficulties, declining expectations or otherwise have some risk to their underlying asset base as they are essentially investment holding companies whose reported earnings are not of the same kind as for operating companies.
> 
> RY




Turning out to be quite a nice portfolio, up about 11% (I've excluded funds).


----------



## Ves

craft said:


> Ves – probably the most insightful post I have seen.
> 
> Here’s some things I know about you.
> 
> You can analyse earnings risk and understand competitive advantage.
> 
> You can analyse financial risk of a corporate structure and comprehend any economic advantages or disadvantages embedded. (ie capital intensity etc)
> 
> You can avoid valuation mistakes because you can form your own view on valuation using a raft of valuation tools.
> 
> That all means you can find quality businesses at a price that makes sense.
> 
> You convert your current excess capital to well priced quality assets on a regular and consistent basis.
> 
> The long term score card is the cash you receive back from your assets but you won’t get your investor report card on that basis for a long time. If you are looking for the market to score your approach on an interim basis then expect its evaluation of your method to vary with its bull/flat/bear phases.
> 
> Taking on risk when it’s appropriately priced is the determinant of successful investing. Appropriate pricing requires a true and honest appreciation of what you don’t know about the future.
> 
> Reaching the stage where I lost all my false sense of certainty was a critical step for me – I had by that stage however, still enough faith in my judgement of identifying mispriced risk to be a strong hand in sizing and holding certain exposures and continuing on made all the difference.
> 
> All your work comes down to making good judgements. (the catch 22 is you can’t make good judgements without the background work) Continuing beyond random outcomes with bad judgement will ultimately results in failure, continuing on with good judgement results in success.




Hi craft

Thank you for the encouragement - I think I've got a long way to go yet with some of those concepts that you mentioned,  but you are right in saying that I do know what they all are and I at least know where to start looking (ie. competitive advantage, financial structure, earnings risk) and experience will provide some cream on top of what I already do know.  I try to not get too far ahead of myself, to use a metaphor  I feel like the initial part of my journey was finding the right road _for me_,  and now that I have found that road I need to learn how to walk it.

I believe that when Buffett mentioned that 90% of investing revolved around temperament he assumed that the investor already had enough background knowledge (without being a rocket scientist) to be able to start applying it to real life scenarios.

The other statements in your post that resonate with me are "Risk adjusted returns"  and "mispriced risk" (beating the market over the long-term is one thing,  but doing so with less (calculated) risk is ideal).

I also like the focus on cash flow  (both received from the company & which the company can re-invest at higher returns than me as an investor).

I like Socrates approach "I know nothing"  (which fits into losing that false sense of certainty that you mentioned).  If you believe that you know nothing it forces you to keep asking questions.

The hardest part (at least for me) is keeping these concepts close to the front of my thinking when the noise gets louder.   A good example of where I would like to go as an investor was your recent post in the NVT thread and a post in this thread about DTL's earnings cycle vs current market pricing.  It is occurrences such as NVT & MMS,  and the UGL re-structure that I have found difficult to interpret because I hadn't seen them in real-life scenarios, in real-time, with real money on the line.  It would be interesting to see how my response to each would differ if I walked away for a week or two and did not respond immediately.

The removal of the instant gratification of getting immediate or regular feedback on your investments is a pretty hard concept to get my head around.  Definitely something that I need to work on, but something I know that I can do if I put my mind to it.



KnowThePast said:


> Hi Ves,
> 
> This has really resonated with me, a great observation, I often feel the same.
> 
> I try to think of it as swimming with the current. My efforts may speed up or slow down the progress, but a large/most of the progress with determined by overall market movement.
> 
> Continuing to invest using the same strategy, while my portfolio was falling, has been more difficult than I thought it would be.
> 
> In Giverny capital letters, they talk about Rule of 3, which I find comforting to remeber:
> - One year out of three, the stock market will go down at least 10%.
> - One stock out of three that we buy will be a disappointment.
> - One year out of three, we will underperform the index.



Hi KTP

I remember reading one of the Giverny letters that mentioned those three things (I probably even linked it on here somewhere?). The rule of 3 is a good mental model,  it probably also works if you invert it (ie. 1 stock out of 3 will be a really good buy).

I'm probably a bit different to you in that my goal is to find stocks that I can hold forever and as craft once put it buy the cow for its milk with no intention of reselling it. Please note that when my intention and reality diverge, I may need to sell because the cow stops producing quality milk, but not for the reason of cashing it in to vindicate my initial decision to buy.  That potentially means that I can ignore the tide?


----------



## VSntchr

Ves said:


> That potentially means that I can ignore the tide?




Or perhaps it means that on low tide you will be busy buying those hard-to-buy-always-expensive hold forever businesses...and on high tide, you'll be off surfing :bowser:

Oh and BTW, some great discussion here VES.


----------



## Ves

Hi craft

I noticed in your previous posts further up the page in this thread the Excel valuation examples that you linked were 25 years in length for the "cash flow" period.

Given that you aim to invest in companies which you believe have enduring / robust competitive advantages this would make sense it allows you to forecast up to two or three economic cycles ahead  (I assume that you do indeed do this for companies in which you have a strong conviction on their quality).  Logically,  the longer a company can plough excess capital into a strong economic position (_edit: at rates in excess of your required return)_,  the more that company should be worth.   The difference is fairly obvious if you compare a valuation with 10 years of cash flow projections versus a valuation with 25 years of cash flow projections.

I will admit that I have not been comfortable going beyond 10 years of projections at this point,  but I have found that with companies such as Navitas (NVT) it does not provide enough scope to factor in the long-term expansion into key overseas markets that in my opinion could potentially bear fruit for a very long time yet.  

Would it be fair to say that Buffett would never have bought Coca Cola at the price he did if he was only looking at the next 10 years + Terminal value?

Of course it is a company by company judgment. It definitely forces you to focus higher up the quality chain.

I have been pondering this for many months and keep coming back to this conclusion...



VSntchr said:


> Or perhaps it means that on low tide you will be busy buying those hard-to-buy-always-expensive hold forever businesses...and on high tide, you'll be off surfing :bowser:



VS, that sounds like a fantastic plan to me!


----------



## Huskar

Ves said:


> The more I think I know,  the less I really know.




Great post Ves!

"The first and wisest of them all confessed to know this only: that he nothing knew"...


----------



## craft

Ves said:


> Hi craft
> 
> I noticed in your previous posts further up the page in this thread the Excel valuation examples that you linked were 25 years in length for the "cash flow" period.
> 
> Given that you aim to invest in companies which you believe have enduring / robust competitive advantages this would make sense it allows you to forecast up to two or three economic cycles ahead  (I assume that you do indeed do this for companies in which you have a strong conviction on their quality).  Logically,  the longer a company can plough excess capital into a strong economic position (_edit: at rates in excess of your required return)_,  the more that company should be worth.   The difference is fairly obvious if you compare a valuation with 10 years of cash flow projections versus a valuation with 25 years of cash flow projections.
> 
> I will admit that I have not been comfortable going beyond 10 years of projections at this point,  but I have found that with companies such as Navitas (NVT) it does not provide enough scope to factor in the long-term expansion into key overseas markets that in my opinion could potentially bear fruit for a very long time yet.
> 
> Would it be fair to say that Buffett would never have bought Coca Cola at the price he did if he was only looking at the next 10 years + Terminal value?
> 
> Of course it is a company by company judgment. It definitely forces you to focus higher up the quality chain.
> 
> I have been pondering this for many months and keep coming back to this conclusion...




The 25 years you refer in that example was only to see the magnification over time that small changes to the imputation system made.

I don't forecast 25 years in advance for valuation. I do consider if the business is cyclical into the future so as to not be potentially misled by current numbers - but that's really about the extent of the forecasting. The rest is competitive advantage, how sustainable that is and how much can the business be expanded within that advantage.

I assume Buffets reasoning for coughing up for Coke was the durability of its competitive advantage and its world scale for expansion.


----------



## Ves

craft said:


> The 25 years you refer in that example was only to see the magnification over time that small changes to the imputation system made.
> 
> I don't forecast 25 years in advance for valuation. I do consider if the business is cyclical into the future so as to not be potentially misled by current numbers - but that's really about the extent of the forecasting. The rest is competitive advantage, how sustainable that is and how much can the business be expanded within that advantage.
> 
> I assume Buffets reasoning for coughing up for Coke was the durability of its competitive advantage and its world scale for expansion.



Thanks

Perhaps I am reading your message wrong, but I think I know what you mean,  because it sounds exactly what I am trying to achieve...  however,  I'm yet to find a way to represent my thinking on competitive advantage and earnings cycles in a mathematical fashion that seems to make complete sense. 

Part of me thinks that there must be a better way to represent earnings power than is represented in the text books as standard DCF practice* .   Am I correct in saying that your method diverged from this over the course of your journey this far?  Picking a forecast cash flow for year 1, 2, 3, 4 and so on however far you want to go into the future seems a bit _counter-intuitive_ to me.  Your posts read to me that you do something different to this (although it's hard to discern how far different).

*Standard text book is similar to the 25 years spread sheet you posted.


----------



## Ves

Greenwald said this in 2008 about American Express in this article 

http://money.usnews.com/money/perso.../07/bruce-greenwald-on-value-investing?page=2



> American Express: If you ask yourself what the average yearly earnings should be even in a fairly distressed economic environment, it's probably about $3.50 a share. Typically, they commit to pay out at least half of those earnings to you in cash, so you're getting a 7 percent cash return either in buybacks or the dividend. Then they reinvest 7 percent of your money. In the short run, where that money is going is cash to protect themselves financially against any catastrophic drop in credit card repayments, but in the long run it's going to credit card loans, and the economics of those are fairly transparent: They lend at 15 percent, borrow at 4 or 5 percent, have a 10 percent margin, and the default rate is around 5 percent. So they make 5 percent on every dollar of loans, and they leverage up because you can because it's fairly safe. Even if they do 7 to 1, which is a fairly conservative ratio, you're making 5 percent times seven on your unemployed equity capital which is 35 percent, or 20-percent-plus post-tax. And billings by American Express just grow over time. It's probably faster than GDP because they have high-income customers, and spending is skewed towards services, which are growing faster than (spending) on goods. You probably get another 5 percent even making conservative growth (projections). You're looking at returns, without any improvement in the multiple, of well over 20 percent. That's the sort of investment (Buffett) sees. It gives you an enormous margin of safety for long-lived bad economic conditions.




The short-hand formula for something like this is:

Expected Return (IRR) = Div Yield % + Buyback Yield % + Future Growth in cash Returns % + Organic Growth %  (ie return to trend cyclical earnings)  _less_  a margin of safety based on probability of company losing its competitive position

Obviously any growth priced in has to be profitable growth within a franchise & there is the caveat that any numbers are based on the company maintaining its competitive position....


Which reminds me I need to get around to reading Leibowitz' _Franchise Value_ now that I have got more questions to ask...


----------



## craft

Ves said:


> Which reminds me I need to get around to reading Leibowitz' _Franchise Value_ now that I have got more questions to ask...




I hope you like formula's - but if any book is going to get you near a mathematical solution to what you are searching for it will be that one.  

Grab your wife  and try to have a simple game of noughts and crosses using only your mind to record the moves. What's easy visually is not easy from memory.

What am I trying to say? - you can't easily reduce judgement to a system or formula.

I suspect you already know enough of what is important ( I would swap your research/analysis skills for mine)  - how you accept/act on it without being able to proof it seems to be an issue though, maybe that's where you need to concentrate for a while. but I don't have any advice on that as I was just born arrogant enough to back the beliefs I believed I had logically reached.


----------



## Ves

craft said:


> I hope you like formula's - but if any book is going to get you near a mathematical solution to what you are searching for it will be that one.
> 
> Grab your wife  and try to have a simple game of noughts and crosses using only your mind to record the moves. What's easy visually is not easy from memory.
> 
> What am I trying to say? - you can't easily reduce judgement to a system or formula.
> 
> I suspect you already know enough of what is important ( I would swap your research/analysis skills for mine)  - how you accept/act on it without being able to proof it seems to be an issue though, maybe that's where you need to concentrate for a while. but I don't have any advice on that as I was just born arrogant enough to back the beliefs I believed I had logically reached.



Good idea with the noughts and crosses.... I play a lot of chess,  and she won't play because I'm *too good*,   maybe blindfolded chess would even the stakes.  I do a lot of chess puzzles where you cannot move the pieces and need to think a few moves ahead (http://www.chesstempo.com - it's free) and yes,  visual memory and thinking visually does not come easy for me  (my visualisation skills are also pretty weak with art, remember faces,  picking up minor details on movies / real life scenarios etc). I'm much better at words and numbers.

I'm also much better with big picture vs small picture,  and that's probably why I get stuck with valuation.   For instance,  I'm happy to look at Navitas,  assess the business model and prospects,  and say that it has the potential to be five times bigger and generate $500m+ cash flow in 25 years or something like that  (PS:  take that with a grain of salt,  those numbers are for illustrative purposes only,  they may not be my actual projections). Maybe it'll take longer,  maybe it'll be a few years shorter.  Or it won't happen.  It seems to me that the smaller details have a lot of influence in a DCF model because of its reputation to having a sensitivity to variables.

The trouble with valuation is that I need to fill in all the minor details and project how it will get there to come up with a net present value. It's not an exact science - I know that. But I still find it hard to come up with those details in a way that I can place enough conviction in, so that's where I get stuck.  And that's probably the "proof" part.  Expressing the big picture in the form of mathematical calculations.  That's an art.  I'm getting better at it - and by that I mean I actually do it and make purchases...


----------



## Ves

Hi craft

I've read the first 30-odd pages of the Leibowitz book (Franchise Value)  and it's really interesting -  a focus on the future capital investments that can be ploughed into a franchise (strong competitive position) and the excess profitability spread above the cost of capital that the firm can reap.  It's not so much a matter of how long,  but how much  -  rather than Dividend Discount Model (DDM) and its reliance on "smooth growth".

I also like the comments about "knowable"  and the concept of _hyper-franchise_  (the unknowable cream on top that you can't and don't value  - the faith / belief part). 

Reading your post again 



			
				craft said:
			
		

> The 25 years you refer in that example was only to see the magnification over time that small changes to the imputation system made.
> 
> I don't forecast 25 years in advance for valuation. I do consider if the business is cyclical into the future so as to not be potentially misled by current numbers - but that's really about the extent of the forecasting. The rest is competitive advantage, how sustainable that is and how much can the business be expanded within that advantage.
> 
> I assume Buffets reasoning for coughing up for Coke was the durability of its competitive advantage and its world scale for expansion.




Safe to say that you really like this book?

Can't wait to see some of the maths later in the book...


----------



## VSntchr

Hoping someone can help me try to understand subscriber acquisition costs a little better.

I understand that they are expenses such as advertising that are 'capitalised' as intangible assets which are then amortised over a specified period.

But how does this actually work from a cash perspective? Are the costs that are identified as subscriber acq. costs excluded from the PnL and sent straight to the balance sheet - to then be recognised in the PnL over the future periods through amortisation?

If my description above is correct then I think it would be safe to say that this should not be added back when normalising earnings as one would do for say - acquired customer bases.

For some reason the whole concept of adding back certain amortised intangibles bends my mind and sends me in loops, so hopefully someone a little more educated can shed some light or point to some relevant reading...


----------



## McLovin

VSntchr said:
			
		

> But how does this actually work from a cash perspective? Are the costs that are identified as subscriber acq. costs excluded from the PnL and sent straight to the balance sheet - to then be recognised in the PnL over the future periods through amortisation?




Yes. The expense is capitalised so is removed from the P&L and only the amount to be amortised over that period will be expensed. From a cash perspective, OCF will be higher because the capitalised costs will appear in ICF, in the same way that any other capex would.



			
				VSntchr said:
			
		

> If my description above is correct then I think it would be safe to say that this should not be added back when normalising earnings as one would do for say - acquired customer bases.




Hmmm...It kind of depends. Capitalising expenses is a pretty good way to massage earnings (I won't mention that BRG had a $2m jump in capitalised expenses this FY). How confident can you really be that they will earn a return on that "investment" or that it's not just stay in business marketing which is really just an expense. Generally, I think of capitalised expenses as a warning sign that management are fairly aggressive with their accounting and I'd usually add it back to get a proper picture of what's going on. That does mean that earnings will be lower than what they otherwise would be when a company is going through a high growth phase, but better to err on the side of caution.


----------



## hiddencow

VSntchr said:


> I understand that they are expenses such as advertising that are 'capitalised' as intangible assets which are then amortised over a specified period.
> 
> ..




Advertising is not an expense that usually qualifies for being capitalised.


----------



## VSntchr

McLovin said:


> Yes. The expense is capitalised so is removed from the P&L and only the amount to be amortised over that period will be expensed. From a cash perspective, OCF will be higher because the capitalised costs will appear in ICF, in the same way that any other capex would.
> 
> 
> Hmmm...It kind of depends. Capitalising expenses is a pretty good way to massage earnings (I won't mention that BRG had a $2m jump in capitalised expenses this FY). How confident can you really be that they will earn a return on that "investment" or that it's not just stay in business marketing which is really just an expense. Generally, I think of capitalised expenses as a warning sign that management are fairly aggressive with their accounting and I'd usually add it back to get a proper picture of what's going on. That does mean that earnings will be lower than what they otherwise would be when a company is going through a high growth phase, but better to err on the side of caution.




Thanks McLovin, that helps me wrap my head around it a lot better. As for the adding back, I was referring to the amortisation of the created intangible, rather than the initial capitalisation...
But what you have said seems like prudent conservatism.



hiddencow said:


> Advertising is not an expense that usually qualifies for being capitalised.



Agree HC, but if you look through a few of the telco's reports you will find subscriber acquisition costs. I didn't mean advertising per se, but if you look at the taxation guidelines there are a number of expenses which are possible to be grouped under this category if they fit. See here: http://www.aasb.gov.au/admin/file/content105/c9/INT1042_12-04.pdf


----------



## McLovin

VSntchr said:


> Thanks McLovin, that helps me wrap my head around it a lot better. As for the adding back, I was referring to the amortisation of the created intangible, rather than the initial capitalisation...
> But what you have said seems like prudent conservatism.





Yeah, add back the amortisation but subtract the full amount that was capitalised for the period.


----------



## Ves

I still can't think of much else more psychologically intimidating (in my life) than the market  (at least from an investor's perspective).

It's full of contradictions and conflicts  (arguably self-created).

On one hand...  sharp, and often sustained, declines in stock prices  (I'm talking individual stocks,  not the ASX as a whole)  present opportunities to buy future cash flow streams at great prices....   as long as you don't need to commute the asset,   it can stay there for years and it's a great benefit,  even better if you have the liquidity to keep buying.

On the other hand....  if you are wrong in your initial assessment you're toast. But you often won't know for a long time.  

The only "real time" performance data you often have is probably on a different feedback loop.

Sometimes trying to be patient in a world full of instant gratification and constant streams of information that lead to popular opinions that can turn on a dime is pretty tough,   especially when the market (and often other participants) are keen to offer you a white flag or an easier way out should you need it...

...other times it's a well timed slap in the face that makes you better at identifying risk and how it applies to your own strategy.

This probably won't help anyone deal with the issue,  but often it's a good idea to recognise it.


----------



## craft

Ves said:


> I still can't think of much else more psychologically intimidating (in my life) than the market  (at least from an investor's perspective).
> 
> It's full of contradictions and conflicts  (arguably self-created).
> 
> On one hand...  sharp, and often sustained, declines in stock prices  (I'm talking individual stocks,  not the ASX as a whole)  present opportunities to buy future cash flow streams at great prices....   as long as you don't need to commute the asset,   it can stay there for years and it's a great benefit,  even better if you have the liquidity to keep buying.
> 
> On the other hand....  if you are wrong in your initial assessment you're toast. But you often won't know for a long time.
> 
> The only "real time" performance data you often have is probably on a different feedback loop.
> 
> Sometimes trying to be patient in a world full of instant gratification and constant streams of information that lead to popular opinions that can turn on a dime is pretty tough,   especially when the market (and often other participants) are keen to offer you a white flag or an easier way out should you need it...
> 
> ...other times it's a well timed slap in the face that makes you better at identifying risk and how it applies to your own strategy.
> 
> This probably won't help anyone deal with the issue,  but often it's a good idea to recognise it.




For something as simple as buying cash flows for less than they are worth – it isn’t easy.

The more you listen to the market and everybody tell you you’re wrong the harder it is.

Are you wrong?  Only you can answer that and you have to answer it unequivocally before you can happily stand in the face of volatility, criticism and uncertainty and come out the other end holding the excess return that doing so offers.   If you have any doubts that you can be a strong hand (truly committed) the earlier you choose to fold the better. 

Being wrong (being defined as wrong on the business analysis) on some stocks doesn’t mean you’re not suited to an analysis approach – It just means sometimes you’re wrong.  Sell, take your punishment and move on. No matter how you tackle the market you have to become a good loser. But the question of magnitude of an individual loss is an important factor – fundamental investing doesn’t lend itself to small loses on individual stocks when the businesses fail to perform how we expect.   

If you need near term liquidity or the market to immediately reinforce your opinion/position use a market price reactive approach.  My personal opinion is that there is no easily available excess return from such a crowded, transactionally expensive, zero sum approach but it may be better then capitulating as an investor.

None of this post is directed at you VES just a general response to the difficulties you expressed in your insightful post.


----------



## Ves

craft said:


> None of this post is directed at you VES just a general response to the difficulties you expressed in your insightful post.



Thanks craft...   and  you have added another insightful post yourself.    I am still thinking about your comment in another thread re:  significant highs as a scan.  I'll let it churn around in my head for a while  (months) and see what comes of the idea.


----------



## galumay

Ves said:


> This probably won't help anyone deal with the issue,  but often it's a good idea to recognise it.




It helps a little! I go thru the same thought process not infrequently, it is important to have a clarity of mind and a way to shut the noise out - while listening for clues that may lead to nectar!

Certainly one of the challenges with this style of strategy is the long wait before you know whether you have got it right or not.


----------



## tech/a

craft said:


> For something as simple as buying cash flows for less than they are worth – it isn’t easy.
> 
> The more you listen to the market and everybody tell you you’re wrong the harder it is.




Particularly if the trade is also heading south.



> Are you wrong?  Only you can answer that and you have to answer it unequivocally before you can happily stand in the face of volatility, criticism and uncertainty and come out the other end holding the excess return that doing so offers.




If you see that your valuation is one you wish to take advantage of---wouldn't it be easier if you waited to take the trade when it was heading north? 



> If you have any doubts that you can be a strong hand (truly committed) the earlier you choose to fold the better.




Agree.
But is true commitment a guarantee of profit?--No
Could be blind faith in your valuation in face of evidence to the contrary.
Surely a confluence of positive price action with valuation be desirable.




> Being wrong (being defined as wrong on the business analysis) on some stocks doesn’t mean you’re not suited to an analysis approach – It just means sometimes you’re wrong.




Any approach really



> Sell, take your punishment and move on. No matter how you tackle the market you have to become a good loser.




Great point and one Ill add to.
This releases you to be able to take advantage of other opportunity.
I think also it can often be a case of timing---right analysis---wrong time---often my problem.
But easily overcome if evidence continues to confirm your analysis---just keep at it!



> But the question of magnitude of an individual loss is an important factor – fundamental investing doesn’t lend itself to small loses on individual stocks when the businesses fail to perform how we expect.




True but it can---again timing.
I for the life of me cant see why you cant hold a long term undervalued view---yet monitor your timing of entry and in many cases re entry based upon price.



> If you need near term liquidity or the market to immediately reinforce your opinion/position use a market price reactive approach



. 

OR as I have suggested a synergistic approach



> My personal opinion is that there is no easily available excess return from such a crowded, transactionally expensive, zero sum approach but it may be better then capitulating as an investor.




A few here including me would disagree.


*Why don't we run a test case.*

The Fundi experts picks say 5-10 stocks that are undervalued and we trade them longer term and I and the other Techi experts use the same stocks picked by the Fundies but the Techies attempt to out perform the pure Fundi traded portfolio's

If we decide not to trade it give us a few more in the portfolio to have a watch list--say 5 more so say have a stable of 15 and try and get the best performance out of each method.

Run it for a year or 3

I made this suggestion last year when the best fundamental picks for 2014 came out.




Was met with horror at even suggesting it!---don't know why.
Surely we can collaborate!


----------



## craft

tech/a said:


> I made this suggestion last year when the best fundamental picks for 2014 came out.
> 
> View attachment 60803
> 
> 
> Was met with horror at even suggesting it!---don't know why.
> Surely we can collaborate!




You talking about this thread?

https://www.aussiestockforums.com/forums/showthread.php?t=27748&page=2&highlight=hybrid

My view is still the same as expressed there.

Interesting you recall that exercise as 







> horror at even suggesting it



I thought it just died then normal Tech/A death of no follow through on a comprehensive exercise.


----------



## craft

tech/a said:


> If you see that your valuation is one you wish to take advantage of---wouldn't it be easier if you waited to take the trade when it was heading north?




Ah opportunity costs.....

I lifted this from a previous post - hopefully you can understand.



> – in the context of my investment philosophy, which is to buy assets that generate a greater ‘real’ cash flows over their life time then the price paid for them.
> 
> Once an opportunity is identified, there are two risks in relation to timing, one is buying too early, the other is missing out on the price that gives rise to the opportunity.
> 
> Buying too early means I suffer a few % points of opportunity cost over my envisaged time frame but I have at least locked in acceptable actual return. (so long as my assumptions were correct).
> 
> The ramifications of ‘could have, would have, should have’ are potentially unlimited opportunity costs and missing the opportunity to lock in an acceptable actual return.
> 
> Buying too early is a mistake of commission that sucks. ‘Could have, would have, should have’ is a mistake of omission that whilst probably easier to bear, can ultimately be a lot more detrimental to wealth creation.
> 
> Obviously I would like to buy at the absolute low – but I’m not that good, given my fallibility I err on the side of buying too early rather than missing out. But I’m not oblivious to the charts or the short term momentum of the business – they guide how aggressively I accumulate




I have made more mistakes of commission then most, but probably less mistakes of omission then most. That's a hard psychological path to tread - but long term market has rewarded it exceptionally.


----------



## craft

tech/a said:


> Could be blind faith in your valuation in face of evidence to the contrary.




That is not a valid argument against fundamental investing - Only poor implementation of a strategy ignores evidence to the contrary.  

That failure will kill any approach.

Following the business trend and ignore evidence contrary to our opinion about the business, is no different to following the price trend and ignoring contrary evidence about the price. The former doesn't invalidate FA just as the latter doesn't invalidate TA


----------



## craft

tech/a said:


> I for the life of me cant see why you cant hold a long term undervalued view---yet monitor your timing of entry and in many cases re entry based upon price.



 In addition to the previous post points - Scale.




tech/a said:


> *Why don't we run a test case.*




Try running your test case with a 25M plus account size.


----------



## craft

tech/a said:


> A few here including me would disagree.





Excellent - no opportunity for outperformance in the market without disagreement.


----------



## craft

tech/a said:


> *Why don't we run a test case.*
> 
> The Fundi experts picks say 5-10 stocks that are undervalued and we trade them longer term and I and the other Techi experts use the same stocks picked by the Fundies but the Techies attempt to out perform the pure Fundi traded portfolio's
> 
> If we decide not to trade it give us a few more in the portfolio to have a watch list--say 5 more so say have a stable of 15 and try and get the best performance out of each method.
> 
> Run it for a year or 3
> 
> I made this suggestion last year when the best fundamental picks for 2014 came out.
> 
> View attachment 60803
> 
> 
> Was met with horror at even suggesting it!---don't know why.
> Surely we can collaborate!




There appears to be lots out there who think combining the two add value so you shouldn't have too much trouble finding a co-collaborator - but FFS if you start it follow it through to the end for once.

You could also unilaterally show (with the live exercise) your trading adds value to everything assertion by trading Robusta's portfolio for example- he runs it live and you are familiar with that thread.

ps 

ZIP ZAP also had a thread about trading overlay improving performance - but that ended up going nowhere either.


----------



## tech/a

craft said:


> That is not a valid argument against fundamental investing - Only poor implementation of a strategy ignores evidence to the contrary.
> 
> That failure will kill any approach.




Its not meant to be an argument against fundamental investing.



> Following the business trend and ignore evidence contrary to our opinion about the business, is no different to following the price trend and ignoring contrary evidence about the price. The former doesn't invalidate FA just as the latter doesn't invalidate TA




Not talking about invalidation---*improving.*

I want to reply to all of your posts Craft---but about to nick off for the weekend.
Will re visit.


----------



## craft

Howard Marks latest Memo.

http://www.oaktreecapital.com/MemoTree/The%20Lessons%20of%20Oil.pdf


----------



## McLovin

craft said:


> Howard Marks latest Memo.
> 
> http://www.oaktreecapital.com/MemoTree/The%20Lessons%20of%20Oil.pdf




You beat me to it. I read that last night. Good read as per usual.


----------



## VSntchr

craft said:


> Howard Marks latest Memo.
> 
> http://www.oaktreecapital.com/MemoTree/The%20Lessons%20of%20Oil.pdf




Some excellent bits to ponder from this memo. Thanks craft.


----------



## tech/a

craft said:


> That is not a valid argument against fundamental investing - Only poor implementation of a strategy ignores evidence to the contrary.
> 
> That failure will kill any approach.
> 
> Following the business trend and ignore evidence contrary to our opinion about the business, is no different to following the price trend and ignoring contrary evidence about the price. The former doesn't invalidate FA just as the latter doesn't invalidate TA




It depends on "The evidence" Price action isn't seen as evidence by many. Infact a falling price is often seen as evidence to buy more even though at the time the stock is undervalued.

Business evidence  often takes months to develop and months to prove or disprove ---
By which time you are either spectacularly right or spectacularly wrong or neither.

Maybe its just me but I like to be right or wrong quicker than that!




craft said:


> In addition to the previous post points - Scale.
> 
> Try running your test case with a 25M plus account size.




Sure but aren't we discussing this relative to the average trader?




craft said:


> There appears to be lots out there who think combining the two add value so you shouldn't have too much trouble finding a co-collaborator - but FFS if you start it follow it through to the end for once.




Well there are no others by the looks and a clear reason why I lose interest---THERE IS NONE!



> You could also unilaterally show (with the live exercise) your trading adds value to everything assertion by trading Robusta's portfolio for example- he runs it live and you are familiar with that thread.




Its not *MY TRADING*---Its the addition of another element to trading. I may just do something (Using Robustas as a trade source)  and report on the trades when I do something---enter---exit--stop-add to it---stop trading it---re enter it---whatever.
Starting from trades he chooses from 1/1/2015




> ZIP ZAP also had a thread about trading overlay improving performance - but that ended up going nowhere either.




Yes I think I remember that but will have a look.


----------



## craft

tech/a said:


> Business evidence  often takes months to develop and months to prove or disprove ---
> By which time you are either spectacularly right or spectacularly wrong or neither.
> 
> *Yep*
> 
> Maybe its just me but I like to be right or wrong quicker than that!




Its not just you - its most of the market participants. The constant reaction to price rather than the business creates the opportunities.



Merry Christmas.


----------



## tech/a

craft said:


> Its not just you - its most of the market participants. The constant reaction to price rather than the business creates the opportunities.
> 
> 
> 
> Merry Christmas.




There is reaction to price and there is analysis of price then action taken on that analysis.
Most market participants who react to price react only to direction.
Not the catalyst to that direction nor the accumulation or distribution that happened in that last consultation at that last support/resistance level.

Have a great Xmas and safe 2015


----------



## Ves

craft,

A quick question if you will oblige.   Better asked in this thread but with reference to the post you made in the SMSF Returns thread here.

Given the main basis of your strategy is based on cash flow (see post #1 in this thread etc. and lots of other posts in this thread, some recently) with reference to business analysis and not price action,   I was a bit confused to read your comment on the rotation between investments due to price momentum.   Is this a core part of the strategy (was it always?)  or is it just you playing around the edges trying to gain a few % points here and there?

Please don't take my post as a criticism. It's been bugging me  (ie. am I missing something?)

Cheers


----------



## craft

Ves said:


> craft,
> 
> A quick question if you will oblige.   Better asked in this thread but with reference to the post you made in the SMSF Returns thread here.
> 
> Given the main basis of your strategy is based on cash flow (see post #1 in this thread etc. and lots of other posts in this thread, some recently) with reference to business analysis and not price action,   I was a bit confused to read your comment on the rotation between investments due to price momentum.   Is this a core part of the strategy (was it always?)  or is it just you playing around the edges trying to gain a few % points here and there?
> 
> Please don't take my post as a criticism. It's been bugging me  (ie. am I missing something?)
> 
> Cheers




Nothing has changed.



> I was also using that period to sell some stock that had good momentum and replace it with some unloved alternatives



 I think this is the line that confused you - Sorry.  Let me try and put it another way.

I sold some stock that had in my view become expensive on a cash flow evaluation basis as a result of positive market price momentum and bought some stock that I perceived as much better value (once again on a cash flow basis) 

or - if you like

Sold some expensive stuff that was going up to buy some cheap stuff that was going down. (plan being - short term pain for long term gain) 


Sell cash flow for more then its worth - Buy cash flow for less then its worth - repeat as often as the market allows - harvesting some earnings multiple expansion spices the return a bit over time - but the underlying backbone to decent long term returns still remains being exposed to good businesses imo. 


Cheers


----------



## galumay

craft said:


> ......- but the underlying backbone to decent long term returns still remains being exposed to good businesses imo.
> 
> Cheers




A great point to keep reminding ourselves!


----------



## Ves

Thanks craft

My ambivalence towards such a concept _at the moment_ could be either:

a _philosophical_ thing:   I'm a bit of a hoarder in this respect - I don't like swapping the cash flow back to capital unless the fundamental investment thesis is broken or substantially changed - perhaps mainly because every time I've tried to be clever in this respect I seem to have been worse off compared to "doing nothing."

a _practical_ thing:  I don't have the scale - selling usually means selling either all or a very significant portion of my investments....   there's no point trimming off the top to rebalance,  brokerage / cap gains tax would be hard to justify unless it was a _very compelling_ opportunity.

Perhaps time & an increased capital base will change my mind.  You never know,  my mind isn't closed on the matter.

Currently I am also considering the way going forward:    perhaps pure 100% stock picking isn't necessarily the only way for me. I would like to continue stock-picking as a _core function_, but additional asset allocation  strategies involving low-cost, low-turnover ETFs might assist me.  _Not sure yet._


----------



## hiddencow

How does one handle CGT in the rebalancing scenario?
I guess it's a lesser impact in a SMSF scenario especially in TTR or pension phase when it has no impact.

With CGT you get a lesser amount of your capital back to put into buying another stream of cash flows so you will have to be extra confident that the alternative stream will produce higher cash flows in order to do the rebalance. I think this will become more of a problem later in the investment journey where numbers get bigger, attracting higher rates of tax and more gains are accumulated through the years.
This might mean a shifting of strategy more to just holding, and accumulating using new inflows of cash.


----------



## Ves

After a bit more thinking:

The answer for me at the moment is still....



Ves said:


> pure 100% stock picking




...  and after deciding still to be a _lone wolf_ these....



Ves said:


> additional asset allocation  strategies involving low-cost, low-turnover ETFs




.... are not relevant at the moment for me.    

Will re-visit again in 12 months.


----------



## craft

Ves said:


> Will re-visit again in 12 months.




Hi Ves

Have you got the ability to plot your equity curve against the all ords accumulation index yet?

IMO everybody should have this data to assist in the decision of continued active management vs indexing. 

Outperformance is a zero sum game (less expenses). Are you better then average? that's a question requiring an objective data source to answer, especially as its a determination made by you about yourself.  (biases run wild in this space - that's why the majority think they are better then average)

If you are objectively outperforming the market is it by enough to justify your time?

That's how I evaluate continued active personal management.


----------



## Ves

craft said:


> Hi Ves
> 
> Have you got the ability to plot your equity curve against the all ords accumulation index yet?
> 
> IMO everybody should have this data to assist in the decision of continued active management vs indexing.
> 
> Outperformance is a zero sum game (less expenses). Are you better then average? that's a question requiring an objective data source to answer, especially as its a determination made by you about yourself.  (biases run wild in this space - that's why the majority think they are better then average)
> 
> If you are objectively outperforming the market is it by enough to justify your time?
> 
> That's how I evaluate continued active personal management.



Hi craft

I ended up manually plotting monthly data for the ASX 200 accumulation index direct from the share tables on AFR.com.au

Yes...  my returns since I started in April 2011 are above the ASX 200 accumulation index.... 

My data is based on a unitised valuation of my portfolio at each data point (ie. it is recalculated each time I add funds or reduce funds within portfolio).

If you took today's data point  since about October 2013  I have under-performed the benchmark (mainly because of SKE,  UGL,  DTL).  However.... my portfolio did reach all time highs per unit in August 2014.

2014 as a whole I was a few points below the benchmark.

How do you measure your own portfolio risk vs the ASX accumulation indices?  How long is a piece of string?  

In all honesty,  I don't spend an inordinate amount of my spare time managing the portfolio,  so it's not really a big consideration. Although some periods are more obsessive than others.    It's more the mood swings between self-doubt and self-enthusiasm and whatever in between.   Mainly arising from the question:    would I achieve my goals by being a passive investor?   It's possible I would.   On the other hand:   am I wasting some skill / talent by being passive?   I think they call it cognitive dissonance.

How else do you find out but try?  My biggest driver in life is competency.  Without it I feel like I'm lost.

 I think you probably need between 5-10 years to fairly answer that question.   I'm almost tempted to say the first 3-4 years are learning.  

I have found through self-reflection that I am unfairly harsh on my own abilities in life (not just investing) and often too kind in my appraisal towards the abilities of others.


----------



## Huskar

craft said:


> Hi Ves
> 
> Have you got the ability to plot your equity curve against the all ords accumulation index yet?
> 
> IMO everybody should have this data to assist in the decision of continued active management vs indexing.
> 
> Outperformance is a zero sum game (less expenses). Are you better then average? that's a question requiring an objective data source to answer, especially as its a determination made by you about yourself.  (biases run wild in this space - that's why the majority think they are better then average)
> 
> If you are objectively outperforming the market is it by enough to justify your time?
> 
> That's how I evaluate continued active personal management.




I couldn't agree more Craft. If you don't measure yourself, you are kidding yourself.

One suggestion is running your portfolio as if it were a fund and then calculating net asset value. This is insensitive to capital inflows and outflows. See here for related discussion https://www.aussiestockforums.com/forums/showthread.php?t=23106&page=10&p=761594#post761594


----------



## Ves

Huskar said:


> I couldn't agree more Craft. If you don't measure yourself, you are kidding yourself.
> 
> One suggestion is running your portfolio as if it were a fund and then calculating net asset value. This is insensitive to capital inflows and outflows. See here for related discussion https://www.aussiestockforums.com/forums/showthread.php?t=23106&page=10&p=761594#post761594



That is the way I have been doing it.  Thanks


----------



## VSntchr

Huskar said:


> I couldn't agree more Craft. If you don't measure yourself, you are kidding yourself.




+2.
In trading, capturing data/metrics/results is paramount if you wish to improve - I think it would be perhaps the most critical of all tasks that should be undertaken.
In investing, it is also important - however the feedback loops are slower. This might mean that the data doesn't feel as important in the short term (as it lacks any ability to offer concrete ideas), but as time wears on the 'helpfulness' of the portfolio tracking vastly improves.

I have witnesses this with my own investing, I started tracking in 2010 and the first year was a real drag. Slowly each year I would rebuild my spreadsheet and automate a few more things, adding in a few additional features, improve the taxation reporting etc...now 4 years later and I love looking into the analytics of my investing performance...it really does provide me with some good information on where I am at with my goals and where to set my goals going forward.


----------



## galumay

I totally agree with what you are all saying, the only proviso I would add is that with long term investing you have to be balanced about your performance in the first couple of years, expecting out performance from the get go is unrealistic. If you have done your job well and found a portfolio of undervalued companies it may take some time for the market to realise the valuation and so underperformance may be the outcome in the short term.

Not withstanding that, I think its essential to set up a process for measure performance, and also a process for regular and frequent review of one's strategy and individual decision making processes around companies that you are invested in.


----------



## craft

This post is a response to a question in another thread about switching from trading to investing. (hopefully Ill be forgiven here for being off topic.)

It’s just 1 persons experience – everybody else’s experience past or future may be different.


Minor ‘physical’ reasons (shares) 

Market impact decreases the return (chasing volume to get things done in a reasonable time often pushes the market away from the trigger/reason to act) 

Physical transaction time and associated bookkeeping increases (splitting orders to try and hide a bit) 

I traded Aust shares and I'm sure some of the physical limitations to size could be addressed with other instruments (US shares, Interest rates, futures, FX)  

But the more major issues for me were psychological. In addition to the ‘physical’ impact of size above – there were additional diminishing return because of psychological issue when I attempted to scale up.

Possible basis for those psychological issues:

Lack of belief in myself as a trader;  Lack of belief in trading as a ‘sustainable’ pathway for increasing funds;  Fear that I may have just been on the lucky side of the return distribution to date;  Concern that I could keep adapting to the next market paradigm shift; Concern about correctly differentiating between a normal drawdown and a system failure  etc etc.

All in all it was hard work (for me) staying good enough to make money in a game that is not loaded in my favour.  Accumulating money has a diminishing marginal incentive to work hard.

Because of the above – and with the reality that what I could earn going forward was worth less to me then what I had accumulated and could lose meant I didn’t have the psychological ability to scale up without finding something more certain for myself. 


My trading returns when working only at a comfortable scale didn’t justify ignoring the rest of my capital.  

My search for methods that would allow me to scale brought me to business analysis investing. (ironically it has more volatility then short term trading) But I felt a firmer foundation for taking risk.  Maybe more than anything I landed there because of my personal traits. The real world difficulties of size and work load are reduced but more importantly the psychological fit is much better. 

The existence of prop shops during my time of transition may have made a difference. They seem like a very good way to leverage trading skills and alleviate some of the psychological pressures.  (Though I’m just guessing because I have no experience of them) Trading your own capital in the range of ‘My family could retire on this if I don’t do anything risky’ is difficult – building your capital past this point without risk would be gold.


----------



## skc

craft said:


> This post is a response to a question in another thread about switching from trading to investing. (hopefully Ill be forgiven here for being off topic.)
> 
> It’s just 1 persons experience – everybody else’s experience past or future may be different.




Thanks Craft. 

Some of the stuff about scaling up etc I am starting to feel a little bit, albeit as you said, I am in the fortunate position of trading someone else's capital.

Plenty of food for thought here although I am probably not quite at the level where I can concurr with everything you've said. Hope to get there someday though...


----------



## DeepState

From Credit Suisse 2015 Yearbook.

Real return embedded in the US market is currently at 10th centile expensive at 4.2%.  They find that valuation metrics are next to useless at monthly intervals.  However, at longer intervals, some sort of mean reversion appears to be present.  To me: valuation is useless for near term return prediction but remains a valid consideration over the longer term....but you might need to wait an awfully long time.


----------



## craft

Updating some charts with month end data.

GDP Regressed Earnings telling a very interesting story in this one.


----------



## galumay

craft said:


> Updating some charts with month end data.
> 
> GDP Regressed Earnings telling a very interesting story in this one.




Craft, do you have any explanation you could link to? I am not familiar with "GDP Regressed Earnings".


----------



## DeepState

craft said:


> Updating some charts with month end data.
> 
> GDP Regressed Earnings telling a very interesting story in this one.
> 
> View attachment 62209




Q1: Are you regressing on nominal GDP?
Q2: Do you happen to have industrials-only (ie. ex Resources, A-REIT and Financials) GDP regressed earnings on tap? V.interested if so.

Fascinating. Thanks for posting it up.


----------



## galumay

Also, Craft I have been reading thru this thread from the beginning because it has a lot to teach me in my strategy and also the mechanics of DCF calculations using FCFE. I stumbled across your post on page 6 about rebalancing, https://www.aussiestockforums.com/f...t=23385&page=5&p=708630&viewfull=1#post708630

It is a question I have been struggling with over the whole easter break! I looked at both my portfolios, personal and SMSF and did a decision tree exercise on whether there were any companies I should sell or sell down my holdings in. The initial conclusion was to sell down all positions to rebalance back towards original stake size, where they had become more than 10% out of balance.

I revisted the decision to rebalance and basically ran a detailed "why not to rebalance" case, costing out a range of outcomes. (drop in price, price stable, increase in price.) - and came to a contrary conclusion that it didnt really make sense, it was "cutting the flowers" as Peter Lynch calls it, and the benefits if the price did drop were illusory in a long term hold strategy anyway.

The only other benefit iI was left with was that it did free up cash for other investments, but thats not certainly a benefit - if the other investments are not at least as good as the one i sell out of!

So as I sit now I am inclined to allow the positions to run, there are obvious benefits in markets being shut for 4 days!

Was the post I have linked to your final view on rebalancing or has it changed again?


----------



## craft

galumay said:


> Craft, do you have any explanation you could link to? I am not familiar with "GDP Regressed Earnings".




Hi Galumay

It’s a statistical process to determine what normalised earnings would be given a certain level of GDP.

What it is saying is that if GDP continues on has it has recently we should expect lower then trend earnings – of course there is a flip side – ie it could also be saying we should expect GDP to increase back to longer term trends.

The GDP deflator is what has changed (yep DS its Nominal).  – It’s basically flat lined for the last few years.




So the chart indicates to me either we have a paradigm shift in broad inflation with ramifications for future earnings levels or (flipside) increased inflation lays shortly down the track. Both have differing implications for valuation.

Ps
Sorry DS I can’t supply industrials specific earning figures. But I too would like them.


----------



## craft

galumay said:


> Also, Craft I have been reading thru this thread from the beginning because it has a lot to teach me in my strategy and also the mechanics of DCF calculations using FCFE. I stumbled across your post on page 6 about rebalancing, https://www.aussiestockforums.com/f...t=23385&page=5&p=708630&viewfull=1#post708630
> 
> It is a question I have been struggling with over the whole easter break! I looked at both my portfolios, personal and SMSF and did a decision tree exercise on whether there were any companies I should sell or sell down my holdings in. The initial conclusion was to sell down all positions to rebalance back towards original stake size, where they had become more than 10% out of balance.
> 
> I revisted the decision to rebalance and basically ran a detailed "why not to rebalance" case, costing out a range of outcomes. (drop in price, price stable, increase in price.) - and came to a contrary conclusion that it didnt really make sense, it was "cutting the flowers" as Peter Lynch calls it, and the benefits if the price did drop were illusory in a long term hold strategy anyway.
> 
> The only other benefit iI was left with was that it did free up cash for other investments, but thats not certainly a benefit - if the other investments are not at least as good as the one i sell out of!
> 
> So as I sit now I am inclined to allow the positions to run, there are obvious benefits in markets being shut for 4 days!
> 
> Was the post I have linked to your final view on rebalancing or has it changed again?




SMSF has a maximum of 25% portfolio concentration limit at market prices.  Funds outside super have a 33% cap.  These rules deal with my psychological and information limitations.  They are not performance enhancing rules, at least not in theory and I wouldn’t argue with anybody who has a different view.  If the rules ultimately come at a cost in my single situation - I’m happy to accept it.


----------



## galumay

Thanks Craft, I am thinking along similar lines, dont really like the arguments that rebalancing adds return to the portfolio, I couldnt model that return. As you say it becomes a philosophical exercise, I am no where near those sort of %'s so I am going to concentrate on alternative learning for now!

I think the Altman Z score got a mention in this thread, I am just running a couple of companies thru it and one thing that jumps out at me is that if there is very little debt then the company ends up with a very high score, (because EV/Debt*0.6 = a very high number), but if the debt is 0, then it can end up with a low score (because EV/Debt*0.6=0). 

As an example I get a Z score of 1.29 for DWS if I put in debt of 0, but if I put in $1 of debt I get a score of 36216001.29!!

Am I having a blonde moment here?


----------



## Klogg

galumay said:


> ...but if the debt is 0, then it can end up with a low score (because EV/Debt*0.6=0).
> 
> As an example I get a Z score of 1.29 for DWS if I put in debt of 0, but if I put in $1 of debt I get a score of 36216001.29!!
> 
> Am I having a blonde moment here?




If debt is 0, you'd most likely be getting a divide by zero error in your calcs.


----------



## galumay

Klogg said:


> If debt is 0, you'd most likely be getting a divide by zero error in your calcs.




Yes, excel gives an error if debt is 0, what i did was overwrite the formula, bv/debt*0.6 and enter a 0 for that value where the debt was 0, then it gave me the score of 1.29. I realise that is not a valid solution to the problem of 0 debt!

What is the solution? Or is the Altman Z score not appropriate to zero and very low levels of debt, and if thats the case what level of debt does it begin to become appropriate?

The obvious point being that are company with no debt, or very low debt is not immune from bankruptcy is it?


----------



## Ves

Altman Z Score - my understanding of how it is calculated based on here:



> The original Z-score formula was as follows:
> 
> Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.99T5
> 
> T1 = Working Capital / Total Assets. Measures liquid assets in relation to the size of the company.
> 
> T2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.
> 
> T3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.
> 
> T4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.
> 
> T5 = Sales/ Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).




For DWS I used the 2014 figures as follows:

t1 = 22.282/73.799 = 0.301928
t2 = 25.603/73.799 = 0.346929
t3 = 18.589/73.799 = 0.251887
t4 = 108.761/13.439 = 8.092938   (MV of Equity based on closing price 7 April 2015)
t5 = 94.397/73.799 = 1.279109

Z = (0.301928*1.2) + (0.346929*1.4) + (0.251887*3.3) + (8.092938*0.6) + (1.279109*0.99)
Z = 0.362314 + 0.4857 + 0.831227 + 4.855763 + 1.266318
Z = 7.801322


----------



## galumay

Ves said:


> Altman Z Score - my understanding of how it is calculated based on here:
> 
> 
> 
> For DWS I used the 2014 figures as follows:
> 
> t1 = 22.282/73.799 = 0.301928
> t2 = 25.603/73.799 = 0.346929
> t3 = 18.589/73.799 = 0.251887
> t4 = 108.761/13.439 = 8.092938   (MV of Equity based on closing price 7 April 2015)
> t5 = 94.397/73.799 = 1.279109
> 
> Z = (0.301928*1.2) + (0.346929*1.4) + (0.251887*3.3) + (8.092938*0.6) + (1.279109*0.99)
> Z = 0.362314 + 0.4857 + 0.831227 + 4.855763 + 1.266318
> Z = 7.801322




So you use total liabilities instead of debt? Thats different to the guides I have read! Otherwise I get the same results as you.

EDIT - i will leave this discussion here and start another thread - its not relevant to Craft's main topic anyway.


----------



## galumay

Ok, back on topic! Another company I have been studying for a while is TGR, most of the metrics reflect my belief that it is undervalued currently, but my FCFE calculation comes back very low, hence my DCF valuation is also very low.

I am a complete ameteur compared to you guys when it comes to understanding cash flows and their valuation, but it looks to me like the main reasons for the very low FCFE is the proportionally high delta in working capital and pretty high capex. 

The valuation though ends up in a range that is south of $1 - suggesting its very expensive at $3.50.

When i look at a FCF valuation, which is what I used to use, so much simpler, just net operating cash flow less capex, i get a valuation which is many orders of magnitude bigger. I guess thats why a simple FCF analysis is not very reliable!

I suspect the delta in working capital is the driver for the low valuation, in a case like this do you guys then look back at a couple more periods and see if this was an anomoly?

If it turns out to be an anomoly how do you allow for it in a valuation model?


----------



## galumay

Ok, its not an anomoly, it has jumped up a bit in the last period, but going back it was, $23m this period, $18m ppr and $17m before that.  mmm...back to the drawing board!


----------



## craft

galumay said:


> Ok, back on topic! Another company I have been studying for a while is TGR, most of the metrics reflect my belief that it is undervalued currently, but my FCFE calculation comes back very low, hence my DCF valuation is also very low.
> 
> I am a complete ameteur compared to you guys when it comes to understanding cash flows and their valuation, but it looks to me like the main reasons for the very low FCFE is the proportionally high delta in working capital and pretty high capex.
> 
> The valuation though ends up in a range that is south of $1 - suggesting its very expensive at $3.50.
> 
> When i look at a FCF valuation, which is what I used to use, so much simpler, just net operating cash flow less capex, i get a valuation which is many orders of magnitude bigger. I guess thats why a simple FCF analysis is not very reliable!
> 
> I suspect the delta in working capital is the driver for the low valuation, in a case like this do you guys then look back at a couple more periods and see if this was an anomoly?
> 
> If it turns out to be an anomoly how do you allow for it in a valuation model?




Every Free Cash Flow model requires discrimination between maintenance & growth capex/opex.  Have you adjusted for growth Capex in PPE and Growth Opex in biological assets etc?


----------



## galumay

craft said:


> Every Free Cash Flow model requires discrimination between maintenance & growth capex/opex.  Have you adjusted for growth Capex in PPE and Growth Opex in biological assets etc?




No, I used the line from the Cash Flow, "Payment for property, plant and equipment" as my proxy for Capex.
There is no obvious explanation of the distinction between capex/opex in the report that I can see - but then I wouldnt knwo where to look!


----------



## craft

galumay said:


> No, I used the line from the Cash Flow, "Payment for property, plant and equipment" as my proxy for Capex.
> There is no obvious explanation of the distinction between capex/opex in the report that I can see - but then I wouldnt knwo where to look!




The distinction you need to make is between growth expenditure and "existing business maintenance" expenditure. 

Existing business maintence expenditure is not discretionary - you either spend it or economically liquidate the existing business. Growth expenditure is discretionary - it could be returned to shareholders if it wasn't used to build the business.


I have no time before heading away for awhile - If it hasn't twigged or someone else hasn't helped out I'll take it up when I get back.

Cheers


----------



## Tooth Faerie

I'm not sure my question is relevant to the thread but I thought people in this thread would have a thoughtful answer.

In Graham's book, he suggested looking at long term debt to working capital and total debt to net book value (NTA? Are those synonymous?). 

I'm unsure how to take these metrics into my analyses. The obvious is that low debt is better but what about when the two metrics are very different? 

What would having low long term debt to working capital but having high total debt to net assets mean in terms of interpretation? 

From my newbie guess, would it mean that they are highly leveraged but are able to manage their debts?


----------



## craft

Tooth Faerie said:


> I'm not sure my question is relevant to the thread but I thought people in this thread would have a thoughtful answer.
> 
> In Graham's book, he suggested looking at long term debt to working capital and total debt to net book value (NTA? Are those synonymous?).  Net Book Value includes intangibles NTA doesn't.
> I'm unsure how to take these metrics into my analyses. The obvious is that low debt is better but what about when the two metrics are very different?
> 
> What would having low long term debt to working capital but having high total debt to net assets mean in terms of interpretation? Not sure how this could happen - might be misinterpreting what you mean - got an example?
> 
> From my newbie guess, would it mean that they are highly leveraged but are able to manage their debts?




...


----------



## craft

craft said:


> The distinction you need to make is between growth expenditure and "existing business maintenance" expenditure.
> 
> Existing business maintence expenditure is not discretionary - you either spend it or economically liquidate the existing business. Growth expenditure is discretionary - it could be returned to shareholders if it wasn't used to build the business.
> 
> 
> I have no time before heading away for awhile - If it hasn't twigged or someone else hasn't helped out I'll take it up when I get back.
> 
> Cheers




Galumay

Have you made any progress on this topic? I'm a bit reluctant to post on TGR at the Moment.


----------



## galumay

craft said:


> Galumay
> 
> Have you made any progress on this topic? I'm a bit reluctant to post on TGR at the Moment.




I havent craft, I have been busy with other research, but the quick look I had at the annual report I couldnt see those numbers broken down.

I guess thats something I am struggling with in general, how do you know when and how to break down elements of a FCFE model? I suspect its easier with US companies where the reporting is more detailed.


----------



## Ves

Without looking at Tassal right now,  I'll give you a hint.   It takes 3-4 years from birth until Salmon are ready to be prepared for sale.   I'm fairly sure,   if my memory serves me correctly, that this all goes through the OCF.   For that reason when they are really expanding their production output there is a massive drag on cash flow for the first few years.    

Problem is,   that the previous production cycle will overlap the new one,  which may smooth out cashflow a bit.   It's up to you to fill in those gaps with the numbers provided.

Also need to look at cost of plant (which goes in capex) over the entire life cycle.

It's easier with Tassal and similar companies to thinking outside of a single year basis.   Look at multi year periods.


----------



## VSntchr

galumay said:


> I havent craft, I have been busy with other research, but the quick look I had at the annual report I couldnt see those numbers broken down.



Pg 8 Annual report might help.



> I guess thats something I am struggling with in general, how do you know when and how to break down elements of a FCFE model?



I link it with growth. If you are estimating revenue growth, then (depending on the business model) you will need to budget for this growth. Upon reaching maturity will allow you to find your sustainable level of maintenance capex.


----------



## galumay

Ves said:


> It's easier with Tassal and similar companies to thinking outside of a single year basis.   Look at multi year periods.




I am starting to think that TGR is just overvalued! Looking back over the last 4 years there is not a lot of variation in the metrics, change in working capital and capex are both fairly smooth over that time period. My simple FCF model has them over priced, my FCFE model has them very overpriced.

The thing that has me in two minds is the earnings, they are higher and more consistently higher, than I would expect if my FCFE/FCF valuations are correct. Also a number of the other metrics are pretty good, EV/E, P/S, M/B.

Its not even so much about TGR but getting to the point where I have sufficient confidence in the numbers that my DCF models generate!


----------



## Ves

I'm not so sure about that.  Biological assets have almost doubled  (ie.  they're breeding a lot more fish than they're selling),   debt has decreased and I'm sure they have spent a fair bit on new infrastructure assets over this period.  Yet they've not needed to tap shareholders for this once during the period.  If you want to understand the nature of the cash flow you'd need to figure out how this happened.

Return on assets increased from 9% to 12.5% over the same period.   

I recall their investor presentations being pretty helpful.   Other than that I could only suggest that you'd need to understand how the industry works  (what they need to spend funds on,  and when it occurs in the cycle,  also when the cash is received and what determines how much they receive).


----------



## galumay

Ves said:


> If you want to understand the nature of the cash flow you'd need to figure out how this happened.
> 
> I recall their investor presentations being pretty helpful.   Other than that I could only suggest that you'd need to understand how the industry works  (what they need to spend funds on,  and when it occurs in the cycle,  also when the cash is received and what determines how much they receive).




Thanks for the input, Ves, I guess I am not good enough.......yet! More homework required.


----------



## craft

Ves said:


> I'm not so sure about that.  Biological assets have almost doubled  (ie.  they're breeding a lot more fish than they're selling),   debt has decreased and I'm sure they have spent a fair bit on new infrastructure assets over this period.  Yet they've not needed to tap shareholders for this once during the period.  If you want to understand the nature of the cash flow you'd need to figure out how this happened.
> 
> Return on assets increased from 9% to 12.5% over the same period.
> 
> I recall their investor presentations being pretty helpful.   Other than that I could only suggest that you'd need to understand how the industry works  (what they need to spend funds on,  and when it occurs in the cycle,  also when the cash is received and what determines how much they receive).




I hoped you would show up with some thoughts for Galumay.

For what its worth I have TGR on an almost 10% normalised discretionary free cash flow return at current prices. In addition to that I think their growth expenditure is adding value and the real kicker for me is the improving return metrics following previous round of growth expenditure. The companies LTI has a hurdle rate of 15% ROA before anything vests - so its a fair indication of where things are heading.

De Costi acquisition and perhaps associated cap raising; Senate Inquiry; people taking queues from the  medium term down trend and lack of familiarity with AASB141 all helping with price at the moment.

TGR isn't the screaming buy of a couple of years ago but this pull back in the longer term picture has put it back in the ball park of potential opportunity.   Its an interesting point in time where I feel I need to be listening more then reinforcing my biases by talking. So that's it for me on them for a while.


----------



## Tooth Faerie

craft said:


> Net Book Value includes intangibles NTA doesn't.




Thanks craft. I finally have a but more clarity when reading analyses now. 

I've been calculating debt/NTA because it makes logical sense to me since intangible assets won't help in repaying debt.




craft said:


> Not sure how this could happen - might be misinterpreting what you mean - got an example?




When looking at MND's latest half year report. My calculations show:

Liabilities/NTA = 126%
Long-term liabilities/WC = 7%

Am I doing something wrong?


----------



## luutzu

Tooth Faerie said:


> Thanks craft. I finally have a but more clarity when reading analyses now.
> 
> I've been calculating debt/NTA because it makes logical sense to me since intangible assets won't help in repaying debt.
> 
> 
> When looking at MND's latest half year report. My calculations show:
> 
> Liabilities/NTA = 126%
> Long-term liabilities/WC = 7%
> 
> Am I doing something wrong?




I own a handful of MND so take my calculations with possible biases.


From 2014 annual report, Total Debt to NTA is 1.079, or 108% by the sound of what you're doing.
Might look bad but since NTA takes out all the Goodwill and Intangibles, which might make sense as you say since intangibles aren't real... BUT... depends on what those tangibles are... what the Goodwill are made up of.

Say MND bought a few companies, pay at price higher than the acquired asset's various assets' bookvalue... that is added to Goodwill right? So if the intangibles were to have a lot of goodwill, while it may really be as assume and be worth nothing but payment in excess of book... if the assets acquired were land or something that actually appreciates in value etc. etc.

So if you're looking to see if it were liquidated then could it pay off its debt... maybe use the Liquidating value instead of this.

My opinion.


---

With regards to MND financial position - it's very strong. 
Current Ratio = 1.67 (2014 AR), that is, for every dollar of current liability it has $1.67, or $0.67 to spare.

Look at that in relation to its Debt Ratio and Interests.Bearing Debt Ratio... Debt ratio of 0.52 means 52% of its assets are financed by debt... however, the int.only debt ratio is an amazing 0.09, or 9%. This mean MND was able to tell his subcontractors to lend it services and goods for free... also mean only 9% of its debt are bank borrowings or financial debt so it could theoretically borrow a lot more to finance further adventures.

And that is why its share price has been halved since my first purchase, haha
Never let reality ruin a beautiful dream I'd say.


----------



## craft

Tooth Faerie said:


> When looking at MND's latest half year report. My calculations show:
> 
> Liabilities/NTA = 126%
> Long-term liabilities/WC = 7%
> 
> Am I doing something wrong?




Hi TF

Your original question asked about long term debt which you now refer to as liabilities – first clarification I need is whether you are talking about interest bearing debt or ALL liabilities whether they incur interest or not? 

Second clarification is about whether you are including cash balance (all, surplus or none) in working Capital.


----------



## craft

luutzu; said:
			
		

> Say MND bought a few companies, pay at price higher than the acquired asset's various assets' bookvalue... that is added to Goodwill right? So if the intangibles were to have a lot of goodwill, while it may really be as assume and be worth nothing but payment in excess of book... if the assets acquired were land or something that actually appreciates in value etc. etc.




???

Am I misreading your post or are you suggesting land can make up part of goodwill?


----------



## luutzu

craft said:


> ???
> 
> Am I misreading your post or are you suggesting land can make up part of goodwill?




land is written at book value - the costs of purchase.

Was referring to when a company acquire another company. My understanding is that when the buyer, say MND, bought corp.X and pays above book value... that overpayment is classified as Goodwill. While on paper it may appear that MND new Goodwill is just intangible, it may be the case that MND, when valuing Corp.X, appraise the assets, say land, at the current value and that current value is above the bookvalue as appear on Corp.X's account.

So it could be the case that what is technically Goodwill and hence intangibles may not be so.

Say my company were to buy Xcorp. The land bank it has is $10M on its book. If it's reappraised now those land are now $20M say. 

If I were to buy the land only and not the company, on my book value it'd be $20M; but if I buy the company, the land is $10 at book and $10 as goodwill.

Pretty sure that's how accounting define these, unless I'm wrong.


----------



## craft

luutzu said:


> land is written at book value - the costs of purchase.
> 
> Was referring to when a company acquire another company. My understanding is that when the buyer, say MND, bought corp.X and pays above book value... that overpayment is classified as Goodwill. While on paper it may appear that MND new Goodwill is just intangible, it may be the case that MND, when valuing Corp.X, appraise the assets, say land, at the current value and that current value is above the bookvalue as appear on Corp.X's account.
> 
> So it could be the case that what is technically Goodwill and hence intangibles may not be so.
> 
> Say my company were to buy Xcorp. The land bank it has is $10M on its book. If it's reappraised now those land are now $20M say.
> 
> If I were to buy the land only and not the company, on my book value it'd be $20M; but if I buy the company, the land is $10 at book and $10 as goodwill.
> 
> Pretty sure that's how accounting define these, *unless I'm wrong*.




You're wrong.


----------



## luutzu

craft said:


> You're wrong.




Mind to elaborate to help me (us) out?


Another example to show what my take on Goodwill regarding acquisition is.


Say Xcorp is a timber company, and on its books are land it first purchased and the seeds it planted. All up, costs for land and seed was $10M. That was 100 years ago, since then Xcorp does nothing but water those seedlings into fine trees now. Assumes it has no other assets or liabilities, or whatever and so its net book value is $10M.

If my Ycorp bought Xcorp for $20M... How does Ycorp record this acquisition on its books? Additional $20M bookvalue or only $10M into book and the excess above book paid for Xcorp (another $10) is define as Goodwill?


I always thought that if you were to just buy the asset, then the bookvalue is $20M, but if you buy the company, then you must be conservative and either record bookvalue at cost or the lower of market, but never revise it up.


oh, by bookvalue above I mean the bookvalue of the land/property.


----------



## McLovin

luutzu said:


> Mind to elaborate to help me (us) out?
> 
> 
> Another example to show what my take on Goodwill regarding acquisition is.
> 
> 
> Say Xcorp is a timber company, and on its books are land it first purchased and the seeds it planted. All up, costs for land and seed was $10M. That was 100 years ago, since then Xcorp does nothing but water those seedlings into fine trees now. Assumes it has no other assets or liabilities, or whatever and so its net book value is $10M.
> 
> If my Ycorp bought Xcorp for $20M... How does Ycorp record this acquisition on its books? Additional $20M bookvalue or only $10M into book and the excess above book paid for Xcorp (another $10) is define as Goodwill?
> 
> 
> I always thought that if you were to just buy the asset, then the bookvalue is $20M, but if you buy the company, then you must be conservative and either record bookvalue at cost or the lower of market, but never revise it up.
> 
> 
> oh, by bookvalue above I mean the bookvalue of the land/property.




When you buy a company you get the tangible assets valued. This is the value that you transfer over to your balance sheet. The amount paid for the company over this valuation is goodwill. Internally generated intangibles will be carried over at cost *I think*.


----------



## luutzu

McLovin said:


> When you buy a company you get the real assets valued. This is the value that you transfer over to your balance sheet. The amount paid for the company over this valuation is goodwill.




So if the $10M original costs for land/seedling is now valued at $20M, and I pay $20M. Is there any goodwill for my Ycorp's book?

It would make sense if the new book value for land/trees is now $20M, not $10M... But I remember this point being stressed because it was repeated a couple times as to how accounting can be misleading.

But yea, personally, if I'm interested in the stock as a bookvalue/NTA play I would go and make adjustments anyway.

Thanks


----------



## craft

luutzu said:


> Mind to elaborate to help me (us) out?
> 
> 
> Another example to show what my take on Goodwill regarding acquisition is.
> 
> 
> Say Xcorp is a timber company, and on its books are land it first purchased and the seeds it planted. All up, costs for land and seed was $10M. That was 100 years ago, since then Xcorp does nothing but water those seedlings into fine trees now. Assumes it has no other assets or liabilities, or whatever and so its net book value is $10M.
> 
> If my Ycorp bought Xcorp for $20M... How does Ycorp record this acquisition on its books? Additional $20M bookvalue or only $10M into book and the excess above book paid for Xcorp (another $10) is define as Goodwill?
> 
> 
> I always thought that if you were to just buy the asset, then the bookvalue is $20M, but if you buy the company, then you must be conservative and either record bookvalue at cost or the lower of market, but never revise it up.
> 
> 
> oh, by bookvalue above I mean the bookvalue of the land/property.




Business combination accounting requires all identifiable assets to be revaluated at current fair value as of the purchase date. 

Refer AASB 3


----------



## McLovin

craft said:


> Business combination accounting requires all identifiable assets to be revaluated at current fair value as of the purchase date.
> 
> Refer AASB 3




Identifiable! That was the word I was looking for!

In fairness, I did have ten beers tonight watching the AFL (largely to overcome the boredom).


----------



## luutzu

craft said:


> Business combination accounting requires all identifiable assets to be revaluated at current fair value as of the purchase date.
> 
> Refer AASB 3




Cool... thanks.


----------



## craft

McLovin said:


> In fairness, I did have ten beers tonight watching the AFL (largely to overcome the boredom).




I've been helping my daughter with some high school math homework - I could really have done with some of your beers, at least then I would have an excuse for just how much I have forgotten


----------



## Tooth Faerie

luutzu said:


> And that is why its share price has been halved since my first purchase, haha
> Never let reality ruin a beautiful dream I'd say.




Just opportunity to make even more money 




craft said:


> Hi TF
> 
> Your original question asked about long term debt which you now refer to as liabilities – first clarification I need is whether you are talking about interest bearing debt or ALL liabilities whether they incur interest or not?
> 
> Second clarification is about whether you are including cash balance (all, surplus or none) in working Capital.




I am sorry for any confusion. I come from a non-finance background. I'm slowly self-educating myself and sometimes I still confuse terms.

Firstly, to make it easier for myself at the moment, I use debt and liabilities synonymously.

For working capital, I'm using the difference between current assets and current liabilities.

Thanks for taking time to help me out!


----------



## luutzu

Tooth Faerie said:


> Just opportunity to make even more money




Yea, bought some more at $10.70 or so, then it goes to around $7 and $8 - see the pattern?
Then thought of buying more at around $8.40 but it shot up to $13 so bought Santos instead...

Who knows, MND might use its recent water infrastructure acquisition and head to California and Brazil to give a hand with their water problem. Either way, there's going to be a lesson or two for me with this one - so I'll profit either way 

Positive thinking they say


----------



## craft

Tooth Faerie said:


> Firstly, to make it easier for myself at the moment, I use debt and liabilities synonymously.



Figures are for MND 2014 Full year all figures $,000


I think of debt as interest bearing and generally preferentially secured obligation to the lender. MND has 20,001 short term, 17,030 Long term for total of 37,031.

Liabilities are every thing the company owes, interest bearing or not. MND has 362,561 short term (current), 24,931 long term (Non-Current) for total of 387,492



Tooth Faerie said:


> For working capital, I'm using the difference between current assets and current liabilities.




I think working capital is conventional defined as all current assets except for surplus cash less all current liabilities except for short term debt . 


Assuming None of MND's cash of 217,859 is surplus then calculation would be Current Assets of 606,272 less Current liabilities of 362,561 plus short term debt of 20,001 = 263,712.




Tooth Faerie said:


> In Graham's book, he suggested looking at long term debt to working capital and total debt to net book value (NTA? Are those synonymous?).




Net Book Value (also known as Net Assets or Equity) = 362,665
Net Tangible assets = Net Book Value less intangibles = 362,665 – 3,791 = 358,874.  Not a big difference in MND’s case but for some companies it can be huge.

Long term *debt* to working capital

17,030 / 263,712 = 6.4%

Total *debt* to net book value

37,031 / 362,665 = 10.2%

Or *substituting liabilities for debt *the numbers are very different.

24,931 / 263,712 = 9.4%
387,492 / 362,665 = 106.8% 

Not sure what Graham was suggesting – but defining his definitions would be necessary before we can guess as to what it was.

But blanket rules are dangerous in any case.

MND is pretty conservatively leveraged on any ratio based approach – but a contracting company can still go bankrupt without any interest bearing debt at all. The devil is in the contractual details of their projects. If they have fixed revenue from a contract and have mis-calculated the expense of meeting their contractually enforceable obligations they can incur big losses (and seeming out of nowhere unless you have very good industry knowledge).


----------



## galumay

craft said:


> I think working capital is conventional defined as all current assets except for surplus cash less all current liabilities except for short term debt .




Interesting, I have always used CA-CL=WC for my FCFE calculations.


----------



## luutzu

craft said:


> Net Book Value (also known as Net Assets or Equity) = 362,665




Pretty sure Graham define BookValue as also excluding senior securities like preference shares. Most companies might not have any, but if they do it ought to be taken out.

I would also remove minority interests.


In terms of interest bearing or non-interest liabilities. It's technically correct that both are debt to be paid... so that's fine if we're only interested in knowing how much debt it owes. 

But if we're interested in its borrowing capacity, or examine its competitive advantage... this is one of the few places you could see that. 

Money that are owe to suppliers or customers, if inventory turnover are good, if position is strong, and if these liabilities are consistently acceptable and part of the business... it's like a float - using other people's money for practically nothing.

It's nice to have people lend you money for free - you owe them for sure, and you've got to pay it every 4 or 5 weeks, but if it's consistently like that month on month. question is, can MND get that month after month... unlikely to be at that level given current condition, but it's another indication of capable management.


----------



## craft

galumay said:


> Interesting, I have always used CA-CL=WC for my FCFE calculations.




IN FCFE calculations you are interested in change in WC (defined as CA-CL) *+ Net Borrowings*. Washes out the same. Its just when you are analysing working capital in isolation you need to bring the net debt back inside the WC definition.


----------



## galumay

craft said:


> IN FCFE calculations you are interested in change in WC (defined as CA-CL) *+ Net Borrowings*. Washes out the same. Its just when you are analysing working capital in isolation you need to bring the net debt back inside the WC definition.




Thanks craft, i realised that when i went back and looked at my spreadsheet again, i use Damodaran's method of calculating Debt to Capital ratio and inputing that into the FCFE formula - so as you say debt is already factored into the equation.


----------



## galumay

While I am laid up with a squashed foot I have revisted TGR to see if I could learn from what various posters have written in this thread about my analysis, and DCF IV based on FCFE.

When I look back at my calculations, there are two possible explanations for the very low FCFE number, either my number for Capex is too high or my calculation for change in working capital is too high. Another possibility is Depreciation & Amortisation is incorrect.

Checking back through the annual report, the only value for Capex I can discern is the line in Cash Flow for "Payment for Property Plant & Equipment", given that there is no explanatory notes or breakdown, I have to accept this as proxy for Capex.

The change in working capital I have relied on the usual, CA-CL for the current reporting period, minus CA-CL for the previous reporting period.

I suspect somehow this is where I have to break out at least part of the biological assets to adjust the numbers.

My interest here is not specifically in investing in TGR, its about understanding why my DCF model is breaking down with this particular company, and what the specific reason for that is. Its difficult to have confidence in my anaysis for other companies I I dont understand what I am doing wrong here!

Sorry for my labouring about this analysis, but I have no formal economics or finance training so I have had to learn all of this from scratch.


----------



## craft

galumay said:


> but I have no formal economics or finance training so I have had to learn all of this from scratch.




Ditto, and it appears I can't even do high school math anymore. So consider yourself warned before you consider anything I post.

But I think the first thing you have to do is decipher how much is being spent on business maintenance and how much is being spent to fund growth. 

Can't really progress until you have an estimate on this.


----------



## Tooth Faerie

luutzu said:


> Yea, bought some more at $10.70 or so, then it goes to around $7 and $8 - see the pattern?
> Then thought of buying more at around $8.40 but it shot up to $13 so bought Santos instead...
> 
> Who knows, MND might use its recent water infrastructure acquisition and head to California and Brazil to give a hand with their water problem. Either way, there's going to be a lesson or two for me with this one - so I'll profit either way
> 
> Positive thinking they say




I have yet to "average down" but after doing my so-called "analysis", MND does appear to be an outstanding company and I'm am tempted every time it goes sub-$9.



galumay said:


> Sorry for my labouring about this analysis, but I have no formal economics or finance training so I have had to learn all of this from scratch.




That's what makes ASF such an amazing place. We are all on a self-learning journey and it's great to learna and bounce ideas off people. At the moment, I'm mostly learning.

Been slowly going through business and finance textbooks.



craft said:


> Figures are for MND 2014 Full year all figures $,000
> 
> 
> I think of debt as interest bearing and generally preferentially secured obligation to the lender. MND has 20,001 short term, 17,030 Long term for total of 37,031.
> 
> Liabilities are every thing the company owes, interest bearing or not. MND has 362,561 short term (current), 24,931 long term (Non-Current) for total of 387,492




Thank you for clearing up what debt is, rather than all liabilities.




craft said:


> I think working capital is conventional defined as all current assets except for surplus cash less all current liabilities except for short term debt .
> 
> 
> Assuming None of MND's cash of 217,859 is surplus then calculation would be Current Assets of 606,272 less Current liabilities of 362,561 plus short term debt of 20,001 = 263,712.




I have been using the wrong definition for working capital. The figure I arrived at is close and seems to slightly underestimate WC.




craft said:


> Net Book Value (also known as Net Assets or Equity) = 362,665
> Net Tangible assets = Net Book Value less intangibles = 362,665 – 3,791 = 358,874.  Not a big difference in MND’s case but for some companies it can be huge.
> 
> Long term *debt* to working capital
> 
> 17,030 / 263,712 = 6.4%
> 
> Total *debt* to net book value
> 
> 37,031 / 362,665 = 10.2%
> 
> Or *substituting liabilities for debt *the numbers are very different.
> 
> 24,931 / 263,712 = 9.4%
> 387,492 / 362,665 = 106.8%




As I used all liabilities, I arrived at the strange latter figures. The former figures make much more sense.



craft said:


> Ditto, and it appears I can't even do high school math anymore. So consider yourself warned before you consider anything I post.




I would never have guessed. Your posts on fundamental anaylsis on the forum are an inspiration.


----------



## craft

galumay said:


> While I am laid up with a squashed foot I have revisted TGR to see if I could learn from what various posters have written in this thread about my analysis, and DCF IV based on FCFE.
> 
> When I look back at my calculations, there are two possible explanations for the very low FCFE number, either my number for Capex is too high or my calculation for change in working capital is too high. Another possibility is Depreciation & Amortisation is incorrect.





How's the foot G? 

A little kick along on for you.

Over the last 10 years TGR has spent 315 Million Capex yet depreciation charges have been 83 Million.  So how much capex is required to maintain the current status quo and how much is growth related?


As a side not - because its important in this case - how quickly does profitability on new capex increase to full clip. What's the profile of future capex as a lot of the infrastructure is now done.

Since DEC 10 when I first started recording the number TGR has made fair value adjustments to Biological assets of 64 Million. This increase is included in Working Capital - but does it impact cash spent?

My question on TGR - Will the buy De Costi? How will they fund it? I like what Mark Ryan has done so far but my big test for him is to see how he spends TGR script if the transaction goes ahead. Feasibly they could debt fund it but I don't think its in the companies nature to run anywhere close to the line since it was reborn out of bankruptcy and lessons have been noted.

Another question - how much do you think Mark Ryan is dreading facing a senate enquiry to tell a story of worlds' best sustainability practices for salmon production endorsed by the WWF?  Yes there is an argument against salmon production - but the same argument can be made against all protein production/extraction and the ones making the noise have vested interests in other fisheries or would have us all be mainly vegetarian with maybe a few sardines. Unlike wood chipping and some other environmental issues TGR is not lacking a social licence with main stream Tasmanians.

Wait there - I wasn't going to talk about TGR because I have a positive bias but the cheaper it gets the happier I will be - and people don't usually understand that.


----------



## galumay

craft said:


> How's the foot G?




Bloody sore! Deep lacerations to the heel and badly sprained, still cant walk.



> Over the last 10 years TGR has spent 315 Million Capex yet depreciation charges have been 83 Million.  So how much capex is required to maintain the current status quo and how much is growth related?




So I presume that implies a lot of the capex is for future growth? 



> As a side not - because its important in this case - how quickly does profitability on new capex increase to full clip. What's the profile of future capex as a lot of the infrastructure is now done.




I have no idea! Is it related to the life cycle of the fish? Presumably the future capex should drop as less infrastructure spending required so the gap between capex and depreciation will narrow.



> Since DEC 10 when I first started recording the number TGR has made fair value adjustments to Biological assets of 64 Million. This increase is included in Working Capital - but does it impact cash spent?




I tried to unwrap those fair value adjustments, as I could see the impact on WC, but i wasnt confident to discount them.



> Wait there - I wasn't going to talk about TGR because I have a positive bias but the cheaper it gets the happier I will be - and people don't usually understand that.




Well just consider it as an expample to help me unwrap the mystery of DCF models! I am not looking to buy TGR as it stands, just understand why my valuation is so wide of the mark. I do uderstand the attraction of companies getting cheaper!

I will go back and work thru the numbers and the report again and see if I can make any progress!

Thanks for your time & effort, craft.


----------



## Ves

What about the interaction between operating leverage and cashflow as their scale of operations /  salmon volume increases?   They hinted at this in presentations as early as 2010 and 2011  where they had target metrics of 16% ROA and 25% ROIC by 2016 FY.  The target date is next year,   do you think they will make it?  Looks achievable so far.

I also think you will find that the reason that OCF (excl.  finance costs and tax)  is generally less than EBITDA  is because they are funding growth in their biological assets through this line item rather than investing cash flows.   

By my estimates, discretionary free cash flow is much closer to about $50m  than the $25m or so you get from in the 2013 and 2014 cash flow statement.  It's not like in a steady state business you would be expanding your future harvest volumes or the infrastructure at your harbour  (see comments by company re Macquarie Harbour!).

As an exercise to help....  what quantity of salmon did they have in their assets in 2010 compared to 2014?

Note to self:  need to investigate the deferred tax liabilities and tax accounts...


----------



## craft

Ves said:


> What about the interaction between operating leverage and cashflow as their scale of operations /  salmon volume increases?   They hinted at this in presentations as early as 2010 and 2011  where they had target metrics of 16% ROA and 25% ROIC by 2016 FY.  The target date is next year,   do you think they will make it?  Looks achievable so far.  G this is what I meant by 'how quickly does profitability on new capex increase to full clip' Excecutive hurdle rates for bonuses are 15/17% statutory ROA so I suspect they think they will make it.
> I also think you will find that the reason that OCF (excl.  finance costs and tax)  is generally less than EBITDA  is because they are funding growth in their biological assets through this line item rather than investing cash flows. Totally correct as well s the non-cash AASB141 adjustment their is also cash spent at the OCF level for growth.
> By my estimates, discretionary free cash flow is much closer to about $50m  than the $25m or so you get from in the 2013 and 2014 cash flow statement.  It's not like in a steady state business you would be expanding your future harvest volumes or the infrastructure at your harbour  (see comments by company re Macquarie Harbour!).
> 
> As an exercise to help....  what quantity of salmon did they have in their assets in 2010 compared to 2014?
> 
> Note to self:  need to investigate the deferred tax liabilities and tax accounts...Deferred tax liabilities are large because tax accounting and AASB differ. TGR included the statutory tax in their reported profit but don't have to fork out the cash until much later. That's why the Div is only part franked so far - but it will go to FF as biological growth slows




Nice work Ves


----------



## galumay

craft said:


> Nice work Ves




Indeed, looks like its head down, bums up for me! Lots of work to get to the point where I can pull together the info  from reports with the sort of understanding you guys have.

Thanks to both of you, again.


----------



## craft

craft said:


> but the cheaper it gets the happier I will be




Could some one please tell TGR to take some notice of HUO announcement this morning.


----------



## galumay

craft said:


> Could some one please tell TGR to take some notice of HUO announcement this morning.




What amazes me is that an announcement of missing a profit guidance by a small amount, for a clear reason, should make some holders believe their shares were worth 15% less! People still promote the efficient market theory.


----------



## craft

galumay said:


> What amazes me is that an announcement of missing a profit guidance by a small amount, for a clear reason, should make some holders believe their shares were worth 15% less! People still promote the efficient market theory.




Pretty Unknown company missing prospect guidance - reaction probably not so surprising. If you gain some knowledge from the digging around you are doing at the moment and Huon sets into a bit of a post float funk here it may just at some stage afford you that intersection of knowledge and opportunity that offers decent risk/reward.


----------



## galumay

craft said:


> Pretty Unknown company missing prospect guidance - reaction probably not so surprising. If you gain some knowledge from the digging around you are doing at the moment and Huon sets into a bit of a post float funk here it may just at some stage afford you that intersection of knowledge and opportunity that offers decent risk/reward.




Yes, I have done well a number of times buying in similar situations, MMS was probably the best of them for me. There is some sort of scaling relationship that I think you get a feel for, the impact in real terms of the announcement, the effect on the current price and the opportunity that presents. I also saw it with Sirtex recently, although I was too slow and missed the opportunity. 

One thing I have realised those opportunities are fairly frequent, so sooner or later you are watching when it happens, and you have the intersection of knowledge and confidence to act on them.


----------



## craft

Sirtex life changing.

I have a 25% mark to market maximum concentration for my personal (non SMSF) funds.  Sirtex was initially purchased some time ago and had run up to bump its head against the limit and has since run into major volatility. I have simply kept exposure at my 25% max which has resulted in much buying and selling of late and thrown of cash to such an extent that I look back and think how lucky the announcement on 17 March didn’t go as I expected.  How ironic.

But the financial success of the Sirtex investment is not what has been life changing – that sort of thing has already happened before. It’s the scouting around in cancer sufferer/survivor forums that has been pivotal.  The explicit examples of how important time is when viewed through the eyes of those who truly comprehend theirs is limited have seemed to resonate with me pushing mid 40’s. 

With this change in perspective on time – I think I really now have the motivation to change how I use time and spending as much time as I do on this forum ain’t on the bucket list.

Hope to still drop in from time to time but not as regularly as I have.

Mid-life crisis here I come. 

Happy journey’s people.


----------



## DeepState

craft said:


> change in perspective on time
> 
> Mid-life crisis here I come.
> 
> Happy journey’s people.






craft said:


> Thank you Robin Williams. You made me laugh you made me think and you made me feel.




"Carpe Diem."  Every day.



"..because we are food for worms, lads..
..because, believe it or not, each and every one of us in this room is one day going to stop breathing, turn cold and die." 

High quality choice, Craft.  Best investment you will ever make.

In tribute to this thread, Present Values usually include some terminal value.  In life, that's not generally a perpetuity.


----------



## galumay

Best of luck Craft, you will be sorely missed here - your contributions have been of the highest level and your generosity in sharing your knowledge has been gratefully received. 

As one who is currently having my own experience in re allocation of time and resources through my 'gap year', I can heartily recommend the investment in one's self and family!

Hopefully you will find time to make the odd post here and keep us in the loop. Best of luck with your ventures.


----------



## skc

craft said:


> Hope to still drop in from time to time but not as regularly as I have.
> 
> Mid-life crisis here I come.
> 
> Happy journey’s people.




Hope to see you around, Craft.


----------



## Klogg

McLovin said:


> I agree. I think WOW is a classic example of overpaying for growth. It has the highest margins of almost any grocery chain in the world and, as I think I've mentioned before, margins are notorious for being mean reverting.
> 
> Greenwald is excellent and a bit overlooked. He mixes quantitative and qualitative better than most and forces you to really think about how one effects the other, IMO.




I'm very slowly working my way through this thread and found this - thought it was quite amusing given recent announcements from Woolies.


----------



## craft

I’m leaving – yer I know again.
 Hey but if you’re reading this thread you can probably understand the mental journey required as part of being a full time investor and I’ve displayed some volatility I know. 

This time it’s not so much about me craving mental space and silence.  I’m revitalised with a whole new set of objectives and ambitions around our PAF, and that aspect of finding meaning has been a bigger struggle than I realised until I solved it for quite a while – there was a hole, I thought I wanted to fill it with sharing what had helped me and my attempts always felt futile, but that’s not an ambition anymore.

I’m just doing this time what people do and voting with my feet (mouse) Making my protest. I strongly dislike some aspects of the ASF culture and I can’t ignore it (I’m an old housing commission boy – I have trouble not fighting back).  I don’t want to be a part of it anymore.

I owe a debt of gratitude to many people who I have talked shop with over my time here: 

VES
McLovin
skc
Robusta (where is he?)
VSntchr
Klogg
Can OZ
Heskings1
Smurf1976 (not sure we talked but sure read your stuff especially on Tassie)
Deep State
Hiddencow
Galumay
Know the Past
Systematic
Shouldaindex
Intrinsic Value 
Peter2
Newt
So Cynical
cynic
Sinner
ROE
fraa
Faramir
Vixs
Junior
skyQuake
Trembling Hand
Kid hustler
Lone wolf
Burglar 
r and r  
oddson

and many more, apologises to those I have forgotten, but memory is not my strong suit.

You guys/girls? Taught me lots. Thanks.

Hopefully we will cross paths again some day.


----------



## galumay

craft said:


> I’m leaving – yer I know again.
> .....
> 
> You guys/girls? Taught me lots. Thanks.
> 
> Hopefully we will cross paths again some day.




No, you taught us more than you will ever realise. You will be sadly missed.

I totally understand, the frustration level has been high this week.

Please dm me an email address if you would, I would love to stay in contact and discuss the odd thing with you!

best of luck mate!


----------



## McLovin

craft said:


> there was a hole, I thought I wanted to fill it with sharing what had helped me and my attempts always felt futile, but that’s not an ambition anymore.




They definitely weren't futile for those of us who took the time to understand. So long, mate. You've taught me a hell of a lot about investing.


----------



## skc

craft said:


> I’m leaving – yer I know again.
> 
> Hopefully we will cross paths again some day.




Craft,

All the best mate. This place can be trying at times and the reward/effort/frustration mix isn't always what we desire. I fully understand your decision. 

Look me up if you are ever in BrisVegas.

cheers


----------



## kid hustlr

Kid hustlr* 

Thanks for everything craft


----------



## Value Hunter

Sorry to see you go Craft. You have been a great contributor to this forum.


----------



## robusta

Craft,

Dragged me out of my hibernation. 

The wealth of your insights are calculated in more than dollars.

Thank you again.


----------



## McLovin

robusta said:


> Craft,
> 
> Dragged me out of my hibernation.
> 
> The wealth of your insights are calculated in more than dollars.
> 
> Thank you again.




Don't be a stranger!


----------



## Faramir

Hi Craft

I am honoured to see my name. Especially when I am very new and have not obtain the experience to make valuable contributions like everyone else you have mentioned. I feel fortunate that you liked some of the stocks I was watching.

I actually didn't want to write on this thread because I consider it one of my treasures. I did not want "strain" it with my lack knowledge. Yet I am writing on it to make a request. I am not sure if Craft would agree but it would mean a lot to me.

Can I ask Joe if he would make this thread/topic "Sticky"? I believe this thread deserves at least a "sticky". This thread may be Craft's treasure or maybe it is just another thread to him??? Yet I believe that many others would agree with me. Think of the hours and the knowledge invested into this thread. If I ask if this thread can become "sticky", I am not trying to take anything away from any other thread. I believe that this thread also deserves its place on top of the thread list of this section.

This thread is very detailed for me. As a beginner, I guess I need to re-read it at least 4-5 times to truly appreciate it. The opening page of this thread is somewhat very important (to me at least).

To everyone else: can you ask Joe to delete this post but only after my request to make this thread "sticky" has been heard. I only want to ask. If Craft disagrees, then fair enough but I wanted an opportunity to ask.

Knowledge is knowledge: everyone has more than me. In 2015, I only purchased two stocks and sold 1 stock. This year I have brought nothing (yet). VED was acquired, so I 'lost' it. Money fires up various emotions. Think of what people have been doing to each other in the real world throughout the history of mankind. I guess this forum is just a mini mirror of it. There are other things in my life firing up my emotions and that's way I have written so little this year.

To Craft: last time you left, I felt I missed a massive opportunity as you left just as I joined. Thank you for having the courtesy of letting us know that you need time out: whether it is short, long or (hopefully not) indefinitely. If you need it, then no one can argue.

To Joe: can you please ask Craft if he would mind making this thread "sticky"? I can see so many positive posts in this thread. This is definitely one of Craft's best parting gifts.


----------



## luutzu

craft said:


> I’m leaving – yer I know again.
> Hey but if you’re reading this thread you can probably understand the mental journey required as part of being a full time investor and I’ve displayed some volatility I know.
> 
> This time it’s not so much about me craving mental space and silence.  I’m revitalised with a whole new set of objectives and ambitions around our PAF, and that aspect of finding meaning has been a bigger struggle than I realised until I solved it for quite a while – there was a hole, I thought I wanted to fill it with sharing what had helped me and my attempts always felt futile, but that’s not an ambition anymore.
> 
> I’m just doing this time what people do and voting with my feet (mouse) Making my protest. I strongly dislike some aspects of the ASF culture and I can’t ignore it (I’m an old housing commission boy – I have trouble not fighting back).  I don’t want to be a part of it anymore.
> 
> I owe a debt of gratitude to many people who I have talked shop with over my time here:
> 
> VES
> McLovin
> skc
> Robusta (where is he?)
> VSntchr
> Klogg
> Can OZ
> Heskings1
> Smurf1976 (not sure we talked but sure read your stuff especially on Tassie)
> Deep State
> Hiddencow
> Galumay
> Know the Past
> Systematic
> Shouldaindex
> Intrinsic Value
> Peter2
> Newt
> So Cynical
> cynic
> Sinner
> ROE
> fraa
> Faramir
> Vixs
> Junior
> skyQuake
> Trembling Hand
> Kid hustler
> Lone wolf
> Burglar
> r and r
> oddson
> 
> and many more, apologises to those I have forgotten, but memory is not my strong suit.
> 
> You guys/girls? Taught me lots. Thanks.
> 
> Hopefully we will cross paths again some day.





I am somewhat offended craft. My name's not on the list dude. We did debate didn't we? 

Take care man. 

For what it's worth, don't take things too seriously. Life's too serious to not crack jokes and trade insults on forums.


----------



## luutzu

Faramir said:


> Hi Craft
> 
> I am honoured to see my name. Especially when I am very new and have not obtain the experience to make valuable contributions like everyone else you have mentioned. I feel fortunate that you liked some of the stocks I was watching.
> 
> I actually didn't want to write on this thread because I consider it one of my treasures. I did not want "strain" it with my lack knowledge. Yet I am writing on it to make a request. I am not sure if Craft would agree but it would mean a lot to me.
> 
> Can I ask Joe if he would make this thread/topic "Sticky"? I believe this thread deserves at least a "sticky". This thread may be Craft's treasure or maybe it is just another thread to him??? Yet I believe that many others would agree with me. Think of the hours and the knowledge invested into this thread. If I ask if this thread can become "sticky", I am not trying to take anything away from any other thread. I believe that this thread also deserves its place on top of the thread list of this section.
> 
> This thread is very detailed for me. As a beginner, I guess I need to re-read it at least 4-5 times to truly appreciate it. The opening page of this thread is somewhat very important (to me at least).
> 
> To everyone else: can you ask Joe to delete this post but only after my request to make this thread "sticky" has been heard. I only want to ask. If Craft disagrees, then fair enough but I wanted an opportunity to ask.
> 
> Knowledge is knowledge: everyone has more than me. In 2015, I only purchased two stocks and sold 1 stock. This year I have brought nothing (yet). VED was acquired, so I 'lost' it. Money fires up various emotions. Think of what people have been doing to each other in the real world throughout the history of mankind. I guess this forum is just a mini mirror of it. There are other things in my life firing up my emotions and that's way I have written so little this year.
> 
> To Craft: last time you left, I felt I missed a massive opportunity as you left just as I joined. Thank you for having the courtesy of letting us know that you need time out: whether it is short, long or (hopefully not) indefinitely. If you need it, then no one can argue.
> 
> To Joe: can you please ask Craft if he would mind making this thread "sticky"? I can see so many positive posts in this thread. This is definitely one of Craft's best parting gifts.




How come you're always so polite?

I've never met anyone as polite as you Faramir. But maybe that's just me making them impolite 

If I could pass on an advice my Saturday school teacher once taught us: when writing, don't put yourself down and don't pronounce yourself as someone's junior. 

One, your writing will elevate or put you down itself.

Two, some kid (or newbie) might be reading and since you say you're not worthy, they tend to agree with you.

I think you're alright man, just don't be too polite - it annoys some people.


----------



## So_Cynical

craft said:


> I’m leaving – yer I know again.




ASF at its best is when people really share, let you right in thus leaving themselves open, craft along with many others has added real value to the discussion..thanks.



robusta said:


> Craft,
> Dragged me out of my hibernation.




And that's a good thing.


----------



## craft

Faramir said:


> Hi Craft
> 
> I am honoured to see my name. Especially when I am very new and have not obtain the experience to make valuable contributions like everyone else you have mentioned. I feel fortunate that you liked some of the stocks I was watching.
> 
> I actually didn't want to write on this thread because I consider it one of my treasures. I did not want "strain" it with my lack knowledge. Yet I am writing on it to make a request. I am not sure if Craft would agree but it would mean a lot to me.
> 
> Can I ask Joe if he would make this thread/topic "Sticky"? I believe this thread deserves at least a "sticky". This thread may be Craft's treasure or maybe it is just another thread to him??? Yet I believe that many others would agree with me. Think of the hours and the knowledge invested into this thread. If I ask if this thread can become "sticky", I am not trying to take anything away from any other thread. I believe that this thread also deserves its place on top of the thread list of this section.
> 
> This thread is very detailed for me. As a beginner, I guess I need to re-read it at least 4-5 times to truly appreciate it. The opening page of this thread is somewhat very important (to me at least).
> 
> To everyone else: can you ask Joe to delete this post but only after my request to make this thread "sticky" has been heard. I only want to ask. If Craft disagrees, then fair enough but I wanted an opportunity to ask.
> 
> Knowledge is knowledge: everyone has more than me. In 2015, I only purchased two stocks and sold 1 stock. This year I have brought nothing (yet). VED was acquired, so I 'lost' it. Money fires up various emotions. Think of what people have been doing to each other in the real world throughout the history of mankind. I guess this forum is just a mini mirror of it. There are other things in my life firing up my emotions and that's way I have written so little this year.
> 
> To Craft: last time you left, I felt I missed a massive opportunity as you left just as I joined. Thank you for having the courtesy of letting us know that you need time out: whether it is short, long or (hopefully not) indefinitely. If you need it, then no one can argue.
> 
> To Joe: can you please ask Craft if he would mind making this thread "sticky"? I can see so many positive posts in this thread. This is definitely one of Craft's best parting gifts.




Hi Faramir – Yours was one of the first names that popped to mind because I hugely respect you and wish I could be a bit more like you. 



luutzu said:


> Just don't be too polite - it annoys some people.




Worst advice I have ever seen. But it’s typical of the fight, fight, fight forum culture.

Don’t worry about the sticky – the few that will value the content will find it.

This site seems to sadly reflect something bigger. If Bogan Hunters was on at the same time as a 4 Corners investigation into the difficulties people being brought up in housing commission face – you can bet 4 corners wouldn’t win the ratings. Content doesn’t count – voyeurism of ........  – That’s what is good for business and as far as I’m concerned the moderation of the site condones if not encourages it, so it’s never going to change. 

Maybe its a good thing to have this aspect of human nature play out on forums, maybe it stops it manifesting physically, maybe it encourages it - I realy don't know but I have experienced it physically and my upbringing was probably paradise to some that have come here from war torn countries. End of the day I can’t be part of it  – and that obviously means I have to stop reading too!!!!!

But don’t you stop being you – the world needs a lot more like you.

Ps

Howdy Robusta – Another person that naturally has qualities as an investor and person that I have to fight hard to achieve.

Hope you are well.


----------



## CanOz

Craft, take care son...and look us up with SKC if your ever in Brissy!


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## Ves

craft said:


> Don’t worry about the sticky – the few that will value the content will find it.




I won't say "goodbye" - because it doesn't seem right.  Like everyone else who has spent many hours posting to a forum community your footprint will still exist until it gets taken down for whatever reason. 

On top of that, all of the ideas / values that you stood for will and still do persist for me (at least the parts my memory has cherry-picked).

Whilst, like many individuals,  we can't glean much of another's life from posts on a forum,  I have sensed that you came to a realisation somewhere in the past few years and started asking different questions of yourself.  A lot of them about where investing actually fits into your life.

And I think you should keep doing it because it looks like you're getting some answers.

All the best.


----------



## Huskar

I echo everyone's sentiments Craft and perhaps the forum is +ve in this way: just the like the markets (or life for that matter) there is dross and there is gold about but it is your perspective that really matters and it sounds like yours has continued to grow for the better.


----------



## luutzu

craft said:


> ....
> Worst advice I have ever seen. But it’s typical of the fight, fight, fight forum culture.
> 
> ....




Maybe. But being "impolite" doesn't mean fight and argue for the sake of it. It mean being direct - give people what you think in as straight a manner as you can.

While that would insult people, it might make them think and maybe learn something or see things from a different perspective. Then they can either ignore your pov or take some or grow stronger in their thinking.

Being as polite and sociable on forums and we'll all be talking about the weather and how's the weekends and looking forward to that weekend and thanking god it's Friday.

Anyway, wishing you the best craft. Come back whenever you're bored and want to share with us your thoughts.


----------



## Newt

Take care and all the best for you and your family craft.

I must also thank you for one the greatest gifts I've personally gleaned from what you've shared here on ASF - to focus on longer term returns and performance.  Maybe I'm just getting to be an old fart, but moving out to longer timeframes in trading, work and life in general has worked well for me over the last couple of years.  Making sure you're not missing the big picture while tied up in all the short term challenges (or trades).

Should I ever feel I've learned enough, and have sufficient years positive returns under my belt, to feel qualified to leave some nuggets here for others, then suggesting people revisit your many thoughtful posts would definitely be on the list.

So long, and thanks for all the fish....


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## hiddencow

Hey craft, I'm sad that you won't be posting on here anymore. All the best with everything else in your life. You've already won this investing game and your posts have been an inspiration and a wealth of knowledge for me. I hope you come back every know and then even just to check and post in this thread only.
I don't often check these forums, I only log on every now and then to check the high quality posts from contributors like you and others. It doesn't take much time and adds a lot of value.


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## craft

craft said:


> I’ve done a little more thinking on this rebalancing issue.  Please critique, because I am not sure I have got it right and its hard to see the trees for the forest inside my own thoughts.
> 
> The decision (or lack of decision) to date has been to let the profits run.  I have now decided to limit the mark to market exposure to 25% of an account.  If it goes above I will trim it back to just under.
> 
> MTU was one of the companies that had climbed in % and it has had a fair impact on my final decision. One morning I looked at the screen and seen a little icon in the announcement field.  A little icon that meant MTU wanted me to invest a big chuck of money at short notice at a price over 4 times my average cost – It was renounceable and the price held up early allowing options but it gave me a jolt as to the difficulties around this weighting issue.
> 
> MTU was trimmed during the rights period and got another haircut yesterday as did MMS.  The gut still doesn’t quit feel right selling for weighting issues rather than business performance reasons. Still not a totally settled issue for me – more a work in progress probably awaiting some lessons to be learnt the hard way.



In the process of reviewing SRX trade.

One of the things this investment has done is throw a sharp light on the position sizing rules adopted and discussed in previous posts here.


My maximum exposure rule is 25% based on mark to market capital value.


My purchase position size rule is based on cost price capital value.

The portfolio where SRX is held now holds between 7 and 10 stocks which means I can invest between 10% and 14% of at cost capital into a stock.


The interplay of these rules and volatility of SRX made for a much better outcome than otherwise would have been (something I didn’t envisage when putting sizing rules in place) and in some ways saved me from myself. (the thing they were designed to do)


I’m happy with these rules now especially after the stress testing SRX has given them.


Maybe I would think differently if SRX only ever went smoothly up and had different trial outcomes as the rules would have been detrimental under that scenario.  There is defensible arguments about letting winners run and less (or more) diversification but I I’m happy that these numbers suits me. I’m likely to increase numbers of stocks held and decrease max exposure % slowly over time, but do it strategically in response to age and risk appetite rather than as a response to any given situation.


Only 5 years to fully think through these sizing issues – I'm getting faster.


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## craft

SRX investment review part 2

I first started buying SRX in 2006. The investment story was a self-funding biotech with a promising blue sky potential. Because of an Intellectual Property court case against founder Dr Gray and later the GFC I had the chance to get fully set at a value where I believed I wasn’t paying for the blue sky. My determination was to see the investment through to the major trial outcomes which would have facilitated the first line treatment blue sky if successful.   Apart from Soramic (HCC) those studies have now reported to an extent that I now consider my investment thesis completed and time to review. I can no longer justify a to the moon or bust investment course of action awaiting trial outcomes.


It’s safe to say at times SRX has had a lot higher expectations for the trial outcomes baked into the price than the trials are currently seen to have delivered. On that basis, the trials are a bust and my failing to sell the stock I still hold today at the highs is a million dollar+ misjudgement.


Hope – I really hoped the progression free survival in the liver that Sir Spheres gives would translate to an overall survival benefit in a wide population of sufferers – which is what the trials were designed to show. Turns out the cancers they are dealing with are just god awful systemic beasts and at best SIR-Spheres can help some sub-groups but it can’t help everybody. From my understanding my bottom line was that if I had liver cancer I would want SIR-Spheres as quickly as I could get my hands on it. I somewhat have changed that mindset to I would want to immediately consult the best in the field to see if SIR Spheres would benefit my situation. I think I’ll also double down on healthy living and keep hoping I stay lucky because there’s no easy answers out there for these cancers.


So I’m calling this investment to an end – and putting the results on paper because I’m actually not selling out just yet, rather doing what I consider the hardest thing not to stuff up with biases and coming up with another investment thesis -  preliminarily the numbers seem to stack up on adopting SRX as a cash flow investment – though a very high risk one and it has some near term targets to jump through as it rights a ship that is somewhat off kilter at the moment.


Finalising the to the moon or bust investment thesis outcome.

Average holding cost $3.706

Sell $11.77

Income over holing period 44% of current cost base (varying number of shares held at different dividend dates)

NET Realised profits from numerous buys and sells since first held. 177% of current cost base.


Whilst the SRX investment feels a bit disappointing just at the moment as I seem to be drawn to consider the failure of selling out at the top – which I shouldn’t because even attempting that was not my game, but I like to kick myself anyway.


What I need to remind myself of as failure this outcome is good and not to forget that SRX did a lot to seed other investments in the portfolio as it was trimmed at times along the way to stay under portfolio risk limits.

IF you have somehow managed to read all this and feel so inclined to comment on anything I might not be seeing as I reconsider my SRX investment thesis please do comment -  I know I'm at risk of being blind sided by biases generated by a decade involvement in this investment.


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## Triathlete

craft said:


> Whilst the SRX investment feels a bit disappointing just at the moment as I seem to be drawn to consider the failure of selling out at the top – which I shouldn’t because even attempting that was not my game, but I like to kick myself anyway.




At least you made money on the investment.....I guess my question to you now is how will you approach similar situations going forward?


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## craft

Triathlete said:


> At least you made money on the investment.....I guess my question to you now is how will you approach similar situations going forward?



 Exactly the same - why wouldn't I?

Although I'm not sure I will always want a "to the moon or bust" speculative position in the portfolio. They're entertaining but on the whole I think boring cash flow is probably more profitable long-term unless you get that element of luck your way.


----------



## luutzu

craft said:


> Exactly the same - why wouldn't I?
> 
> Although I'm not sure I will always want a "to the moon or bust" speculative position in the portfolio. They're entertaining but on the whole I think boring cash flow is probably more profitable long-term unless you get that element of luck your way.





For next time.


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## Triathlete

craft said:


> *Exactly the same - why wouldn't I?*
> 
> Although I'm not sure I will always want a "to the moon or bust" speculative position in the portfolio. They're entertaining but on the whole I think boring cash flow is probably more profitable long-term unless you get that element of luck your way.




I am glad you can sit through a 71% decline from the all time high, I certainly could not....I thought you might of added in a strategy to lock in some of your profits when a stock has had such a good run.....


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## VSntchr

Triathlete said:


> I am glad you can sit through a 71% decline from the all time high, I certainly could not....I thought you might of added in a strategy to lock in some of your profits when a stock has had such a good run.....



I don't want to reply for Craft, but just to save a bit of time.. I think he has already added in a strategy which does so. Whilst it has been done in the name of risk management, the 25% rule effectively achieves the effect locking in some profits after a big run. Craft did this on a few occassions with SRX which he documented at the time and which can also be seen in the review post above (the bit about net realised profits)...


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## VSntchr

Great to read your review and thoughts on your investment in SRX Craft.
We all struggle with biases at times, but I think you being aware of when they may start to creep in is a big part of what separates you from the herd


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## Triathlete

VSntchr said:


> I don't want to reply for Craft, but just to save a bit of time.. I think he has already added in a strategy which does so. Whilst it has been done in the name of risk management, the 25% rule effectively achieves the effect locking in some profits after a big run. Craft did this on a few occassions with SRX which he documented at the time and which can also be seen in the review post above (the bit about net realised profits)...




Yes I can see that and no doubt he has done very well out of his investment.
I was making a reply based on part of his comment where he says:


craft said:


> "*Whilst the SRX investment feels a bit disappointing just at the moment as I seem to be drawn to consider the failure of selling out at the top"*



Obviously if he had brought his portfolio position down to the 25% level at the $41 level then from that point onwards he would have lost whatever was his position at the time a loss of over 71%.

It seems to me that he has managed his risk and taking profits accordingly on the way up but not so on the way down.......This seems to be a common theme that I see on ASF...IMHO...eg AKP,SGH to name just two....


----------



## skc

craft said:


> Hope – I really hoped the progression free survival in the liver that Sir Spheres gives would translate to an overall survival benefit in a wide population of sufferers – which is what the trials were designed to show. Turns out the cancers they are dealing with are just god awful systemic beasts and at best SIR-Spheres can help some sub-groups but it can’t help everybody. From my understanding my bottom line was that if I had liver cancer I would want SIR-Spheres as quickly as I could get my hands on it. I somewhat have changed that mindset to I would want to immediately consult the best in the field to see if SIR Spheres would benefit my situation. I think I’ll also double down on healthy living and keep hoping I stay lucky because there’s no easy answers out there for these cancers.




Thanks for the review... I think this may be the only mistake you have made. You hoped that SRX can help more people (which is not a bad thing) but perhaps that clouded your judgement of the risk:reward? Clearly, cancer sufferers also hoped that SRX would work out for them... and from memory you interacted/took their views into account in your research. Did that also influence your judgement? If Sirtex wasn't about life saving cancer treatment, but something else, say a self-funded mining operation + exploration upside, (ignoring commodity cycle for this thought exercise), would you have acted any differently due to different emotions involved? Perhaps you would have sold more when the market priced it with a higher-than-risk-adjusted chance of success? I am fully aware that it's easy for me to make qualitative statements like these in hindsight of the actual trial outcomes. 

Fear, greed and hope are often cited as emotions that are detrimental to investing decisions... but when that hope is anchored on something much bigger than money, perhaps it's harder to deal with?



craft said:


> So I’m calling this investment to an end – and putting the results on paper because I’m actually not selling out just yet, rather doing what I consider the hardest thing not to stuff up with biases and coming up with another investment thesis -  preliminarily the numbers seem to stack up on adopting SRX as a cash flow investment – though a very high risk one and it has some near term targets to jump through as it rights a ship that is somewhat off kilter at the moment.




I think this is actually the part that caught lots of people out. SRX even without elevation into first line treatment is still a very worthy business. But the issues with the corporate governance and faltering sales (be it execution and/or competition) were not something I would have expected if I entered with a moon or bust thesis years back.



craft said:


> Finalising the to the moon or bust investment thesis outcome.
> 
> Average holding cost $3.706
> 
> Sell $11.77



Neither the moon or bust... I think it landed some where like a low altitude orbit.


----------



## craft

skc said:


> Thanks for the review... I think this may be the only mistake you have made. You hoped that SRX can help more people (which is not a bad thing) but perhaps that clouded your judgement of the risk:reward? Clearly, cancer sufferers also hoped that SRX would work out for them... and from memory you interacted/took their views into account in your research. Did that also influence your judgement? If Sirtex wasn't about life saving cancer treatment, but something else, say a self-funded mining operation + exploration upside, (ignoring commodity cycle for this thought exercise), would you have acted any differently due to different emotions involved? Perhaps you would have sold more when the market priced it with a higher-than-risk-adjusted chance of success? I am fully aware that it's easy for me to make qualitative statements like these in hindsight of the actual trial outcomes.
> 
> Fear, greed and hope are often cited as emotions that are detrimental to investing decisions... but when that hope is anchored on something much bigger than money, perhaps it's harder to deal with?
> 
> 
> 
> I think this is actually the part that caught lots of people out. SRX even without elevation into first line treatment is still a very worthy business. But the issues with the corporate governance and faltering sales (be it execution and/or competition) were not something I would have expected if I entered with a moon or bust thesis years back.
> 
> 
> Neither the moon or bust... I think it landed some where like a low altitude orbit.




Hey SKC - thanks for the thoughts.

Hope and emotion was part of the reason I entered the SRX trade – It must have been. Because I would not make a similar play in your example of a mining company with exploration potential. I would rather stick to my more normal cash flow investment scenario’s then a blue-sky scenario on something that doesn’t excite me on an emotional level.

However, it was not entirely a hope based investment. My objective is to take on risk where it is priced favourably to do so.  My assessment when buying in was that I was paying very little to nothing for the upside.  My commitment on entering was to see it through to the trial outcomes unless capital was raised in which case I would review. Perhaps that commitment was wrong but I knew I would face all sorts of forces to pre-guess the outcomes – something I knew I would never have the skills to do. The risk was bought at the right price to see it out. That was my plan – I executed my plan. (except the sell which is where I’m at now and mindful that transitioning the investment to a cash flow thesis whilst still invested is fraught with danger)

“higher-than-risk-adjusted chance of success.” Not that I would have acted on it with my trade plan – but I also never reached that conclusion in real time. If liver progression had translated to significant increase in overall survival SRX would have been a hundred-dollar stock in fairly short order with the eventual debate being what was the right number to put in front of the zero’s.


That SRX is a bit of a shambles operationally now gives rise to the pricing that can make the cash flow thesis viable so long as they can right(size) the ship. I’ve got the information to review the investment thesis. They have the information to review the business operation strategy – The governance and sales force leadership turmoil that accompanied the uncertainty of the trials (related? I suspect so) can’t be forgiven if they misstep going forward now they have some very good marketing data and a better understanding of the potential market population.


----------



## craft

Triathlete said:


> Yes I can see that and no doubt he has done very well out of his investment.
> I was making a reply based on part of his comment where he says:
> 
> Obviously if he had brought his portfolio position down to the 25% level at the $41 level then from that point onwards he would have lost whatever was his position at the time a loss of over 71%.
> 
> It seems to me that he has managed his risk and taking profits accordingly on the way up but not so on the way down.......This seems to be a common theme that I see on ASF...IMHO...eg AKP,SGH to name just two....




Triathlete

I put up some numbers that help understand my SRX outcome without specifying the exact dollar amount.

To make more sense of the numbers you need to assume a quantity of shares – let’s take 100,000.

Average purchase cost:  $370,600
Theoretical Sell: $11.77 = $1,177,000
Un-realised capital gain: = $806,400
Dividend Income (44%) = $163,064
Previous Realised Profit from portfolio limit rules (177%) = $655,962

Profit on $370,600 investment: $1,625,426 -  438% over a decade.

That result is O.K but not great considering how long the money was invested for and what it could have been if the trials were an unmitigated success – it works out to something in the range of 15% CAGR.

I’m not going to deny to myself or anybody else the bit you highlight, a 71% drawdown hurts. Its very easy to think of what other meaningful things you could have done with the money that has evaporated.

SRX reached $41.33 at that price the mark to market valuation of 100,000 shares is $4,133,000 and I was hitting portfolio limits so my exposure was 25% of the portfolio.

Mark to Market drawdown = $ 2,956,000 which is nearly twice my actual outcome. If the remainder of my portfolio stands still it is a 18% (71% *25%) drawdown in the portfolio.

But here’s the thing – Yes it hurts but I’m not going to change what I do because it hurts. That immediate profit obsession and avoiding volatility at all costs is the game that everybody else plays because it’s emotionally easy – but it’s not a game that I think makes you rich over the long run.

SRX’s blue sky of uniform first line treatment didn’t work out. Sometimes investments don’t work out – that is risk – that is what we do, we bear the risk.  But it could have worked out and I had a plan that allowed me to be exposed at full clip to the high-risk events. That’s what I wanted – I didn’t want to avoid them.

It’s easy to say they should have been avoided in hindsight – But I have yet to meet a rich hindsight warrior. And I don’t know of any other more pro-active risk management method (especially at size) that would have not cut you to pieces on the SRX gaps.

If I want to avoid 71% (or higher) drawdowns for emotional reasons, I will avoid making these types of investments altogether but I wouldn’t change how I execute the plan If I do take one again.

I think there will be room for other similar speculative positions in the portfolio and in my emotion bank again in the future - despite the potential drawdowns.


----------



## craft

Just to clarify one final thing on my thoughts on SRX

Whilst I’m saying the SRX trials failed in these last few posts– that is relation to my original investment thesis of success ie. meeting primary end points of overall survival.

There are some potentially good outcomes there for right sided colon cancers and quality of life for HCC treatment which expands their potential market quite considerably.

Whilst, I could have been in charge of marketing with an overall survival result in the armoury – the marketing job will now require more skill, effort and expertise to make sure the oncologist community is fully across where and when SIR Spheres work best. But there are no near-term limits on potential market size they just have to win market share. This is what underlies my new investment story.


----------



## Triathlete

craft said:


> Triathlete
> 
> I put up some numbers that help understand my SRX outcome without specifying the exact dollar amount.
> 
> To make more sense of the numbers you need to assume a quantity of shares – let’s take 100,000.
> 
> Average purchase cost:  $370,600
> Theoretical Sell: $11.77 = $1,177,000
> Un-realised capital gain: = $806,400
> Dividend Income (44%) = $163,064
> Previous Realised Profit from portfolio limit rules (177%) = $655,962
> 
> Profit on $370,600 investment: $1,625,426 -  438% over a decade.
> 
> That result is O.K but not great considering how long the money was invested for and what it could have been if the trials were an unmitigated success – it works out to something in the range of 15% CAGR.
> 
> I’m not going to deny to myself or anybody else the bit you highlight, a 71% drawdown hurts. Its very easy to think of what other meaningful things you could have done with the money that has evaporated.
> 
> SRX reached $41.33 at that price the mark to market valuation of 100,000 shares is $4,133,000 and I was hitting portfolio limits so my exposure was 25% of the portfolio.
> 
> Mark to Market drawdown = $ 2,956,000 which is nearly twice my actual outcome. If the remainder of my portfolio stands still it is a 18% (71% *25%) drawdown in the portfolio.
> 
> But here’s the thing – Yes it hurts but I’m not going to change what I do because it hurts. That immediate profit obsession and avoiding volatility at all costs is the game that everybody else plays because it’s emotionally easy – but it’s not a game that I think makes you rich over the long run.
> 
> SRX’s blue sky of uniform first line treatment didn’t work out. Sometimes investments don’t work out – that is risk – that is what we do, we bear the risk.  But it could have worked out and I had a plan that allowed me to be exposed at full clip to the high-risk events. That’s what I wanted – I didn’t want to avoid them.
> 
> It’s easy to say they should have been avoided in hindsight – But I have yet to meet a rich hindsight warrior. And I don’t know of any other more pro-active risk management method (especially at size) that would have not cut you to pieces on the SRX gaps.
> 
> If I want to avoid 71% (or higher) drawdowns for emotional reasons, I will avoid making these types of investments altogether but I wouldn’t change how I execute the plan If I do take one again.
> 
> I think there will be room for other similar speculative positions in the portfolio and in my emotion bank again in the future - despite the potential drawdowns.




Thanks Craft for your explanation and the numbers always help to explain the situation.
It is always good to see  how others invests especially with large sums.
You have a plan and you stick to it.


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## craft

Triathlete said:


> You have a plan and you stick to it.




A plan that works!

Sticking to it is only a good attribute in light of the plan itself.

Dog **** sticks - but treading in its not a good plan.


----------



## Value Hunter

Craft cheer up about Sirtex, a 15% CAGR over that time frame is still much better than the market and better than what most on ASF have achieved!!

Its like the billionaire with a net worth of $21 billion who is disappointed because his net worth "only" increased by a billion in the past year!! Its still a billion dollars and nobody is going to have much sympathy for him! 

At the end of the day you made a return that is higher than the market and higher than most people in percentage terms. Also the amount (I am guessing) in dollar terms is probably an amount that most normal people could not save in a ten year time-frame.


----------



## craft

Value Hunter said:


> Craft cheer up about Sirtex, a 15% CAGR over that time frame is still much better than the market and better than what most on ASF have achieved!!
> 
> Its like the billionaire with a net worth of $21 billion who is disappointed because his net worth "only" increased by a billion in the past year!! Its still a billion dollars and nobody is going to have much sympathy for him!
> 
> At the end of the day you made a return that is higher than the market and higher than most people in percentage terms. Also the amount (I am guessing) in dollar terms is probably an amount that most normal people could not save in a ten year time-frame.



Not unhappy - just reflecting on an outcome.


----------



## fiftyeight

Ves said:


> Hey guys,
> 
> Return on invested capital  (ROIC)  and / or Return on Capital Employed (ROCE).
> 
> I am currently playing around with this.   It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
> 
> Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation?   I would like to explore issues surrounding goodwill  /  other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible.  For instance, it is possible that a company has overpaid for an acquisition in the past  (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
> 
> Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.




Reading through this thread at the moment and came across this podcast which is semi relevant to the above topic.

http://investorfieldguide.com/dorsey/


----------



## InsvestoBoy

Ves said:


> Hey guys,
> 
> Return on invested capital  (ROIC)  and / or Return on Capital Employed (ROCE).
> 
> I am currently playing around with this.   It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
> 
> Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation?   I would like to explore issues surrounding goodwill  /  other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible.  For instance, it is possible that a company has overpaid for an acquisition in the past  (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
> 
> Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.




Check out the education section of newconstructs.com ...


----------



## fiftyeight

InsvestoBoy said:


> Check out the education section of newconstructs.com ...




Had a quick look while on break, looks like just what I am after.........and the reading list keeps getting longer


----------



## ducati916

Ves said:


> This makes sense - but you were dead right when you once said you have to know what questions to ask before getting any answers out of the great man's letters.
> 
> There's a few other pearls of widsom in that very letter too.  Just small tidbits that hopefully start to add up for me. The bit about being patient and waiting for your turn to bat again is a good reminder.
> 
> The major lesson seems to be:  a premium can be paid for a business with good economics, but in the long run, if you can put large amounts of incremental capital into it and earn large returns on this the purchase price often becomes unimportant.





Interesting thread.

Just with reference to this post and the (general) topic: the 'good economics' that Buffett refers to (and which can command a premium) is 'economic goodwill' as opposed to 'goodwill in excess of tangible assets'.

The trick, is of course recognising one from t'other. There are a few ways to calculate, which gives a more quantitative basis than a pure qualitative estimate, although, some values might be so compelling that they are self-evident.

Additionally, in a PPE heavy businesses, there are ways to calculate hidden free cash-flow rather than just making a guestimate or applying an arbitrary % to the calculation.

jog on
duc


----------

