# Buffett's 5 second intrinsic value calculation



## TPI

Hi,

Buffet has said that he can calculate intrinsic value (IV) in less than 5 seconds, how does he do that?

According to this article...

http://www.wikiwealth.com/dictionary:warren-buffett-intrinsic-valuation

...A simple formula is free cash flow / risk-free rate.

Eg. For REA in 2014 cash flow per share is 139.4 cps and capital expenditure per share is 19.9 cps, so free cash flow per share is 139.4 - 19.9 = 119.5 cps, or $1.195 per share.

If the risk-free rate is the 10 year Australain government bond yield of 3.32%, IV = 1.195 / 3.32% = $35.99.

With the REA share price currently being $47.95.

Any thoughts on using this approach for IV calculation given it's simplicity and requiring less assumptions than DCF calculations?

Perhaps more accurate for companies with more stable and less volatile free cash flow from year to year?

For some stocks using this approach I get IV figures that seem far detached from reality!

Thanks.


----------



## TPI

Note the article linked to seems to modify this formula by using "free cash flow to equity shareholders", I'm not sure if this is a different figure than what I've used?, and adding interest expenses too.


----------



## galumay

TPI said:


> Note the article linked to seems to modify this formula by using "free cash flow to equity shareholders", I'm not sure if this is a different figure than what I've used?, and adding interest expenses too.




I think its a mistake to believe that Buffet ONLY uses a 5 sec calculation. I reckon his first level filter is pretty immediate from what I have read, but to get to the point of investment he does a hell of a lot more research.

I use a Buffet type of filter for my first cut at IV, its not that one. It uses a DCF calculation with some MoS fudging and comparison to risk free investment of the same capital. 

But I would never buy just because it spat out an IV greater than current price - its just the starting point for my fundamental analysis.


----------



## TPI

galumay said:


> I think its a mistake to believe that Buffet ONLY uses a 5 sec calculation. I reckon his first level filter is pretty immediate from what I have read, but to get to the point of investment he does a hell of a lot more research.
> 
> I use a Buffet type of filter for my first cut at IV, its not that one. It uses a DCF calculation with some MoS fudging and comparison to risk free investment of the same capital.
> 
> But I would never buy just because it spat out an IV greater than current price - its just the starting point for my fundamental analysis.




Yeah for sure IV is only a small part of the process.

I'm just looking at a basic filter to avoid excessive valuation, and that doesn't have reference to the share price (eg. dividend yield or PE ratios).

I tried DCF calculators but found this formula interesting due to its simplicity.


----------



## galumay

TPI said:


> Yeah for sure IV is only a small part of the process.
> 
> I'm just looking at a basic filter to avoid excessive valuation, and that doesn't have reference to the share price (eg. dividend yield or PE ratios).
> 
> I tried DCF calculators but found this formula interesting due to its simplicity.




I reckon thats the most important thing - if an input is price, yield or PE, then its irrelevant IMO.

Sounds like you are using it the same way as I use my formula, I will stick some known shares thru the one you found and see how it compares.


----------



## Value Collector

No, You can't use this formula to value a business. The formula does not take into account the quality of the business, which is one of the biggest parts of a valution.

Valuations are based on Quality and Quantity. You can use the formula as *part* of the analysis when deciding a rational price to pay, But other than that it is not useful, and doesn't tell you anything about the companies intrinsic value.


----------



## pixel

I am often a-mused, as well as be-mused, when people take a particular uttering of the little Big Man and try to apply them to their day-to-day trades.
What W.B. can do for a company that's in his sight and sphere of interest is as far removed from the stocks that we ordinary people deal with, as the Space Station is from an Earth Worm Farm.

For starters, Buffet doesn't buy "at market". When he wants a company, he talks to the current owners - who are usually distressed and distraught, desperately in need of cash. So he buys at a 20% or better discount to his "5-second value calculation". If you or I want to buy a share, we place an order on the board, aka Market Depth, and hope some holder is willing to sell down to us. Alternatively, and worse, we have to buy up at the price the most willing seller has indicated is his or her dream price. *What we think may be fair value has no bearing on the price we have to pay*, whether it took us 5 seconds or 5 weeks of research to figure it out.

Based on the above, I find it far more cost-effective to gauge the Market consensus of a share's value. If that consensus appears to rise, I consider buying; if it wanes, I sell. Simple as that.


----------



## ROE

If you know enough about the business, you usually know what price to pay for it 
there is no Warren Buffett secret, people talk about it, he throw pointers here and there
and people think there is some sort of formula he uses.

I doubt he use any such formular ... most business he buy he has a fairly deep understanding of
it and its management and hence he know what price he willing to pay and that is his 5 second calculation


----------



## galumay

pixel said:


> Based on the above, I find it far more cost-effective to gauge the Market consensus of a share's value. If that consensus appears to rise, I consider buying; if it wanes, I sell. Simple as that.




Thats really not relevant as its not a fundamental approach to investment, you are using an entirely different, in fact diametrically different approach to selecting shares to purchase, or sell.

Buffet's economies of scale and later approach of buying whole companies doesnt mean FA isnt accessible to smaller investors. Dont forget Buffet tried TA and found it wasnt for him.

Personally I dounbt Mr Market considers value very often when pricing shares, the response is more often base emotional and irrational. Eventually, if a company is well enough run, and has some competitive advantage, and is able to generate growth, then pricing and value should approach equality. Of course most of the time, with any given company, price and value are out of synch (in one direction or the other), thankfully as this creates the opportunity for the FA!

I guess this has the potential to degenerate into a religious debate if we continue down this path, so lets just leave this to a discussion about filter type formulas that can be used to take an initial stab at assessing value!


----------



## pixel

galumay said:


> I guess this has the potential to degenerate into a religious debate if we continue down this path, so lets just leave this to a discussion about filter type formulas that can be used to take an initial stab at assessing value!




That wasn't my point at all, galumay; nor was it implied in the title whcih clearly makes reference to Buffett's valuation, not any old filter. My point is that trying to adopy Buffett's approach won't do us mere mortals any good. We don't even talk the same language when we and WB use the word "value".

By all means, let's drop the reference to Buffett in the topic header and discuss various definitions of "value" in the context of companies' present and future. In most cases, I use market consensus and expectation as usable first approximations. I don't expect everybody to agree, so I'll shut up and let others explain their views.


----------



## galumay

pixel said:


> That wasn't my point at all, galumay; nor was it implied in the title whcih clearly makes reference to Buffett's valuation, not any old filter. My point is that trying to adopy Buffett's approach won't do us mere mortals any good. We don't even talk the same language when we and WB use the word "value".
> 
> By all means, let's drop the reference to Buffett in the topic header and discuss various definitions of "value" in the context of companies' present and future. In most cases, I use market consensus and expectation as usable first approximations. I don't expect everybody to agree, so I'll shut up and let others explain their views.




Sorry for misunderstanding you, I do disagree with the contention that we cant use Buffet's approach. He has written extensively over the years about his style of fundamental analysis, he has often described that approach in terms of a mortal investor rather than from his personal scale. I think he means exactly the same thing as most FA's when he talks about value. He has also talked about a simple formula that lets him apply a high level filter to stcok valuation.

I still dont see how "market consensus and expectations" have anything to do with value, they have everything to do with price - but that is getting back to the religious debate which belongs elsewhere!


----------



## TPI

galumay said:


> ...so lets just leave this to a discussion about filter type formulas that can be used to take an initial stab at assessing value!...
> 
> ...He has also talked about a simple formula that lets him apply a high level filter to stcok valuation.




Thanks galumay, that's what I was intending with this post.

I certainly agree with all the sentiments made about the quantitative and qualitative aspects both being important in determining overall value.

And that the qualitative aspects are perhaps even more important as if you are invested in the wrong type of business to begin with, that you don't really understand, in the wrong sector and at the wrong time... then all the quantitative factors including performing some sort of intrinsic value calculation become less important/less relevant.

With the formula described it seems to make sense to me as it is very simple, quick to calculate, uses an important and freely available quantitative measure as it's basis (ie. free cash flow), is standardised by the use of a transparent risk-free rate, avoids the huge discrepancies in intrinsic value that can arise out of complex DCF calculations with numerous inputs based on varying assumptions and forecasts, avoids the requirement for costly software or complex spreadsheets to compute valuations, and avoids using current share price as an input (like dividend yield and PE ratios).

And also perhaps one that is more useful when applied only to companies with relatively stable and rising free cash flows to begin with...


----------



## burglar

TPI said:


> Thanks galumay, that's what I was intending with this post ...




Intangibles and Charlie Munger!

Two most important things forgotten so far!

Intangibles prevent IV from being anything near accurate.
That is why Value Investors always talk about a Safety Margin.
Why they are endlessly calculating. 
And why they are endlessly debating "Lambda Corrections"

WB can dream up what he likes but he has to get every transaction past Charlie Munger.
CM is the genius behind WB
Charlie Munger prevents the mistakes!!! ||*appropriate emoticon*


----------



## galumay

burglar said:


> Intangibles and Charlie Munger!
> 
> Two most important things forgotten so far!
> 
> Intangibles prevent IV from being anything near accurate.
> That is why Value Investors always talk about a Safety Margin.
> Why they are endlessly calculating.
> And why they are endlessly debating "Lambda Corrections"
> 
> WB can dream up what he likes but he has to get every transaction past Charlie Munger.
> CM is the genius behind WB
> Charlie Munger prevents the mistakes!!! ||*appropriate emoticon*




The point about Charlie is well made, they were both very lucky to 'discover' each other as they both brought so much to the table, and I suspect the sum was greater than the total of the parts. 

Ultimately its an illustration of the potential of teams in human endeavour.

On the other hand I think you are overstating the impact of intangibles, obviously those of us who practice FA dont believe "_Intangibles prevent IV from being anything near accurate._". I dont think many of us are looking for a specifically very accurate IV, its more of an indicicative and relative value as a tool to share selection.

Safety margin is a risk management tool, and yes amongst other things it acknowledges no calculated IV is perfectly accurate.

I dont know about others but I am not "_endlessly calculating_", but then I would be guilty of accusing TA's of endlessly looking into the past in a forlorn attempt to predict the future! So maybe that says more about our preconceptions of those who dont share our world view!

I know as much about Lambda corrections as candles and teacups!

For my purposes a simple, quick and dirty IV calculation lets me filter out companies that are currently priced by the market well above their IV, if they look on first cut to be fairly valued or below fair value, then I will start looking into the company in more detail, reading through the Annual Reports, analysing the financials, understanding the business, looking for competitive advantage, assessing the risks such as legislative and technological and reading what others have to say about the company and its products.


----------



## TPI

Reading in more detail, the author modifies the basic formula for interest expenses and uses "free cash flow to the firm" (FCFF), which seems easy to calculate though involves a bit more time (>5 seconds!) than the basic formula.

Here's a link to how this is calculated:

http://www.financeformulas.net/Free-Cash-Flow-to-Firm.html

For practical purposes the basic formula seems ok to me as a rough screen.


----------



## burglar

galumay said:


> ... I know as much about Lambda corrections as candles and teacups! ....




Neither a "cup and handle"  nor candlestick person per se.
Like to think i'm well grounded!


I see from your reply that you are also well grounded.
While not trading TA, you seem to admit that it exists in your universe 
and effects your entry and exit points.

That is all I expect from my spike  ...  an admission that predators exist and need to acknowledged!

Wish you well, and if I were a younger person, I too, would like to get rich slowly! :


----------



## luutzu

TPI said:


> Hi,
> 
> Buffet has said that he can calculate intrinsic value (IV) in less than 5 seconds, how does he do that?
> 
> According to this article...
> 
> http://www.wikiwealth.com/dictionary:warren-buffett-intrinsic-valuation
> 
> ...A simple formula is free cash flow / risk-free rate.
> 
> Eg. For REA in 2014 cash flow per share is 139.4 cps and capital expenditure per share is 19.9 cps, so free cash flow per share is 139.4 - 19.9 = 119.5 cps, or $1.195 per share.
> 
> If the risk-free rate is the 10 year Australain government bond yield of 3.32%, IV = 1.195 / 3.32% = $35.99.
> 
> With the REA share price currently being $47.95.
> 
> Any thoughts on using this approach for IV calculation given it's simplicity and requiring less assumptions than DCF calculations?
> 
> Perhaps more accurate for companies with more stable and less volatile free cash flow from year to year?
> 
> For some stocks using this approach I get IV figures that seem far detached from reality!
> 
> Thanks.





That's it. Seriously. But with some clarification.

Video below of Alice Schroeder - his official biographer - explaining what she saw from his papers while researching "The Snowball". Though having seen and explain it, when asked later how she value she uses the DCF, even though she said she had never seen him do it.

--
*FCF* 
I don't think Buffett took it to be a strict calculated FCF. I think he simply view the company's entire history, or some meaningful operating history, and ask that given its position, its standing, its history of earnings... what does this company earn right now. Earns after paying all expenses, after the tax... what does it return to me as the sole owner of the business... that is its FCF, its earnings.

Remember "little or no debt". 

With that figured out, next question is... I need a return of 10%, of 15% etc... on my capital... that if I put this cash at the bank, or put it in this other business I know about, it would return me x%... 

With *E* earnings (normalised earnings I guess you can call it) and my required return of *r*... since the business has been able to achieve this, the company is in a strong financial position, has good competitive advantages to retain its position... given that its history would suggest it will remain, what does a business that earns E at my r be worth?

Hence the *IV = E/r*

Mathematically, more fancifully put, this approach is the Perpetual Annuity calculation. Like a bond as Buffett said in one of his lectures (youtube it, it's where he wear a light purple Hawaiian shirt). And you could look that up and prove it mathematically to be IV = E/r.

This can then be converted to a simple Price/Earning ratio, or capitalisation multiplier. So a 4% return is equivalent to PE of 25; 15% = 6.67 etc.

this is why he could work it out in a few seconds... or given the financial statements and the business, in five minutes.

---

So while it sounds simple... it really is not.
First you got to know the business thoroughly.. know what its possible earnings is. This is often not the latest reported earning; it's not even the average of the past 5 or 10 years or some projection based on these mathematical averages.

What I do is use a few scenarios... e.g. I require 10% return. Worst case scenario this company would earn $100 per year... so value at worst is $100x10 = $1000;
Or I know this business and its assets well... if this bad luck or failures were over; if expenses like legal issues or damages is just a one off, this business will likely earn $150 next year... at 10% required return... $1,500.

What about quality and expansions in the future... I don't know what Buffett say about this, but Graham have said that the future is to be guarded against rather than to pay for. That and personally I think this approach already take into consideration future growth, already taken into account brand name and market position - without strong operations and market position, you wouldn't assume survival in 5 years let alone eternity.

So given its strong position and quality, enabling it to survive and grow... the best thing to do is to not pay for that future prospect, but to see it for the now or very immediate future... and future growth and expansion will simply mean higher value for the company, higher return on your investment if you sell out.

--


----------



## TPI

Great post luutzu, thanks!

I really like the logic and simplicity of what you have written about this approach.

I will watch that video this week and read a bit more about Alice Schroeder's work and post back.


----------



## DeepState

How do/should you allow for different rates of FCF/Earnings growth?  What is the impact of this choice?

FCF <> Earnings in all but the most unusual situations in the nearer term although they should asymptote over longer periods.

Growth in earnings is the most influential factor on stock price movements.     

In the 2013 Annual Letter, the number of times "earnings" was used: 54.  The number of times "Cashflow", "Cash", "FCF" was used in total: 0.  What does that imply about investment focus?

How should you determine the equity risk premium over the gov't bond rate?

There is a ton on DCF in another thread "Present Value of Future Cashflows".


----------



## luutzu

TPI said:


> Great post luutzu, thanks!
> 
> I really like the logic and simplicity of what you have written about this approach.
> 
> I will watch that video this week and read a bit more about Alice Schroeder's work and post back.




There's a free app you can use to download youtube videos. I use 'YTD Video Downloader'.

She describes it around minute 16 or 17 i think.


That's the approach I use, others would, and have, disagree with it.

Retired Young laughs at it, haha... but he was paid handsomely and probably by the hour and when you're paid by the hour, you got to look busy and act smart and pretend you could forecast the future. Else your work day kinda end at brunch. 

As RY's word count show, Buffett doesn't mention FCF, but earnings... FCF should be define as Earnings, or Earning Power, of a company.

Read the post RY mention for long debates on the pro and con...

but i'm free so let me summarise the other fundamental approach for you.


*The Discounted Cash Flow (DCF) approach:*

Conclusion:   Only useful, only work, when applied to valuing bonds or mortgages - where you are very certain of each periodic payment/repayment/FCF/Earning power; and where you can value the changing growth character, the ending sale price or value of the company at your exit point; that and can predict interest rates.

if you could predict all of that, you might as well try to predict the next mega lottery numbers and spend the rest of your life.

DCF cannot apply to valuing a business... and if it could, as Buffett have said, the value you get on a business would be too close for comfort.

As Graham said somewhere, the idea is to know if the price is too much or too cheap, like knowing if a person is too heavy or too thing by looking at him, without knowing his exact weight... and probably without measuring his diets and measuring then comparing it to some charts and skin/fat ratio.


RY... how are things? Back from another vacation? hahah


----------



## TPI

DeepState said:


> How do/should you allow for different rates of FCF/Earnings growth?  What is the impact of this choice?
> 
> FCF <> Earnings in all but the most unusual situations in the nearer term although they should asymptote over longer periods.
> 
> Growth in earnings is the most influential factor on stock price movements.
> 
> In the 2013 Annual Letter, the number of times "earnings" was used: 54.  The number of times "Cashflow", "Cash", "FCF" was used in total: 0.  What does that imply about investment focus?
> 
> How should you determine the equity risk premium over the gov't bond rate?
> 
> There is a ton on DCF in another thread "Present Value of Future Cashflows".




Hi RY, are you saying that current or perhaps 1 year forecast normalised earnings are a more useful measure to use as a basis for valuation than FCF?   

Using the valuation approach described in this thread, with respect to your comment about forecast earnings growth, can't this be factored in somewhat into the required return used, ie. if very high earnings growth is expected you just use a lower required return?

And if the qualitative analysis ticks all the boxes then you would also just lean towards a lower required return to get a fair valuation?

And, not too sure exactly how to work out the equity risk premium, but once you have this figure you could use it as a starting point for your required return and then just make the above adjustments to it depending on forecast earnings growth and qualitative factors?


----------



## TPI

luutzu said:


> As Graham said somewhere, the idea is to know if the price is too much or too cheap, like knowing if a person is too heavy or too thing by looking at him, without knowing his exact weight... and probably without measuring his diets and measuring then comparing it to some charts and skin/fat ratio.




Like the analogy! And I agree about the general idea to know if the price is too much or cheap, and not to place too much emphasis and time on detailed valuation at the expense of qualitative analysis and understanding of the business which is where you may get an edge.


----------



## Value Collector

TPI said:


> not to place too much emphasis and time on detailed valuation at the expense of qualitative analysis and understanding of the business which is where you may get an edge.




Its not an either / or choice. You can't get a proper valuation without qualitive analysis. Qualitive analysis forms a big part of the valuation.

I have heard people say things like, I prefer growth investing rather than value investing, as if they are two different things, which in my opinion, they are the same thing. We all want to invest in growth stocks, Value investing is just about finding growth stocks that are at prices that limit downside risk and allow us to participate in the up side of the growth.

Many people have over paid for good companies and ended up with mediocre results even though the company has performed well over the years.


----------



## switesh

Perhaps we're over-thinking Intrinsic Value? 

A few posters correctly pointed out (and I admire that style of thinking):

It's a lose estimate (using Ben Graham's illustration of judging by inspection)
Emphasising a Margin of Safety is vital
Earnings Power, & Intangibles are Important factors and influence one's estimate of IV quite a bit
Here are some notes from my diary that explains it rather simply.

The Intrinsic Value of a business

(Formula: Discounted (I), present value (PV), of future cash (FV). Discount rate doesn't make much sense as you go further out)

	A Bird in the Hand Is Worth Two in the Bush
	 - Aesop

	• How many birds are there in the bush (if any)?
	• How sure are you that there *ARE* two in the bush?
	• How long do you have to wait to get them out?
	• Is it worth better than the bird in hand?	
	•​ Is there some other bush where I can get three birds?

Berkshire has never distributed anything to its shareholders, but its ability to distribute goes up as the value of the businesses we own increases. We can compound it internally.

If interest rates are 15%, roughly, you've got to get 2 birds out of the bush in 5 years to equal the bird in the hand, but if interest rates are at 3% and you can get 2 birds out in 20 years, it still makes sense to give up the bird in the hand.
It all gets back to discounting against an interest rate.

Here's the original source from the _Oracle of Omaha_:


----------



## DeepState

luutzu said:


> RY... how are things? Back from another vacation? hahah




As a matter of fact, yes.  And it involved beaches, cliff top houses with stunning views and a bloody big catamaran. Makes a nice break from heli-skiing.  How about you?


----------



## DeepState

TPI said:


> Hi RY,
> 
> 1. are you saying that current or perhaps 1 year forecast normalised earnings are a more useful measure to use as a basis for valuation than FCF?
> 
> 2. Using the valuation approach described in this thread, with respect to your comment about forecast earnings growth, can't this be factored in somewhat into the required return used, ie. if very high earnings growth is expected you just use a lower required return?
> 
> 3. And if the qualitative analysis ticks all the boxes then you would also just lean towards a lower required return to get a fair valuation?
> 
> 4. And, not too sure exactly how to work out the equity risk premium, but once you have this figure you could use it as a starting point for your required return and then just make the above adjustments to it depending on forecast earnings growth and qualitative factors?




Hi TPI

1. Yes, in general. Where a company is in negative earnings or drawing cash down, FCF becomes more important.  Under these circumstances, a different valuation method is required.

2. That's how the maths works out. However, you need to be clear about the underlying assumptions and what they mean.  Although the maths works out as you say, the concept is essentially the same as saying you will capitalise the current earnings at a lower expected rate. That's an unusual way of thinking.  Also, if higher growth expectations leads you to require a higher required return to compensate for the possibility of disappointment,.... you see the point. The idea is to allow for growth in terms of escalation of earnings and implications for the discount rate... It would be odd if the actual practical outcome is as you had mentioned, when it all boils down.  You are not buying a bond.

3. The required return is compensation for risk bearing.  There is no magic number.  You could buy crap if the return on offer was high enough relative to what you need to be compensated.  Margin of safety.  A good stock is a stock which is undervalued.  Good companies don't necessarily perform well.

4. There is no correct way to determine it.  There are quite a number of things that can be looked at to figure out if the returns on offer are priced well or poorly against alternatives including cash.  You will find that the growth rate and discount rate differential will drive your valuation.

Remember also, a PE-based valuation is a DCF valuation in shorthand.  If you think a PE valuation is assumption lite, it's not.  It's just that those assumptions are hidden. 

Also, valuation is not an equally strong concept across the stock universe.  Some companies are more readily valued that others.  That has implications with respect to how you assess the investment merits of each situation.


----------



## KnowThePast

TPI said:


> Hi RY, are you saying that current or perhaps 1 year forecast normalised earnings are a more useful measure to use as a basis for valuation than FCF?




That brings up an interesting question - what is the most accurate way to forecast future earnings, statistically? Broker forecasts, current earnings, historical averages, ROC, etc?

RY, you wouldn't happen to know by any chance?

I tend to look at EBITDA margin to get a very quick feel for what average earnings may be in the future, this is before I analyze it in any depth.


----------



## DeepState

KnowThePast said:


> That brings up an interesting question - what is the most accurate way to forecast future earnings, statistically? Broker forecasts, current earnings, historical averages, ROC, etc?
> 
> RY, you wouldn't happen to know by any chance?
> 
> I tend to look at EBITDA margin to get a very quick feel for what average earnings may be in the future, this is before I analyze it in any depth.




Ahhhhhh....and now we get to what actually makes the money.....

I'll offer a tidbit.  EBITDA margin is the strongest mean-reverting variable for most types of companies which are generating earnings.

For all this exchange, is valuation even necessary to get rich? Not really.  But if you are going to do it, might as well do it right.


----------



## KnowThePast

DeepState said:


> Ahhhhhh....and now we get to what actually makes the money.....
> 
> I'll offer a tidbit.  EBITDA margin is the strongest mean-reverting variable for most types of companies which are generating earnings.
> 
> For all this exchange, is valuation even necessary to get rich? Not really.  But if you are going to do it, might as well do it right.




Thanks RY!

This is exactly what I found with my backtests as well, but my data is limited, so I didn't draw strong conclusions from it. 

Fully agree on "proper" valuation not been needed as well, but I'm sure many will disagree.


----------



## TPI

DeepState said:


> Remember also, a PE-based valuation is a DCF valuation in shorthand.  If you think a PE valuation is assumption lite, it's not.  It's just that those assumptions are hidden.
> 
> Also, valuation is not an equally strong concept across the stock universe.  Some companies are more readily valued that others.  That has implications with respect to how you assess the investment merits of each situation.




Thanks RY, good points.


----------



## TPI

luutzu said:


> That's it. Seriously. But with some clarification.
> 
> Video below of Alice Schroeder - his official biographer...




luutzu,

I saw the video and it was interesting to read how Buffet looks at historical earnings and then simply applies his 15% required return, and does not do forecasts, with this being negated by buying with a margin of safety.

With earnings, or normalised earnings, are you using NPAT for this?

What about "owner's earnings" as described by Buffett?


----------



## Value Collector

TPI said:


> luutzu,
> 
> I saw the video and it was interesting to read how Buffet looks at historical earnings and then simply applies his 15% required return,




yes, but this is only in companies that he has a very good understanding on the qualitative side of things, his adage of buying only companies he can understand, that have competitive advantages and good management comes first, only then will he put a price on it


----------



## KnowThePast

DeepState said:


> Ahhhhhh....and now we get to what actually makes the money.....
> 
> I'll offer a tidbit.  EBITDA margin is the strongest mean-reverting variable for most types of companies which are generating earnings.
> 
> For all this exchange, is valuation even necessary to get rich? Not really.  But if you are going to do it, might as well do it right.




Hi RY,

Thanks again for your knowledge, very appreciated.

A follow up question on EBITDA margin - have these results been done over all stocks, or just larger, liquid ones?

My suspicion is that smaller companies will still exhibit this trend, but not to an extent of larger ones. Am I warm?


----------



## DeepState

KnowThePast said:


> Hi RY,
> 
> Thanks again for your knowledge, very appreciated.
> 
> A follow up question on EBITDA margin - have these results been done over all stocks, or just larger, liquid ones?
> 
> My suspicion is that smaller companies will still exhibit this trend, but not to an extent of larger ones. Am I warm?




This has been done over all stocks but is more effective for a sub-set.  Liquidity is not the issue, in particular.  It is the character of the company.  They can be large or small. 

Your statements are correct on a grand sweep basis.  But you can do better than that....

See you in Barbados.  Have a nice day.


----------



## KnowThePast

DeepState said:


> This has been done over all stocks but is more effective for a sub-set.  Liquidity is not the issue, in particular.  It is the character of the company.  They can be large or small.
> 
> Your statements are correct on a grand sweep basis.  But you can do better than that....
> 
> See you in Barbados.  Have a nice day.




That's awesome, RY. I think I am with you. Thank you.


----------



## TPI

Value Collector said:


> yes, but this is only in companies that he has a very good understanding on the qualitative side of things, his adage of buying only companies he can understand, that have competitive advantages and good management comes first, only then will he put a price on it




Yeah that's true. I guess these are the types of companies that I want to be invested in to.


----------



## luutzu

DeepState said:


> As a matter of fact, yes.  And it involved beaches, cliff top houses with stunning views and a bloody big catamaran. Makes a nice break from heli-skiing.  How about you?




Nice. Though I did one better - got our third child. Better until they start talking back, dating... guess better start enjoying the nappy change and sleepless nights.


----------



## luutzu

TPI said:


> luutzu,
> 
> I saw the video and it was interesting to read how Buffet looks at historical earnings and then simply applies his 15% required return, and does not do forecasts, with this being negated by buying with a margin of safety.
> 
> With earnings, or normalised earnings, are you using NPAT for this?
> 
> What about "owner's earnings" as described by Buffett?




I forgot what Buffett said, exactly, regarding owner's earnings... But I take it to mean the earnings that belong to the investor, the owner, after all expenses - taxes, depreciation, interests and the likes.

It's better to answer with a specific example to illustrate, I'll try to do that in a couple months time when I can go from start to finish... That way we can have a good laugh at my understanding, haha... 
 but in general...

A company's Earning Power can be found from its Financial Performance (the NPAT) or its statement of Cash Flow - it depends on the nature of the business. What it depends we get to, but it's worth noting that it's not just a simple reading of the reported NPAT or FCF or Net Operating CF... you got to understand the business, how it make its money, what are its general expenses and income (cash generating cycle)... from these you can make certain adjustments to get to the earning power.

The reported profits can be muck around with, cash flow is harder to play around using accounting gimmicks. So in general, I found that a good company might not report high profit, but you can see its real performance by looking at its operating cash flow. Take that Net operating cash flow, deduct net capital expenditure (the costs to repair/replace properties, plants and equipment)... This delay paying income tax, and trails, the reported profit.

However, I've seen in property/real estate companies like Australand... where they report negative operating cash flow.. .looking at the notes and you'll see that for such a business, its normal operation is buying land and properties, to then develop and build... So over a 12 month period, chances are it can't turn operating cash positive on this operation... but it reports positive profit. (I bought ALZ based more on its book value than on its earnings... so it all depends).

------
But as VC and RY said in their posts, a lot of assumptions and a thorough understanding of the business have to be made before we can get to the valuation.

I literally look at some 50 charts, around 200 to 300 variables, over 8 to 10 years before I get to the valuation stage. But before that, I do a rough estimate to see if I need to even bother doing all that... 

I take a quick look at its financial position - can it keep the lights on in the foreseeable future; are its margins - profit margin I think above 8% is OK, as long as it's consistent; the higher the better but 8 or 10 is acceptable.; its return on Equity, investments... I break down the components of ROE to see what contributes most to it.

So I make an assumption that if this company actual earnings is its reported earning, is its current price too high or could be interesting to look further... 

I think Buffett's advice to start from company A and go to Z, of businesses you can understand... that's a better approach then first looking at the market price. But point is there is a lot to look at before you ought to look at the valuation.

I found that in reading the Annual reports, starting at the earliest year you think is relevant, then make notes of their comments, strategies, then type in the financial figures... by the end of 8 or 10 years I pretty much know how honest the management is, know how able they are, know how the business is and it get pretty easy to determine an acceptable range of value... I could still be wrong but I'd be comfortable and could make contrarian decision a bit easier than otherwise.


----------



## galumay

Great post, Luutzu. I think it does reinforce that like everything else of value in life, it aint easy! Its hard work to firstly learn how to understand a business and then hard work to assess each one you want to consider investing in.


----------



## TPI

Thanks luutzu, great post and insight into your investment process.

When you work out forecast earnings for the next 12 months, to what extent do you generally find your figure differs from 1 year consensus forecast normalised earnings/EPS figures quoted on online broker websites?


----------



## luutzu

TPI said:


> Thanks luutzu, great post and insight into your investment process.
> 
> When you work out forecast earnings for the next 12 months, to what extent do you generally find your figure differs from 1 year consensus forecast normalised earnings/EPS figures quoted on online broker websites?




Just in case you're using the IV = Earnings/r, where r = risk free rate, or interest rate. Not recommended to use r as that. 

The r is your required rate of return, so if it's the risk free rate like bonds or term deposit, you might as well put your money there and take on no risk. Investing in businesses have risks. So if r is 4%, that's a P/E ratio of 25... roughly mean you'll get your money back in 25 years - see Switesh post on bird in the hand.

With my estimates... I don't do forecasts. I simply use the what-ifs analysis and after I get to understand the business well enough, see that it is of high quality, financially sound, does not show the need to raise new capital or take on debt to survive... Once I'm happy with it I just do a simply straight line scenario of sales remaining as is, goes down by x%... what price I'm happy with under such circumstances and see what's the offer is.

Though there are companies, as Phillip Fisher discussed in his very good book... that some companies are so exceptional, so able and well managed that they continue to grow year after year... that kind of company would deserves a premium on its "reasonable" price.

How much does the market tend to pay for that premium I don't know, but you can see what you're comfortable with knowing the business as you have come to know, knowing the market level. Though above 25 times earnings is really really pushing the bound of reasonable, high expectation.

Anyway, I'm just starting to sort out a standard approach I could use, never work in the finance industry so take what i learn for what it's worth.

But one thing to take away is Buffett's and Graham's advice to treat stock as a business, not as a financial instrument. As Buffett said, once you think like that, everything else will follow. 

-----

With consensus and expert forecasts, with rating agencies... It's safer to ignore them completely. The expert forecast seem to be very good at forecasting next quarter or next year's earnings... but that could just be pure luck or pure manipulation by management - often I looks like simply straight line projection. No one knows until it's too late.

In my opinion, to accurately forecast a company's future earnings; to forecast it to a high degree of certainty - which is what you ought to else it's just guess work and is more harmful than useful... to get a forecast right to a degree acceptable by science, say +95% certainty the data and samples and figures aren't random guesses... that takes a lot of brain and a lot of work... most of which an analyst working for a fund manager who then give it out for free to newswires for free just can't afford to have.

With the few lawsuits against the major rating agencies in the US after the GFC... most say their work are no more than opinions, like newspaper columns, not advise or expert analysis. But yea, somehow their work affect companies and gov'ts ability and costs to raise fund and attract investors.


Let say you want to forecast a company's earning in two years. How to go about it?
Look at the industry, the structure, the players, the suppliers, the customers, the economy, changing consumer demand... Then once you know all these players and their relationship and influence on one another... 
You don't need to go further to know how insane it is to think anyone could do it, and if they could, rating agencies could pay for it.


----------



## TPI

Thanks luutzu, what you're saying makes sense.

Personally though, in the interests of simplicity in valuation approach I am still leaning towards using 1 year forecast consensus normalised EPS for the *E* in the *IV = E/r* formula.

Reason being is that it is an easy figure to find and do so very quickly, a 1 year figure is more likely to be more accurate than a 5 year figure, these figures are based on company guidance which maybe more conservative to begin with, and small misses in forecasts are unlikely to materially affect the end valuation which is going to be an imprecise figure to be used for general guidance anyway.

Interesting article on this below:

http://www.fastgraphs.com/_blog/Res...-03-14-Carnevale-Forecasting-Future-Earnings/

For CBA as an example: using Google Finance/Thomson Reuters data, CBA's FY15 EPS consensus estimate is $5.4961 (the mean figure based on 16 analysts estimates).

If my required rate of return is 10%, CBA would be worth $54.9461, which could be calculated in less than 1 second once the EPS figure is obtained.

If I have a strongly positive long-term view on CBA and used a lower required rate of return of 8%, CBA would be worth $68.70.

With today's share price being $74.80.

Notwithstanding of course all the qualitative and personal factors (eg. the requirement for greater yield which maybe present despite apparent over-valuation) that go into the final purchase decision.


----------



## galumay

TPI said:


> Personally though, in the interests of simplicity in valuation approach I am still leaning towards using 1 year forecast consensus normalised EPS for the *E* in the *IV = E/r* formula.




Personally I dont like using any forecasts, when I am using earnings in calculations I only use previous year earnings and I adjust that if its not in line with historical growth.


----------



## McLovin

TPI said:


> Personally though, in the interests of simplicity in valuation approach I am still leaning towards using 1 year forecast consensus normalised EPS for the *E* in the *IV = E/r* formula.




This is just a terminal value formula that assumes zero growth. Have you played around seen what happens at various risk levels or if you add 1-2% growth? It kind of shows up the pointlessness of that formula.

Also, those one touch formulas are prone to extrapolating the good times in a boom and the bad times in a bust.


----------



## luutzu

McLovin said:


> This is just a terminal value formula that assumes zero growth. Have you played around seen what happens at various risk levels or if you add 1-2% growth? It kind of shows up the pointlessness of that formula.
> 
> Also, those one touch formulas are prone to extrapolating the good times in a boom and the bad times in a bust.




True that it assumes zero growth, but that's the point though.

Also true that if we apply this to companies doing very well because its industry is booming, we'd be poorer when that boom burst.

But... 

That's why we shouldn't take last year's earnings, or the average previous earnings at face value.
That's why we look at the company's quality, its market position, its financial strength, its management.

That's easier said than done, and when it's done - I think I did it right on two occasions so far - it's still quite scary to see the market doesn't agree with you.

But when you study the company properly, happy with its quality and position, comfortable with its price... as Buffett said somewhere, something good might happen.

One of the advice Fisher gave was to ask whether the company has done well because it is lucky or it is able; or whether it is both able and fortunate. If the answer to a company doing well right now is simply that it was lucky, that its industry is booming and a rising tide lifts all boats; that it's lucky because one of its products does very well... then may not want to get in to it... But if it was well managed, if its management had made more intelligent decisions than poor ones, that there are R&D or other efforts to produce new products/services, to expand further beyond the current luck and boom, it's worth the risk.

So we can look at, say the mining companies or the industrial services... and see that it is obviously not booming, going downhill. If the investor know the business and the industry... I don't think it's correct to say that the entire industry and every business in it will drop by x% in revenue.

Who knows, a top quality operator in a contracting industry may even benefit from the slow down.. It might die too but it could manage to survive and buy off smaller and weaker rivals now struggling or going bankrupt; because of its position and reputation, it might win contracts that would go to someone else at lower prices in boom time. 

Anyway, that's just my opinions and what I understand this approach to imply... to do otherwise is to try and predict the future, most likely from understanding the general industry or macro-economic trend... that and to pay at a price where that future never come - an approach which might be safe in the downturn but prove expensive in boom time.


----------



## galumay

luutzu said:


> t... But if it was well managed, if its management had made more intelligent decisions than poor ones,...




I have been thinking about this criteria a bit lately, I am not sure that its not better to look for bad management being able to make good profits - if you pick companies with really good management making good profits, there is always a risk that management will change to less good or just make some poor decisions and profitibility will suffer.

On the other hand a really badly managed business that is very profitible has more 'risk' of management changing for the better!

I look at companies like RIO, which is probably the most incompetently managed company I have ever had a close association with , and say TLS which has suffered massively from poor management - yet both have managed to make squillions of dollars and deliver real wealth to shareholders. 

Its a bit counterintuitive but maybe I need to filter for poor management/high EPS


----------



## luutzu

galumay said:


> I have been thinking about this criteria a bit lately, I am not sure that its not better to look for bad management being able to make good profits - if you pick companies with really good management making good profits, there is always a risk that management will change to less good or just make some poor decisions and profitibility will suffer.
> 
> On the other hand a really badly managed business that is very profitible has more 'risk' of management changing for the better!
> 
> I look at companies like RIO, which is probably the most incompetently managed company I have ever had a close association with , and say TLS which has suffered massively from poor management - yet both have managed to make squillions of dollars and deliver real wealth to shareholders.
> 
> Its a bit counterintuitive but maybe I need to filter for poor management/high EPS




Very true. haha

I think Peter Lynch or Buffett said similar things - it's better to buy a business any idiot can run, because one day an idiot will run it.


I read "Barbarians at the Gates" before and yea, how KKR analyse Nabisco for the takeover was along the line you're thinking. The RJR-Nabisco's CEO was known for the extravagance fleet of executive jets, suites, private hangar etc... so KKR deduct these expenses but still couldn't make the numbers... until some executive somewhere within the empire points to them that the CEO ordered him to spend x amount on needless advertising to keep the profit low as he prepared for the management buy out that led to all these.

I heard of this executive where I worked buying a $5000 chair. An office chair, gas lift... $5 grand... dam. Public company, not his money.


----------



## McLovin

luutzu said:


> True that it assumes zero growth, but that's the point though.




Well, I guess we disagree. I always thought a valuation should have some modicum of reality in it.


----------



## luutzu

McLovin said:


> Well, I guess we disagree. I always thought a valuation should have some modicum of reality in it.




Once you can estimate a company's current earning power, and being current does not mean it will report this earning, or achieve this earning right now - that earning power would show itself in one or two years time, after the current difficulties or the current boom for example... 

Doing such estimates under various scenarios and there is no need to assume x% growth in the future. It is already expected to grow by at least the rate r that you required into eternity. The future might proved it exceed or decline from that requirement... if exceed, the business is worth more etc.

To assume growth at x% in the future you tend to project the current reported earning, if not projection but do analysis to get the earning power then estimate its growth - in one or two phases - you can do that, I just don't think I could do it, and if I could, my understanding of this approach make it unnecessary.

Just like Alice Schroder said in that YouTube, Buffett would say, after his calculations, that this company earns this much and I need this much return, can this company do it; If it can, it would be at this price, is the market offering this company at that price?


----------



## McLovin

luutzu said:


> Doing such estimates under various scenarios and there is no need to assume x% growth in the future. It is already expected to grow by at least the rate r that you required into eternity. The future might proved it exceed or decline from that requirement... if exceed, the business is worth more etc.






It isn't expected to grow by r. R is the required return.


----------



## TPI

galumay said:


> Personally I dont like using any forecasts, when I am using earnings in calculations I only use previous year earnings and I adjust that if its not in line with historical growth.




Fair enough, I guess this is a more conservative approach which also makes sense. 

In the end having some relative consistency in your approach is the main thing I think.


----------



## TPI

McLovin said:


> This is just a terminal value formula that assumes zero growth. Have you played around seen what happens at various risk levels or if you add 1-2% growth? It kind of shows up the pointlessness of that formula.
> 
> Also, those one touch formulas are prone to extrapolating the good times in a boom and the bad times in a bust.




When I looked at purchasing a small business I got my accountant to do a valuation.

To do so he looked at current year earnings, as well as the last 3 years history of earnings, made some adjustments for items that were unlikely to appear in the next year (but without extrapolating and forecasting the next year's earnings figure as I am by using forecast consensus EPS figures) to come up with a figure for future maintainable earnings, then divided this figure by the required rate of return (which was largely based on recent comparable industry sales).

If this sort of approach is often used to value small businesses, why can't it be used for listed companies?


----------



## McLovin

TPI said:


> When I looked at purchasing a small business I got my accountant to do a valuation.
> 
> To do so he looked at current year earnings, as well as the last 3 years history of earnings, made some adjustments for items that were unlikely to appear in the next year (but without extrapolating and forecasting the next year's earnings figure as I am by using forecast consensus EPS figures) to come up with a figure for future maintainable earnings, then divided this figure by the required rate of return (which was largely based on recent comparable industry sales).
> 
> If this sort of approach is often used to value small businesses, why can't it be used for listed companies?




How realistic do you think it is that CBA will never, ever grow earnings? Inflation is 2-3% year, so using a no growth model assumes that over time CBA's earning will continue to fall in real terms.

As to why your accountant valued that way, most small business seem to be valued based on payback period with really low multiple p/e (2-4x). So that's a 25%-50% rr. As for the reasons, the earnings are usually less stable, the input of the owner can be critical to the success, the growth opportunities are usually pretty limited, there's no real competitive advantage etc. For that reason they are usually conservatively valued based on low multiple of current earnings.


----------



## luutzu

McLovin said:


> It isn't expected to grow by r. R is the required return.




Grow for me by at least r, into infinity. Grow or at least maintain its return on equity.

Growth I don't take to be growth in sales or revenue. A good business is expected to also grow its sales, but I'd be perfectly happy if its sales are just at or above inflation, as long as its margins are maintained, and maintained so with little or no debt, as Munger and Buffett say.

I approach it as though I own the entire business. It does me little or no good if my company grow its equity from retained earnings while profitability decline - that just mean business is doing tough and it needs more of my cash, cash it now return at a lower margin, cash that without the company might do much worse.

In the same vein, it does me the owner no good if the company grow its sales but its profitability declines and its balance sheet is stuffed with debts. I'd be fine with sales decline but margin is maintained or at least not deteriorated too much. 


the DCF models is fine if apply to assets with predictable cash flows and interest rates/growth rates... As you said, if estimates are wrong by 1 or 2 percent, valuation is very different. Add to that, if inflation is more than expected, if growth is lumpy, or did not materialise in the timeframe as predicted... I'd be in a panic as to what causes what.

I run my own business and it could be just me but I could never estimate how much I'd be making next year or two. But I'm pretty good at predicting my margins though - I try to keep at the same level as previous; though with higher scales, I tend to get higher margins, economies of scale and stuff.


----------



## McLovin

luutzu said:


> Grow for me by at least r, into infinity. Grow or at least maintain its return on equity.




That's not growth. I think you need to understand how those formulas work, because it seems like you don't really understand them at all.

$x/r will deliver you $x and not a cent more for inifinity. You will still be getting your required "r", because if you buy something for $100 paying $10 then you'll get your 10% return as long as it earns $10. So in the case of CBA, CBA will be earning $5.50 in 10, 20, 30, 50, 100, ∞. With inflation running at 2-3% you are going backward in real terms. That's why I don't see the point of using such a method of valuation. But anyway, you do what you like.


----------



## luutzu

McLovin said:


> That's not growth. I think you need to understand how those formulas work, because it seems like you don't really understand them at all.
> 
> $x/r will deliver you $x and not a cent more for inifinity. You will still be getting your required "r", because if you buy something for $100 paying $10 then you'll get your 10% return as long as it earns $10. So in the case of CBA, CBA will be earning $5.50 in 10, 20, 30, 50, 100, ∞. With inflation running at 2-3% you are going backward in real terms. That's why I don't see the point of using such a method of valuation. But anyway, you do what you like.




OK, "grow" can be confusing... return. 

I've reviewed this many times over the years. It's simplistic but that's why I understand and can do it 

This formula is the present value of an ordinary perpetuity. So we have a series of cash flows (earnings) stretch into infinity. Yes, if the E and the r remain the same, then we'd have a problem... but we adjust them as we need to.

So I do the work, come to see that earning is E and at the moment my return is r... what is the value of a bond that returns E at r into infinity right now? P= E/r. Then next year or two... due to inflation, due to my greed... the required r is now r+i... What is the E now? If it's the same, then value is now less. 

So while it seems like it's fixed, it's not fixed and static because it's reviewed and adjusted as required.

Since the E and the r are reviewed and adjusted all the time... and once you review and adjust these two variables with the changes you see in front of you, and do so when changes are clear and apparent, it results in more accurate estimates than estimating future growth in sales and future interest rates/inflations etc.

Don't know, it's what make sense to me and what I'm comfortable with.

Here's a shorter version of Schroder's speech on what she saw Buffett does:


----------



## TPI

McLovin said:


> How realistic do you think it is that CBA will never, ever grow earnings? Inflation is 2-3% year, so using a no growth model assumes that over time CBA's earning will continue to fall in real terms.




I see what you are saying McLovin, but my interpretation is that with this approach the valuation in practical terms is made for a particular point in time only, and not meant to include x number of years of growth into the future at y% pa, as luutzu also describes.

Though indirectly you can factor this in by using a slightly lower required rate of return to express a degree of confidence in the future growth prospects of the business.

Just out of curiosity, I would be interested in what intrinsic value you would place on CBA using your own valuation approach?

Also luutzu and galumay, if you are still reading this thread, what intrinsic value would you calculate for CBA using your own approaches?

Thanks!


----------



## DeepState

TPI said:


> I see what you are saying McLovin, but my interpretation is that with this approach the valuation in practical terms is made for a particular point in time only, and not meant to include x number of years of growth into the future at y% pa, as luutzu also describes.
> 
> Though indirectly you can factor this in by using a slightly lower required rate of return to express a degree of confidence in the future growth prospects of the business.




All valuations are for a point in time.  We wish to know what a company is worth right now in order to assess if it is trading cheap/expensive/fair right now.  The discussion is about methodology for assessment.

Capitalising current earnings is, broadly, a reasonable thing to do.  It's the assumptions beneath it that matter a great deal because so much hangs off the Earnings / FCF / Dividends that are capitalized.

If you are going to use a multiple of E/FCF/D approach, you will be using what is called the Gordon Growth model, ultimately.  As McLovin and I have pointed out, the gap between the growth rate of the E/FCF/D and the required rate of return is the primary driver of valuation if you are going to do this.

If you want to hash earnings growth by saying there is no growth, it is an unrealistic portrayal of the vast bulk of companies.  However, as you say, you can drop the required return figure such that, in total, the valuation doesn't change.

Is that a realistic thing to do?  If CBA is expected to grow at a rate faster than inflation, but you assume zero growth, does the required return actually drop by the growth rate?  Absolutely not.  In general, you need a higher return to compensate you for risk when the growth rate is zero or negative unless it is just a cash box.

This is why adjustments to the discount rate which are made just to ape the lack of growth rate assumed is incorrect and are merely efforts to disguise an inaccuracy and force an artificial fit.  This remains so if you have some notion of a fixed hurdle rate.

As McLovin said, valuations should try to reflect reality.  Bending a capitalization formulation out of shape to allow for poor assumptions is not a move in this direction.

McLovin's approach is sound.


----------



## herzy

DeepState said:


> All valuations are for a point in time.  We wish to know what a company is worth right now in order to assess if it is trading cheap/expensive/fair right now.  The discussion is about methodology for assessment.
> 
> Capitalising current earnings is, broadly, a reasonable thing to do.  It's the assumptions beneath it that matter a great deal because so much hangs off the Earnings / FCF / Dividends that are capitalized.
> 
> If you are going to use a multiple of E/FCF/D approach, you will be using what is called the Gordon Growth model, ultimately.  As McLovin and I have pointed out, the gap between the growth rate of the E/FCF/D and the required rate of return is the primary driver of valuation if you are going to do this.
> 
> If you want to hash earnings growth by saying there is no growth, it is an unrealistic portrayal of the vast bulk of companies.  However, as you say, you can drop the required return figure such that, in total, the valuation doesn't change.
> 
> Is that a realistic thing to do?  If CBA is expected to grow at a rate faster than inflation, but you assume zero growth, does the required return actually drop by the growth rate?  Absolutely not.  In general, you need a higher return to compensate you for risk when the growth rate is zero or negative unless it is just a cash box.
> 
> This is why adjustments to the discount rate which are made just to ape the lack of growth rate assumed is incorrect and are merely efforts to disguise an inaccuracy and force an artificial fit.  This remains so if you have some notion of a fixed hurdle rate.
> 
> As McLovin said, valuations should try to reflect reality.  Bending a capitalization formulation out of shape to allow for poor assumptions is not a move in this direction.
> 
> McLovin's approach is sound.




Thank you RY. Not having any formal training in accounting, this really clarified the distinction between McLovin and Luutzu's approaches. 

However... what is McLovin's (and your) approach? How do you attempt to factor in growth etc in your valuation?


----------



## DeepState

herzy said:


> Thank you RY. Not having any formal training in accounting, this is really clarified the distinction between McLovin and Luutzu's approaches.
> 
> However... what is McLovin's (and your) approach? How do you attempt to factor in growth etc in your valuation?




No worries.  The below is the bread and butter approach.  McLovin obviously has a lot of skill and experience, and I'll leave it to him to describe how full bore M&A valuations and corporate-advisory/private-equity valuations work in case that's on your plate.

First, it is very tough and often not thought to be possible to capture the growth path of an equity by a simple, single, growth rate together with a discount rate.  To the extent that you think growth rates will not be constant, you can see that a single figure is really an approximation.  The more varying the periodic figures are, the worse the approximation.  Even normalizing the earnings for capitalization can easily move valuations with similar information loads by +/-10% or more. As such, in many companies, it is worth going for little more detail.  These are particularly the ones with fairly steady key elements in P&L, FCF and/or dividends that you can allow for.

The growth rates for different stocks are determined differently.  It depends on what drives the stock.  Again, everything is an approximation.  In the case of CBA, one approach would be to take a look at NOMINAL GDP growth, the credit expansion related to this as a credit system and CBA's share of it.  Unless you have amazing insight into macro, it is reasonable to grab estimates off forecaster surveys (incl RBA, Treasury, NAB) for GDP and inflation.  You can look at historical relationships for credit and CBA's share.  Nothing heroic needs to be done.  Then you need to assess margins, capex, fixed costs, tax....  You can get an idea from examining historical accounts and comparables.  Voila, you have the basis of a working model. 

Don't get scared by this.  It is actually a very small number of key assumptions. Once you knock out your first, it becomes pretty clear.  Any fundamental analysis requires a look into these variables.  Might as well use them to value the firm. You can get these for the most part.  Exact is not really important. No-one has exact. Sales, gross margin, fixed costs, capex, tax.  Those are the key bits that drive a FCF valuation.  You do not need a 200 line model. By doing this you also figure out where key sensitivities are which will help you assess the required margin-of-safety/moat.  This clearly differs for different situations.  Doing calculations in this way helps you figure out the size of uncertainty you are facing if you cannot get a good handle on the input.  This is very important.

You can then fade these in to some sort of steady state after a few years (depending on how long you figure these assumptions get to some sort of steady state - a company never achieves steady state in reality, just at some time, you fade a company into a state where you think it would be in equilibrium and then grows from there at a steady rate.  This steady rate is usually below Nominal GDP growth.  Not doing so is assuming the company will ultimately become World GDP) and then use the Gordon Growth model in the 'outer' years (this might be around 3-6 years, that is the practice in funds management and broking. That's half to one business cycle for a company's financials to settle down. Longer for resource companies whose mine lives are understood).  Discount the whole lot back and you have a valuation that takes market implied major drivers and allows you to figure out how they translate to earnings/FCF/D and discount it at whatever your required rate of return is (normally these are after tax return on 10 year long bond rate + around 5% for equity risk premium although you can adjust this for beta if you like).  You can add the value of franking to this as well.

Now, it can be argued that you have so many assumptions that everything is too wobbly to bother with.  I think that is a possibility for wildly unpredictable companies. They have cash flows all over the place and no dominant steady driver. These companies are almost impossible to value anyway other than via scenario. A capitalised approach is of no help here either. However, as you get to more stable companies, that argument gradually fades in favour of something like the above or variants thereof. 

Rather than using zero growth and some ad hoc, compensatory, adjustment to required rate of return, the above is an attempt to produce a realistic assessment of valuation.  To the extent that each parameter brings uncertainty, it was already in the capitalized current E/FCF/D method already.  Not looking at it is not exactly making the problem go away. However, the benefit of the slightly more expansive approach is that you can see what's going on and you can make a better effort to model the activities of a company and actually understand what is driving the valuation at a level that offers a viewpoint and offers a chance to get in the ballpark.  Importantly, it will help you much more accurately judge what the margin of safety might be.  When valuation ranges of a firm like CBA will easily be about 30% wide, this is very important.  The width of the estimate uncertainty partly highlights why people who do this have such small numbers of stocks they are prepared to contemplate.  Not many will actually look cheap enough to feel comfortable with.  Also, the kinds of people who do this buy certain types of companies that lend themselves to this type of approach.  

Using a capitalized approach, it is exceptionally hard to figure out what the margin of safety should be because the central estimate is already unknown.  What does it mean to vary the 'gap' between zero growth and the adjusted discount rate (however adjusted) by 1%?  An adjustment to an adjustment??? That grinds out a massive number of underlying changes to the actual valuation whose interactions are not even visible.

I hope you find the opportunity to take the effort if valuation is a part of your investment considerations.


----------



## galumay

TPI said:


> Also luutzu and galumay, if you are still reading this thread, what intrinsic value would you calculate for CBA using your own approaches?
> 
> Thanks!




I have moved away from trying to calculate IV, this thread amongst others, has convinced me its a nearly impossible and black art! Instead I am spending more time researching all the aspects of the business (earnings, cash flow, R&D, ROE, ROIC, margins etc) and finding good businesses to own. If I get that right then I am happy to buy and not too worried what my IV calculates as.

CBA is a good example of the problems I find with IV's, one of my methods which is essentially an earnings based model that has a 2 stage predicted growth factor and selectable MoS and RoR, gives an IV of $90 (and thats with conservative settings. ) My FCF model, which is very simplistic, but does give me and IV for comparisons sake - gives an IV of around $55!


----------



## luutzu

DeepState said:


> No worries.  The below is the bread and butter approach.  McLovin obviously has a lot of skill and experience, and I'll leave it to him to describe how full bore M&A valuations and corporate-advisory/private-equity valuations work in case that's on your plate.
> 
> First, it is very tough and often not thought to be possible to capture the growth path of an equity by a simple, single, growth rate together with a discount rate.  To the extent that you think growth rates will not be constant, you can see that a single figure is really an approximation.  The more varying the periodic figures are, the worse the approximation.  Even normalizing the earnings for capitalization can easily move valuations with similar information loads by +/-10% or more. As such, in many companies, it is worth going for little more detail.  These are particularly the ones with fairly steady key elements in P&L, FCF and/or dividends that you can allow for.
> 
> The growth rates for different stocks are determined differently.  It depends on what drives the stock.  Again, everything is an approximation.  In the case of CBA, one approach would be to take a look at NOMINAL GDP growth, the credit expansion related to this as a credit system and CBA's share of it.  Unless you have amazing insight into macro, it is reasonable to grab estimates off forecaster surveys (incl RBA, Treasury, NAB) for GDP and inflation.  You can look at historical relationships for credit and CBA's share.  Nothing heroic needs to be done.  Then you need to assess margins, capex, fixed costs, tax....  You can get an idea from examining historical accounts and comparables.  Voila, you have the basis of a working model.
> 
> Don't get scared by this.  It is actually a very small number of key assumptions. Once you knock out your first, it becomes pretty clear.  Any fundamental analysis requires a look into these variables.  Might as well use them to value the firm. You can get these for the most part.  Exact is not really important. No-one has exact. Sales, gross margin, fixed costs, capex, tax.  Those are the key bits that drive a FCF valuation.  You do not need a 200 line model. By doing this you also figure out where key sensitivities are which will help you assess the required margin-of-safety/moat.  This clearly differs for different situations.  Doing calculations in this way helps you figure out the size of uncertainty you are facing if you cannot get a good handle on the input.  This is very important.
> 
> You can then fade these in to some sort of steady state after a few years (depending on how long you figure these assumptions get to some sort of steady state - a company never achieves steady state in reality, just at some time, you fade a company into a state where you think it would be in equilibrium and then grows from there at a steady rate.  This steady rate is usually below Nominal GDP growth.  Not doing so is assuming the company will ultimately become World GDP) and then use the Gordon Growth model in the 'outer' years (this might be around 3-6 years, that is the practice in funds management and broking. That's half to one business cycle for a company's financials to settle down. Longer for resource companies whose mine lives are understood).  Discount the whole lot back and you have a valuation that takes market implied major drivers and allows you to figure out how they translate to earnings/FCF/D and discount it at whatever your required rate of return is (normally these are after tax return on 10 year long bond rate + around 5% for equity risk premium although you can adjust this for beta if you like).  You can add the value of franking to this as well.
> 
> Now, it can be argued that you have so many assumptions that everything is too wobbly to bother with.  I think that is a possibility for wildly unpredictable companies. They have cash flows all over the place and no dominant steady driver. These companies are almost impossible to value anyway other than via scenario. A capitalised approach is of no help here either. However, as you get to more stable companies, that argument gradually fades in favour of something like the above or variants thereof.
> 
> Rather than using zero growth and some ad hoc, compensatory, adjustment to required rate of return, the above is an attempt to produce a realistic assessment of valuation.  To the extent that each parameter brings uncertainty, it was already in the capitalized current E/FCF/D method already.  Not looking at it is not exactly making the problem go away. However, the benefit of the slightly more expansive approach is that you can see what's going on and you can make a better effort to model the activities of a company and actually understand what is driving the valuation at a level that offers a viewpoint and offers a chance to get in the ballpark.  Importantly, it will help you much more accurately judge what the margin of safety might be.  When valuation ranges of a firm like CBA will easily be about 30% wide, this is very important.  The width of the estimate uncertainty partly highlights why people who do this have such small numbers of stocks they are prepared to contemplate.  Not many will actually look cheap enough to feel comfortable with.  Also, the kinds of people who do this buy certain types of companies that lend themselves to this type of approach.
> 
> Using a capitalized approach, it is exceptionally hard to figure out what the margin of safety should be because the central estimate is already unknown.  What does it mean to vary the 'gap' between zero growth and the adjusted discount rate (however adjusted) by 1%?  An adjustment to an adjustment??? That grinds out a massive number of underlying changes to the actual valuation whose interactions are not even visible.
> 
> I hope you find the opportunity to take the effort if valuation is a part of your investment considerations.




The "proper" DCF approach as describe, seems to me, to be this:

Company A is going to grow at x% for y years; after that it will grow at x2% for y2 years etc... Given these assumptions/projections/forecasts, what is the present value if interest rate is this or that.

In other words, this approach, using sound or otherwise economics, macro trends, maybe personal insight or bias... project Company A's trajectory... then discount back to the present what that trajectory is worth.

That does not sound like a smart thing to do to me. First, you're paying for a future that might never happen; second, if that future happen as predicted, you're simply paying for it up front and hope it works out that way.

---

The approach I follow - I can't say it's mine because I didn't come up with it; can't say it's Buffett's or anyone else's either because I can't be sure... before my reasoning for it, let's explain why I think Buffett follow this approach:

1. Munger and Shroder, even Buffett himself, have said that they have not seen Buffett ever using the DCF model.
2. Buffett have said before, when Munger said he never saw this DCF, that yes, the results from DCF will be too close for safety.
3. Munger and Buffett have said many times that they cannot predict the future, not going to try and change that.

there are more examples of instances I've heard from their interviews and lectures, from reading... but these are just name droppings.

The reason I find this approach sound is this simple: This company can earn this much normally, I need this much return on my money right now - can the company do it; Now that I am comfortable this company could return me earning E at my required rate - what is a company, a financial instrument, that pays me E at my rate from now and into eternity be worth right now.

At the price being offered, is it fair value? Is there a certain margin of safety in case I'm wrong about its earning power. In other words, I already make money the moment I bought it - it usually are not reflected right away in the market price, but I have already made a profit.

In other words, I pay for what the company's series of return is worth to me right now; not what its future earnings could be and what those would be worth if they were discounted at some interest rate.  

So if in the future the company earn more, it's worth more; if its earning deteriorated due to macro factors or war or whatever, then it's worth less. That's the risk a business owner must take.

To reduce that risk, you look for quality businesses; businesses that is hard to replicate or challenge etc.

-----

I think we forget that economics is not a hard science, it's not like engineering or rocket science. There's a bunch of factors, most of which the development and growth one can guess at, some of which no one, not even management or God, would have a clue of its existence or how it will affect and influence a company's future.

To predict a living, dynamic entity's movement; to chart its course in current we at best have only a vague idea of direction and influence on our target... That sounds like a very hard thing to do... and if the results of the fund management industry is anything to go by, it hasn't been that impressive.


----------



## DeepState

luutzu said:


> The "proper" DCF approach as ...
> 
> ...That does not sound like a smart thing to do to me. First, you're paying for a future that might never happen; second, if that future happen as predicted, you're simply paying for it up front and hope it works out that way.




You insist on zero growth rate on the basis that you don't want to pay for a future that you cannot predict will occur.  Do you even vaguely realise how un-smart this statement and concept is?  

Zero growth is entirely arbitrary.  Let's say I don't want to pay for a future that 'might never happen'.  Why zero growth?  Why not -0.000001% growth?  That's more conservative in terms of paying for a future that might not come.  Much better and equally arbitrary to zero.  In case you want to quibble on this point, zero what?  Zero nominal?  Zero real? Zero in USD? Zero in Gold?  Every one of these is zero growth. The denominator is also relative.  There is no concept of zero that makes it safe in any sense whatsoever if the proceeds are to applied for another purpose. ie. You actually plan on using the money for something else instead of buying stock to the end of the universe.

Then, if we can't be sure about a future, we can't be sure that a company won't explode into the ground the very next second.  Equally arbitrary nonsense.  Following your 'logic' the right price for a stock where you don't want to pay 'for a future that might never happen' or otherwise are 'paying for it up front and hoping it works out that way' is ZERO.  Even at zero growth you are discounting a future that you don't know will happen. Do you understand the ridiculousness of your position? 



> McLovin:
> 
> 1. I always thought a valuation should have some modicum of reality in it.
> 2. I think you need to understand how those formulas work, because it seems like you don't really understand them at all.




+1 +1 = +2 




luutzu said:


> The approach I follow - I can't say it's mine because I didn't come up with it; can't say it's Buffett's or anyone else's either because I can't be sure... before my reasoning for it, let's explain why I think Buffett follow this approach:
> 
> 1. Munger and Shroder, even Buffett himself, have said that they have not seen Buffett ever using the DCF model.
> 2. Buffett have said before, when Munger said he never saw this DCF, that yes, the results from DCF will be too close for safety.
> 3. Munger and Buffett have said many times that they cannot predict the future, not going to try and change that.
> 
> there are more examples of instances I've heard from their interviews and lectures, from reading... but these are just name droppings.
> 
> The reason I find this approach sound is this simple: This company can earn this much normally, I need this much return on my money right now - can the company do it; Now that I am comfortable this company could return me earning E at my required rate - what is a company, a financial instrument, that pays me E at my rate from now and into eternity be worth right now.
> 
> At the price being offered, is it fair value? Is there a certain margin of safety in case I'm wrong about its earning power. In other words, I already make money the moment I bought it - it usually are not reflected right away in the market price, but I have already made a profit.
> 
> In other words, I pay for what the company's series of return is worth to me right now; not what its future earnings could be and what those would be worth if they were discounted at some interest rate.
> 
> So if in the future the company earn more, it's worth more; if its earning deteriorated due to macro factors or war or whatever, then it's worth less. That's the risk a business owner must take.
> 
> To reduce that risk, you look for quality businesses; businesses that is hard to replicate or challenge etc.




More assumptions and incoherent assertions without good data or otherwise completely misread data.

Let's get some real data... again. 

These are extracted from the latest Berkshire annual letter.  Written by Warren himself, not a secondary source.  Directly on paper, not on YouTube.  In his own words, not mistranslated or misconstrued.

Here they are.  Just a few short clips will suffice.









luutzu said:


> ... not even management or God, would have a clue of its existence or how it will affect and influence a company's future.




If it is not clear to you what Buffett and Munger are up to the above should highlight that:
1. They allow for growth
2. They want to be able to forecast earnings for five years out or more within a range (ie. allowance for the impacts of God himself).

Your practice is unique to you.  It is logically inconsistent.  You cannot vicariously claim to be aligned with the practices of Buffett and Munger as support.  They do not use it.  They use DCF.  You use DCF too, you just don't seem to know it because the assumptions are so far off plantation that you have become caught up in them as opposed to their real meaning.


----------



## DeepState

luutzu said:


> That does not sound like a smart thing to do to me. First, you're paying for a future that might never happen; second, if that future happen as predicted, you're simply paying for it up front and hope it works out that way.
> 
> ---
> 
> ...these are just name droppings.




Let's drop in another name.  Let's say Benjamin Graham.  After all, Buffett is 85% Graham as you have been fond of saying.  Remembering that Graham was of a previous generation to Buffett.  This is his valuation formula:




What do you know?  It allows for growth. Yours doesn't. I guess he's wrong too.

...and this dooozy:



luutzu said:


> ...And if Buffett does what you are doing, he too is wrong


----------



## luutzu

DeepState said:


> You insist on zero growth rate on the basis that you don't want to pay for a future that you cannot predict will occur.  Do you even vaguely realise how un-smart this statement and concept is?
> 
> Zero growth is entirely arbitrary.  Let's say I don't want to pay for a future that 'might never happen'.  Why zero growth?  Why not -0.000001% growth?  That's more conservative in terms of paying for a future that might not come.  Much better and equally arbitrary to zero.  In case you want to quibble on this point, zero what?  Zero nominal?  Zero real? Zero in USD? Zero in Gold?  Every one of these is zero growth. The denominator is also relative.  There is no concept of zero that makes it safe in any sense whatsoever if the proceeds are to applied for another purpose. ie. You actually plan on using the money for something else instead of buying stock to the end of the universe.
> 
> Then, if we can't be sure about a future, we can't be sure that a company won't explode into the ground the very next second.  Equally arbitrary nonsense.  Following your 'logic' the right price for a stock where you don't want to pay 'for a future that might never happen' or otherwise are 'paying for it up front and hoping it works out that way' is ZERO.  Even at zero growth you are discounting a future that you don't know will happen. Do you understand the ridiculousness of your position?
> 
> +1 +1 = +2
> 
> More assumptions and incoherent assertions without good data or otherwise completely misread data.
> 
> Let's get some real data... again.
> 
> These are extracted from the latest Berkshire annual letter.  Written by Warren himself, not a secondary source.  Directly on paper, not on YouTube.  In his own words, not mistranslated or misconstrued.
> 
> Here they are.  Just a few short clips will suffice.
> 
> View attachment 59806
> 
> 
> View attachment 59807
> 
> 
> 
> If it is not clear to you what Buffett and Munger are up to the above should highlight that:
> 1. They allow for growth
> 2. They want to be able to forecast earnings for five years out or more within a range (ie. allowance for the impacts of God himself).
> 
> Your practice is unique to you.  It is logically inconsistent.  You cannot vicariously claim to be aligned with the practices of Buffett and Munger as support.  They do not use it.  They use DCF.  You use DCF too, you just don't seem to know it because the assumptions are so far off plantation that you have become caught up in them as opposed to their real meaning.




Maybe I'll write to Buffett and ask him, haha

You can take his words that he want to estimate five year's earnings in a literal sense if you want, I obviously take it to mean that he is confident enough in the business and that the future is pretty much the same as today; that when he said future productivity and price will improve, it's a worst case/best case scenario - not an exact forecast of price or productivity.

I'm quite simple... when a few people who knew the guy said they have never seen him do a DCF; when DCF means forecasting the future; When forecasting the future means taking into consideration macro, perhaps geopolitical factors; When the guy says he does not involves himself in macro forecasting or geopolitical analysis; When the guy said that if the Fed Chairman - Greenspan at the time - were to tell him what the interest rate will be it won't change a thing in his analysis.. etc. etc.

I tend to put these things together - deductive reasoning? That and with my simple mind, it makes sense to me.

That and I heard from Peter Lynch that Buffett never use stuff like the Reuters or the Bloomberg terminals... I imagine it'd be hard to forecasts stuff without a decent database, or a calculator.

I guess all these people must be lying or didn't understand or know his secret data warehouse full of MBA analysts.

Like I said before elsewhere, to pay at a price where you're right if the future and all various factors panned out exactly as predicted... it sounds really smart... too smart for me to try or want to pay for.


----------



## DeepState

luutzu said:


> That and I heard from Peter Lynch that Buffett never use stuff like the Reuters or the Bloomberg terminals... I imagine it'd be hard to forecasts stuff without a decent database, or a calculator.
> 
> I guess all these people must be lying or didn't understand or know his secret data warehouse full of MBA analysts.
> 
> Like I said before elsewhere, to pay at a price where you're right if the future and all various factors panned out exactly as predicted... it sounds really smart... too smart for me to try or want to pay for.




If you knew about this you would realize that your calculation can be done in less than half a second from when you have a normalized earnings figure.  A DCF would take around 5 seconds from the same starting point.  This is Buffett's calculation.  He can do it in his head.  I can also do it in my head, but might need seven seconds for a five year initial path before moving to terminal value. But, then, he's smarter than me.

If the header quote was Buffett's 0.1 second IV calculation, he would be referring to a super-set of your method...as opposed to your method.  That would be Graham's type of valuation.  And it would be sufficient to screen out companies so as not to waste 5 seconds.

There is still no appreciation about the difference between a projection and a prediction or the lack of importance of accuracy in identifying valuation ranges. Fundamental concepts.  As a result this exchange remains mired in ... whatever.  In any case, thread readers have seen both arguments and can make up their own minds.


----------



## burglar

luutzu said:


> ... it sounds really smart... too smart for me to try or want to pay for.




Not so long ago, WB realised that an energy crisis was crystallising before his very eyes.
I saw it too ... as did you!
He realised that the cheapest user of energy at sea was shipping.
But ships don't go so good on the mainland.

So he opted for a Rail System as the cheapest user of energy for transport on land.

I saw that too ... as did you!


How smart was he? He bought a railway, lock stock and barrel, Burlington Northern.
How does that make him smarter than DeepState or me or you.

Simply, ... it doesn't!

You confuse smarts with deep pockets!!


----------



## luutzu

DeepState said:


> If you knew about this you would realize that your calculation can be done in less than half a second from when you have a normalized earnings figure.  A DCF would take around 5 seconds from the same starting point.  This is Buffett's calculation.  He can do it in his head.  I can also do it in my head, but might need seven seconds for a five year initial path before moving to terminal value. But, then, he's smarter than me.
> 
> If the header quote was Buffett's 0.1 second IV calculation, he would be referring to a super-set of your method...as opposed to your method.  That would be Graham's type of valuation.  And it would be sufficient to screen out companies so as not to waste 5 seconds.
> 
> There is still no appreciation about the difference between a projection and a prediction or the lack of importance of accuracy in identifying valuation ranges. Fundamental concepts.  As a result this exchange remains mired in ... whatever.  In any case, thread readers have seen both arguments and can make up their own minds.




OK, I got the Walking Dead and Homeland to catch up on, so my five second attempt at forecasting the future.

1. Interest rate next five year: 2.5%, 2.5%, 3%, 4%, 4.1%.
2. Growth in GDP = 2% next three years, then 4% after that;
3. Growth in my industry at -1%, then -2%, then 2%, then 3% after.

So 3 seconds so far...

This company C is 1 of 5 in its industry. C has 30% share industry sales... Having studied all the other 4 competitors, C is 3rd by sales, scales, financial qualities, great management in place etc. etc....

With the expected decline, in first year the 5th company will go bankrupt; this will mean all prospects within industry now go to remaining four, but not equally since company A is obviously the lead, B then get the next cut, then C then D... so on top of my head in first year C will grow its earning by 2.3456%.

Similar things happen in second, and in third... but in 4th year, new technologies are obviously being adopted and the national and global economies will pick up after defeating the evil death cult... 

Time's up.

I think 'God of Finance' isn't too big a title if you could do that and not laugh out loud that people actually pay you to do this and actually think you or anyone could do it.

---

Anyway, got more interesting science fiction to watch


----------



## DeepState

luutzu said:


> OK, I got the Walking Dead and Homeland to catch up on, so my five second attempt at forecasting the future.
> 
> 1. Interest rate next five year: 2.5%, 2.5%, 3%, 4%, 4.1%.
> 2. Growth in GDP = 2% next three years, then 4% after that;
> 3. Growth in my industry at -1%, then -2%, then 2%, then 3% after.
> 
> So 3 seconds so far...
> 
> This company C is 1 of 5 in its industry. C has 30% share industry sales... Having studied all the other 4 competitors, C is 3rd by sales, scales, financial qualities, great management in place etc. etc....
> 
> With the expected decline, in first year the 5th company will go bankrupt; this will mean all prospects within industry now go to remaining four, but not equally since company A is obviously the lead, B then get the next cut, then C then D... so on top of my head in first year C will grow its earning by 2.3456%.
> 
> Similar things happen in second, and in third... but in 4th year, new technologies are obviously being adopted and the national and global economies will pick up after defeating the evil death cult...
> 
> Time's up.
> 
> I think 'God of Finance' isn't too big a title if you could do that and not laugh out loud that people actually pay you to do this and actually think you or anyone could do it.
> 
> ---
> 
> Anyway, got more interesting science fiction to watch




You really would be safer watching science fiction than investing in this way.  It will be the smartest thing you will have done in a long while. Well done.  

I've thought about it some more. Maybe you are right to use zero growth.  It may be  the lesser evil to stick with your assumptions before even worse ones get made.  Like mistaking ROE for growth.  A mistake so fundamental that, when lined up with the rest of the arguments made throughout, is entirely misaligned with high-conviction instruction on the issue to hand with so little/zero flexibility. 

Do you think the above colourful and nonsensical example indicates your proposed approach is superior to DCF?  It does the exact opposite.  The magnitude of the extent of self-inflicted counter argument is astonishing.  I'm confident this is unclear for you.  Yet again, a spurious and extreme viewpoint which serves the opposing purpose.  

Just by the way, what was normalised earnings in base year? What are 10 year bonds trading at?  What is the leverage in the company?  What is the tax-rate? No idea.  Basic valuation building blocks. Basics.  It is no wonder that your belief remains that DCF doesn't work. Stay there. Please.  And keep watching science fiction.

As you watch Walking Dead, think about this...Do you think the people who tackled the zombies in Walking Dead assumed zero growth for the creatures?  You know, because the future is unknown and all.  Or did they allow for growth by preparing for another wave whose size they do not really know...zombie DCF with ranges.  Can't get away from it.  Another self-inflicted counter argument.  Astonishing.


----------



## luutzu

DeepState said:


> You really would be safer watching science fiction than investing in this way.  It will be the smartest thing you will have done in a long while. Well done.
> 
> I've thought about it some more. Maybe you are right to use zero growth.  It may be  the lesser evil to stick with your assumptions before even worse ones get made.  Like mistaking ROE for growth.  A mistake so fundamental that, when lined up with the rest of the arguments made throughout, is entirely misaligned with high-conviction instruction on the issue to hand with so little/zero flexibility.
> 
> Do you think the above colourful and nonsensical example indicates your proposed approach is superior to DCF?  It does the exact opposite.  The magnitude of the extent of self-inflicted counter argument is astonishing.  I'm confident this is unclear for you.  Yet again, a spurious and extreme viewpoint which serves the opposing purpose.
> 
> Just by the way, what was normalised earnings in base year? What are 10 year bonds trading at?  What is the leverage in the company?  What is the tax-rate? No idea.  Basic valuation building blocks. Basics.  It is no wonder that your belief remains that DCF doesn't work. Stay there. Please.  And keep watching science fiction.
> 
> As you watch Walking Dead, think about this...Do you think the people who tackled the zombies in Walking Dead assumed zero growth for the creatures?  You know, because the future is unknown and all.  Or did they allow for growth by preparing for another wave whose size they do not really know...zombie DCF with ranges.  Can't get away from it.  Another self-inflicted counter argument.  Astonishing.




Define growth for me.

If a company that I own earns $10 a year then pay me all of that as dividend.
Next year it earn another $10. No debt, no new capital raising.

Where did that new $10 earning comes from? Out of thin air?
It's earning, it grow its capital by $10 - by making a profit, not by not making anything. If capital was $100, a return on equity/capital of 10%. Right?
So it grows at 10%, yes? Or zero growth?

If by growth you mean the increase in earnings from previous earnings figure, then yea no growth. But if growth define as what profit the company is making from its money, then 10% return.

As I admit before, using growth in this context can be confusing, but it's not wrong. So I use 'return'.

back to example,
If in that second year the company keep that $10 dollars, capital now $110. It then earn $11 without new capital - without debt or cash injection - in 3rd year. Does the fact that it earns $11 then instead of $10  mean it grow its earnings by an extra $1. Based on your definition, yes it grow by 10% - from $10 to now $11 earnings.

But based on my definition, it hasn't grown its profitability - same rate of earning on capital. It does, however, grow (return) its original $110 by 10% - but since its ROE has been 10% all these time, it give the appearance of zero growth.

----
Anyway, if you think a price based on correctly forecasting all the various variables is the way to go, then that's your way to go buddy.

I think the survivors just try to deal with whatever zombies that come by, not really caring for its future growth rate based on decay stages, figuring out current area's previous living population and the various age group and their chances of surviving an attack and become zombies thereby adding to higher zombie rate of growth...


----------



## TPI

DeepState said:


> If you want to hash earnings growth by saying there is no growth, it is an unrealistic portrayal of the vast bulk of companies.  However, as you say, you can drop the required return figure such that, in total, the valuation doesn't change.




Whether I use a 10% or 8% required return, in practical terms I am still expecting growth to occur on the basis of previous qualitative research and basic fundamental screens, and when using an 8% required return I am just expressing slightly greater confidence that growth will occur and that I am willing to pay slightly more upfront for this. I am not trying to quantify the precise value or rate of that growth x years into the future by adopting a slightly lower required return.

RY, what is your view on the valuation approach used by Roger Montgomery and also Clime which don't use DCF and are based on a Buffett/Walters/Simmons approach?

Also, do you have an excel spreadsheet of your DCF model that you could attach for our interest and to play around with?


----------



## TPI

galumay said:


> I have moved away from trying to calculate IV, this thread amongst others, has convinced me its a nearly impossible and black art! Instead I am spending more time researching all the aspects of the business (earnings, cash flow, R&D, ROE, ROIC, margins etc) and finding good businesses to own. If I get that right then I am happy to buy and not too worried what my IV calculates as.
> 
> CBA is a good example of the problems I find with IV's, one of my methods which is essentially an earnings based model that has a 2 stage predicted growth factor and selectable MoS and RoR, gives an IV of $90 (and thats with conservative settings. ) My FCF model, which is very simplistic, but does give me and IV for comparisons sake - gives an IV of around $55!




I think your focus is right and is similar to my process, and you probably get more bang for buck doing this and will get a general idea of value from doing this anyway I guess.


----------



## luutzu

TPI said:


> Whether I use a 10% or 8% required return, in practical terms I am still expecting growth to occur on the basis of previous qualitative research and basic fundamental screens, and when using an 8% required return I am just expressing slightly greater confidence that growth will occur and that I am willing to pay slightly more upfront for this. I am not trying to quantify the precise value or rate of that growth x years into the future by adopting a slightly lower required return.
> 
> RY, what is your view on the valuation approach used by Roger Montgomery and also Clime which don't use DCF and are based on a Buffett/Walters/Simmons approach?
> 
> Also, do you have an excel spreadsheet of your DCF model that you could attach for our interest and to play around with?




That's right, growth - define as expansion, increased earnings, either through increased profitability or through the same profit margin but able to achieved with new, higher, equity base (retained or new capital). So in a good quality business, expansion is expected, BUT, but not quantified.

It'd be good to be able to forecast a company's earnings in next five years. Problem is - how would you do it with any certainty? If you can't do it with certainty, why bother trying and paying a higher price for it?

Everything else remain the same, if Company C grow (expand) its earnings by 10% - over next 5 years its earnings will be $10, $11, $12.10, $13.31, $14.64....

There's a few problems with that approach and its assumptions. Firstly, everything does not remain the same; second, if a business can expand its earnings at 10%, it will soon take over the world; third, why does anything grow at x% for y year just because it makes it easier for you to forecast?; Fourth, why forecast to 5, or 10 years, then assume zero growth into infinity after that (or assume a lower g after that)?

Forget the costs and unlikelihood of forecasts being correct... to assume growth for next few years, then back to no growth or low growth... do all that so you can pay for a higher price? Well, if business goes down then you'd pay a lower price, but why would you want to get into a business that's goin down?

----

Problem with forecasts... 

There's this concept of statistical significance in science - and this is the social sciences - that measure the confidence in the results being caused by controlled variables (can't remember if it's dependent or independent variable). The idea behind it is this - given all the fancy data collected, all the fancy maths, how confident are you that it is caused by what you said it is and not by chance or by other factors?

If the answer is you're not 95%, at minimum, certain... hypothesis don't hold.

How does one get 95% confidence in forecasting a company's earnings over next 5 years? It will take a heck of a lot of work. And if analysts are paid to cover the entire sector or industry, chances are they just can't do it properly.

Or to forecast interest rates. How many fund manager or analysts could have access to, or have the resources necessary, to study the data the Reserve Bank studies in setting interest rate? To accurately forecast interest rate, you would do what a major department in the RBA does, just be more efficient, right? And how could they forecast it over the next 5 years?


Maybe it's because I can't do it, but something sounds really good on paper until you break down the components and ask a few questions.

I did some work with finance managers and the CFO at a mid-size public company. Every month, each department is to analyse their books, look at purchase orders, look at goods received and paid etc. It took the managers a good two weeks each month, and this is after better systems have been put in place... took them a lot of effort to get this forecast correct so the CFO can report on earnings and status, as well as know how much to borrow and when to borrow etc.

To think that an analyst could do something similar to forecast earnings in next five years, and do so for each of the dozen or so companies he follow - to know the company AND all the various macro factors and their impact on the company... yea, OK.


----------



## TPI

DeepState said:


> Just by the way, what was normalised earnings in base year? What are 10 year bonds trading at?  What is the leverage in the company?  What is the tax-rate? No idea.  Basic valuation building blocks. Basics.




RY, this approach does not preclude knowing all of these factors, I think they are known and are used to select the best/most valuable companies to be invested in in the first place, so indirectly they are used in the valuation process.


----------



## DeepState

TPI said:


> 1. Whether I use a 10% or 8% required return, in practical terms I am still expecting growth to occur on the basis of previous qualitative research and basic fundamental screens, and when using an 8% required return I am just expressing slightly greater confidence that growth will occur and that I am willing to pay slightly more upfront for this. I am not trying to quantify the precise value or rate of that growth x years into the future by adopting a slightly lower required return.
> 
> 2. RY, what is your view on the valuation approach used by Roger Montgomery and also Clime which don't use DCF and are based on a Buffett/Walters/Simmons approach?
> 
> 3. Also, do you have an excel spreadsheet of your DCF model that you could attach for our interest and to play around with?




Hi TPI, hope all's good with you.

1. You can argue that, no problem.  If the gap between growth and discount rate is largely preserved, there is no problem with moving discount rate and growth rate at the same time for small changes.  For a fixed view on the world, this can roughly be thought of as changing the rate of underlying inflation embedded into the calculation.  Decrease the inflation assumption, reduce the absolute level of the discount and growth rates.  The gap is largely preserved and so is valuation (not quite, but somewhat close depending on a bunch of things).

To the extent that this happens without changing your underlying inflation assumptions, distortions of valuation relative to your actual expectations occurs.  An example works best.

Imagine you have a company which is marginally able to meet its interest payments.  These interest payments are fixed, but the cash flow from operations is not.  If the rate of growth comfortably exceeds the growth rate of interest payments, credit risk declines as does the appropriate discount rate.  The gap widens with improved growth.  Conversely, if your growth rate declines, possibly to below the interest rate, this company is going bankrupt. Whilst there is a discount rate under the zero growth process that will result in a matching valuation derived by a more accurate depiction of what you think is actually going on, finding the best figure is totally unintuitive.  If you allow for varying growth rates in the forecast, that concept becomes even less intuitive. 

Forecast accuracy is poor enough, why add to it by further approximations?  Valuations are trying to see what a company is worth.  In order to do that, some realism would seem reasonable?

Though you seem to think changing the discount rate without trying to get a precise value for growth x years out omits the growth assumptions, you are really doing it anyway.  You cannot assess the likelihood of earnings being achieved without having implicit or explicit views on their path.

Why use an unintuitive approach whose parameters do not match your best estimate/guesstimate of reality?  The calculation is no more computationally difficult.  However, it comes with the benefit of actually being able to see what you are assuming explicitly rather than through the veil of compromised assumptions that don't occur for the vast bulk of situations.  You are already making assumptions...why not use better ones that you can actually see has a semblance of truth to them?  Again, it is no more computationally intensive but comes with better intuition.  Intuition in valuations is useful for stress testing.  This is very important. Your reference to confidence in achievement of results is a form of stress testing.  Why not do it explicitly?


2. Clime is using DCF.  It is just doing it with a fixed growth rate after normalisation of the first year.  Their growth rate is developed by RoE and payout considerations. Please note that they allow for growth (with a small mathematical twist involving what is known as a Taylor expansion) and have a market/judgement determined rate of return requirement.  That's exactly in alignment with what I have been saying above.  You are attempting to do this, but with assumptions that are approximate to the reality.  Why not use something closer to reality!  It is yet another example of industry practice diverging from the zero growth proposition.  We can add a very large number of names to that.  I can count on a finger those who purport to use a zero growth assumption.

Please note that a single growth rate after normalisation will lead to troublesome outcomes if the growth rate in different periods differ from the long term growth assumption.  Clime are accepting material approximations in this approach, but a zero growth rate process is not one of them.

Take a look at how large the valuation associated with their example is relative to the zero growth (bond) component.  This is how big the approximation of the zero growth proposition is being distorted....and this is typical.  Zero growth assumptions are not really an effort at valuation for the purpose of investment.  They are crash-and-burn calculations in some cases. But which ones?  Because they are too optimistic for many.  So it doesn't even serve the crash-and-burn purpose:




The idea is a close cousin to Ben Graham's approach, which also allows for growth and market/judgment discount rates.

It is a cut down version of Buffett's methods, but you'll see that his approach is not too much more sophisticated.


3. Sure.  

Here is a link to the Stern School of Business, New York University.  http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm They have a bunch of spreadsheets that illustrate and allow you to determine DCF calculations.  I believe you should start with Focussed Valuation Spreadsheets, and the file "fcfe2st.xls".  It illustrates the approach to value a company which has an initial growth rate assumption that differs from the terminal growth rate assumption.  It is a two-stage model.  The vast bulk of valuations are done with two or three stage models. Please note how light the assumption load is.  It is only slightly more demanding that a single period valuation model.  As a result, from normalised earnings and two growth rates, with a discount rate you get an intrinsic valuation. If you consider the computational load, it should be evident that it can be solved in the head of a seasoned practitioner within a few seconds.

There are many ways you can use this, but let's not start that here.  In terms of the accuracy of the assumptions going in, it is very unlikely that you have absolutely no opinion whatsoever about the future path of growth.  Any sight is better than no insight. You may not have confidence in their precision though. It is not precision which counts in investments.  No-one has precision. What counts is margin of safety.  You are trying to obtain this indirectly by varying the discount rate when you have increased confidence in earnings.  Why not do this more explicitly?  Again, the assumption load is basically identical for a single period valuation and slightly more challenging for a multi period one.

Further, I invite you to fire up "fcfest.xls" which is a single growth rate estimate.  Please consider doing as follows:

1. Observe the overall discount rate and growth rate embedded into the spreadsheet as you open it.
2. Observe the valuation
3. Set the growth rate to zero.
4. Use your intuition to obtain a discount rate that matches the original valuation.  
5. Check how much the 'hash' differs from the actual figure you are trying to approximate in the first place with more direct assumptions. 

Finally, notice how the Stern School spreadsheets come pre-populated with growth assumptions that are not zero.  Another one.

TPI, no-one uses a zero growth rate assumption as a blanket starting point in the professional market.  I sincerely hope the reasons why are evident.  In the end, I hope whatever method(s) you elect to use works out for you.

Cheers


----------



## DeepState

TPI said:


> RY, this approach does not preclude knowing all of these factors, I think they are known and are used to select the best/most valuable companies to be invested in in the first place, so indirectly they are used in the valuation process.




I was referring to the example provided.  A valuation cannot be obtained without them.  Hence, arguing that a calculation cannot be made in some time period whilst providing a rather extreme scenario is made more - something - when insufficient information is provided in the first place.  For example, normalised earnings. No calculation can figure out what a valuation is without some base earnings figure.  Basics for conducting any analysis were missing.

Any reasonable valuation would require that information.  Any valuation outcome embeds these assumptions in some way.  This information is obtainable.  As you say.

We're aligned here.


----------



## TPI

RY, thanks a lot for your comprehensive replies, I'll have to read them a few more times over the weekend before I fully comprehend everything you've written.

And I will have a look at those spreadsheets too, thanks.

Just for interest, of the 23 stocks I own or follow I currently have 3 on my list that are either close to or below intrinsic value based on the Roger Montgomery valuation approach, the IV = FY15 EPS / RR approach (or my interpretation of it) and also based on a relatively low PE ratio:

CAB
CKF
JBH 

This leads me to believe that when stocks are starting to get real cheap, different valuation approaches may start to converge and reach the same conclusions...


----------



## DeepState

TPI said:


> RY, thanks a lot for your comprehensive replies, I'll have to read them a few more times over the weekend before I fully comprehend everything you've written.
> 
> And I will have a look at those spreadsheets too, thanks.
> 
> Just for interest, of the 23 stocks I own or follow I currently have 3 on my list that are either close to or below intrinsic value based on the Roger Montgomery valuation approach, the IV = FY15 EPS / RR approach (or my interpretation of it) and also based on a relatively low PE ratio:
> 
> CAB
> CKF
> JBH
> 
> This leads me to believe that when stocks are starting to get real cheap, different valuation approaches may start to converge and reach the same conclusions...




No probs.  Always welcome.

The formula you have put up is essentially the zero growth formulation.  That's why they match with this zero growth concept that has been discussed.  The key reasons why they might differ relate to how you choose to standardize the FY15 forecast (as opposed to last reported year) and how the discount rate is determined.  Otherwise they are identical.  You will see them converge when the growth rate between last year and current year is actually zero and the discount rate is unchanged - for example.  The examples you have given sort of approximate zero growth for the coming year which leads to your belief that a zero growth model converges to a DCF under conditions of low growth and thus low PE.  If a company really has zero growth, then factor that in to your valuation...but does it make sense to assume that for every other company?

My understanding is that formula is not what Roger is espousing (from the review of another thread in this forum on the matter.  The exchanges were sufficient to get the idea).  He also factors in growth based partly on RoE.  His assumptions in determining the rate of growth are challenging, but that's what you get with a single period model. It's a trade-of between parsimony and inaccuracy.  It seems to have similarities with the method used by Clime...which is probably why you referred to both Clime and RM together when asking about their techniques for valuation.

Valuation is about trying to figure out what the company is worth.  It will be uncertain and we can flex assumptions to see how poor our understanding is.  If the valuations can't be narrowed adequately, or the price is not towards the bottom of the band, move on.  You can use these to crash test valuations too. That's a good idea. How severe a crash test is depends on the nature of the company.  They clearly differ. Zero growth massively differs in the severity of a crash test valuation across a suite of companies making valuation on that basis essentially useless to figure out cheap from rich within a list of stocks.  Attempting to correct for this by varying discount rates is completely unintuitive because it has no concept of the variability of potential earnings and lots of other matters relating to bond valuations.  You are essentially trying to embed valuations related to real options in an obtuse way if this path is pursued.  It's just not obvious.  However, it should be obvious that this embeds a ton more hidden assumptions than a simple, humble, DCF which lays them out in daylight.

Zero growth is a form of crash test....but just like the above examples, they become central estimates for some, or even aggressive valuations for others in decline.  It simply doesn't make sense, even if you greatly value simplicity. It is a concept which oversteps simplicity and works counter to purpose. 

Anyhow, it's your money and obviously your call.


----------



## galumay

TPI said:


> RY, thanks a lot for your comprehensive replies, I'll have to read them a few more times over the weekend before I fully comprehend everything you've written.
> 
> And I will have a look at those spreadsheets too, thanks.
> 
> Just for interest, of the 23 stocks I own or follow I currently have 3 on my list that are either close to or below intrinsic value based on the Roger Montgomery valuation approach, the IV = FY15 EPS / RR approach (or my interpretation of it) and also based on a relatively low PE ratio:
> 
> CAB
> CKF
> JBH
> 
> This leads me to believe that when stocks are starting to get real cheap, different valuation approaches may start to converge and reach the same conclusions...




Not sure thats a safe conclusion! I hold CAB, and by my valuation they are probably the one of those 3 I would call cheap, although its not easy to price the long term effect of the legislative change coming. I am not a fan of the Montgomery approach and PE is a very simplistic and potentially misleading indicator. 

CKF I think you need to be very careful with the debt level, for mine that took it off my watch list. Both Interest coverage and debt/equity ratio.

JBH, its probably the cheapest of the 3 if you can have any confidence in the forecast earnings holding up. I just have a bad gut feeling about JBH in the medium term.

I will be interested to see what others think.


----------



## So_Cynical

DeepState said:


> .
> First, it is very tough and often not thought to be possible to capture the growth path of an equity by a simple, single, growth rate together with a discount rate.  To the extent that you think growth rates will not be constant, you can see that a single figure is really an approximation.  The more varying the periodic figures are, the worse the approximation.




And that's all that needs to be said, the numbers are mostly worthless so lets move on...1000 words not needed.


----------



## TPI

DeepState said:


> The key reasons why they might differ relate to how you choose to standardize the FY15 forecast (as opposed to last reported year) and how the discount rate is determined.




Yeah I did use FY15 EPS for the Roger Montgomery valuation approach, IV = E / r approach and PE ratio, and used the same required returns for each stock.

I guess the question is that if you were to do a full DCF on these 3 stocks (perhaps also using the same EPS figure and required returns) would the conclusion be similar in broad and relative terms or way off the mark?



			
				DeepState said:
			
		

> My understanding is that formula is not what Roger is espousing (from the review of another thread in this forum on the matter.  The exchanges were sufficient to get the idea).  He also factors in growth based partly on RoE.  His assumptions in determining the rate of growth are challenging, but that's what you get with a single period model. It's a trade-of between parsimony and inaccuracy.  It seems to have similarities with the method used by Clime...which is probably why you referred to both Clime and RM together when asking about their techniques for valuation.




I thought Roger Montgomery's approach was the same but Clime also includes franking credits in their normalised earnings figure?:

https://www.eurekareport.com.au/sites/default/files/Eureka webinar - Value Investing_0.pdf



			
				DeepState said:
			
		

> However, it should be obvious that this embeds a ton more hidden assumptions than a simple, humble, DCF which lays them out in daylight.




Yeah I can see how this may be the case.


----------



## TPI

galumay said:


> Not sure thats a safe conclusion! I hold CAB, and by my valuation they are probably the one of those 3 I would call cheap, although its not easy to price the long term effect of the legislative change coming. I am not a fan of the Montgomery approach and PE is a very simplistic and potentially misleading indicator.
> 
> CKF I think you need to be very careful with the debt level, for mine that took it off my watch list. Both Interest coverage and debt/equity ratio.
> 
> JBH, its probably the cheapest of the 3 if you can have any confidence in the forecast earnings holding up. I just have a bad gut feeling about JBH in the medium term.
> 
> I will be interested to see what others think.




Fair points, I guess I wasn't really making comment about whether I would necessarily buy these stocks now or thought that they had very favourable future prospects, just that they appeared to be at or below fair value on the basis of 3 valuation approaches. So this is not withstanding that they may get cheaper in the future and that forward measures of intrinsic value may fall rather than rise.


----------



## luutzu

RY,

*IV = E/r: The Perpetual Annuity Approach.*

If I own a company outright; If the company is expected to pay me earning E from now until eternity; How does a company that earns E year in year out forever be said to have zero growth? I know it does not expand its earning, that it does not earn E+g... But it returns me its E while maintaining its capital base then next year it returns me another E from that same capital base; A zero growth company, with the same capital base (no additional cash from equity raising or debt)... a zero growth would return me zero, not E.

Like I go to a bank, open a term deposit that pays 10% p.a.; this mean each year I collect $10 from my $100 deposit/capital. I think we call that account a 10% growth account, not a 0% growth account. A zero return, zero growth, account give me jack at end of the year.

So OK, growth in the context of a firm and its earnings can be confusing, but return is the same thing in this case isn't it?

So in saying that I require 15% return on my money, how much does a company that earns E each year forever be worth if my required cost of capital is 15%... How is that a zero growth assumption.

It would be only if we look at the E and pay no attention, ignore,everything else. For example, ignore whether new equity is raised, whether the earning is retained, ignore if more debts are incurred... if all these changes occur and the company still earns E... then it might be zero growth if we get the mix right, else it'd be negative growth or worst.

By putting E into the DCF and assumes it grows at g (E is after tax, depreciation etc.) while ignoring the factors that results in E and E's growth (factors like retained earnings, debts, new equity), the approach ignore a lot of important and costly contributions to its earnings and growth, contributions that may come too cheaply or too highly. 


---

The DCF, say the two stage growth assumption in the 'fcfe2st.xls' excel...
How do we mere mortals do that?


----------



## burglar

luutzu said:


> ... If I own a company outright; ...





You would learn PEG Ratio:

[video]http://www.investopedia.com/video/play/peg-ratio/?rp=i[/video]


----------



## McLovin

luutzu said:


> RY,
> 
> *IV = E/r: The Perpetual Annuity Approach.*
> 
> If I own a company outright; If the company is expected to pay me earning E from now until eternity; How does a company that earns E year in year out forever be said to have zero growth? I know it does not expand its earning, that it does not earn E+g... But it returns me its E while maintaining its capital base then next year it returns me another E from that same capital base; A zero growth company, with the same capital base (no additional cash from equity raising or debt)... a zero growth would return me zero, not E.
> 
> Like I go to a bank, open a term deposit that pays 10% p.a.; this mean each year I collect $10 from my $100 deposit/capital. I think we call that account a 10% growth account, not a 0% growth account. A zero return, zero growth, account give me jack at end of the year.
> 
> So OK, growth in the context of a firm and its earnings can be confusing, but return is the same thing in this case isn't it?
> 
> So in saying that I require 15% return on my money, how much does a company that earns E each year forever be worth if my required cost of capital is 15%... How is that a zero growth assumption.
> 
> It would be only if we look at the E and pay no attention, ignore,everything else. For example, ignore whether new equity is raised, whether the earning is retained, ignore if more debts are incurred... if all these changes occur and the company still earns E... then it might be zero growth if we get the mix right, else it'd be negative growth or worst.
> 
> By putting E into the DCF and assumes it grows at g (E is after tax, depreciation etc.) while ignoring the factors that results in E and E's growth (factors like retained earnings, debts, new equity), the approach ignore a lot of important and costly contributions to its earnings and growth, contributions that may come too cheaply or too highly.
> 
> 
> ---
> 
> The DCF, say the two stage growth assumption in the 'fcfe2st.xls' excel...
> How do we mere mortals do that?




I don't know anyone who can post such vast quantities of absolute rubbish. You have no idea what you're talking about and even worse you're leading other people up the garden path with you. Just so the folks playing it at home can understand how absurd this is, the formula is e/(r-g) where g = growth. You've removed g but are trying to argue that you still assume growth. 

RY has done some great posts in this thread there's not much else to add.


----------



## luutzu

burglar said:


> You would learn PEG Ratio:
> 
> [video]http://www.investopedia.com/video/play/peg-ratio/?rp=i[/video]




Thanks Burglar, will take a closer look and see if I could understand it. 


With regards to the earning being E into infinity and how that does not take into account inflation. Mathematically that is true, but in reality it is not. In reality, most businesses, especially outstanding ones with strong market position, most could raise their prices to match or slightly exceed inflation. 

So if inflation is 3% and the company earns 1.03xE, it's not really earning 3% more, it's still earning E in real terms.


----------



## luutzu

McLovin said:


> I don't know anyone who can post such vast quantities of absolute rubbish. You have no idea what you're talking about and even worse you're leading other people up the garden path with you. Just so the folks playing it at home can understand how absurd this is, the formula is e/(r-g) where g = growth. You've removed g but are trying to argue that you still assume growth.
> 
> RY has done some great posts in this thread there's not much else to add.




We're all grown ups here and I have said that I never work in the investment industry. So if what I say do not make sense, people can see that. At least it get us to think and rethink, which is never a bad thing.

As Buffett says, it's better to be approximately right than precisely wrong.

To use an approach with multiple variables, where just about all of which are forecasts of distant futures, and where if one or two estimate are slightly off and the results will be dramatically different... That is not a smart thing to do.

This is investment, not rocket science.


----------



## DeepState

TPI said:


> Yeah I did use FY15 EPS for the Roger Montgomery valuation approach, IV = E / r approach and PE ratio, and used the same required returns for each stock.
> 
> I guess the question is that if you were to do a full DCF on these 3 stocks (perhaps also using the same EPS figure and required returns) would the conclusion be similar in broad and relative terms or way off the mark?
> 
> 
> 
> I thought Roger Montgomery's approach was the same but Clime also includes franking credits in their normalised earnings figure?:
> 
> https://www.eurekareport.com.au/sites/default/files/Eureka webinar - Value Investing_0.pdf




Hi TPI

RM's method is in the same class as Clime's.  Both are single period valuations.  Both allow for growth and discount back using a required rate of return.

The point to highlight here is that these formulas are different to the one you are using which is EPS(FY15)/rr.  That is capitalizing EPS(FY15) at rr which is the same as assuming zero growth in EPS going forward.

Two or three-stage valuations can be very materially different from one which capitalizes using a terminal growth rate alone.  Differences of 10% - 20% would routinely be found.  I think this is material.  However, if the long and shorter term rates of growth are seen to be close, it will converge of course.  Generally, something is going on to near term earnings for a company to move outside of fair value bands.  Hence it is generally (but not uniformly) better to use more than one stage.  

As the example from Clime and RM show, single period methods are in wide spread use in the industry.  Using these is less accurate for the most part relative to your expectations. The key point here is that absolutely none of the methods, real investors, examples, exhibits...use a zero growth rate as a blanket assumption for growth.

Don't be the second....:1zhelp:


----------



## DeepState

So_Cynical said:


> ...1000 words not needed.





I'll keep this brief.

1. Go to Settings.
2. Add my Name to the Ignore List.



So_Cynical said:


> And that's all that needs to be said



+1


----------



## McLovin

DeepState said:


> As the example from Clime and RM show, single period methods are in wide spread use in the industry.




Are they? Or are they used by people selling valuation software? There's so many issues with that formula (you probably read the other thread) that I can't imagine a fund manager using it in isolation.


----------



## DeepState

McLovin said:


> Are they? Or are they used by people selling valuation software? There's so many issues with that formula (you probably read the other thread) that I can't imagine a fund manager using it in isolation.




I have found that people don't use it for absolute valuation because of the shortcomings.  Hence, with TPI and many others who aren't benchmarked against an equity exposure, I prefer something which relaxes the incoherence of many of the assumptions in a single period model.

However, it is in widespread use for managers who think of things against a benchmark or comparative universe which is fully invested.  In this type of situation comparative valuations are the greater focus.  In companies which are comparable in the sense that they operate in similar markets etc (even as part of a sum-of-parts, acknowledging issues there) calculation, growth rates between them will be fairly close or are close in terms of proportion.  In that case, errors in growth assumptions largely wash out.  So it boils down to buying the cheaper (adj) P/E, more or less. The less comparable, the greater the mismatch (even allowing for growth rate differences) in calculated P/E needs to be to take a position. Some people look at PEG for example to try and make them more comparable (heaps of problems with that ratio). Forget about mines, loss makers etc..  

ROIC calculations, Yield, liquidity adjustment, EPS consensus and delta(EPS Consensus), EPS trend, debt level/serviceability, outright uncertainty around your estimates, composition of growth... are also considered from within the 3-way accounts examination and consensus figures.  Everything is compared to everything else whose price moves. Then there is all the qualitative stuff which actually takes up 90% of the day.

Much of the effort day to day work is really focused on how relative EPS (expectations) will move over the next 2 years unless valuation considerations are overwhelming or a corporate action occurs.  This is generally the greater influence in stock prices of this type of horizon.


----------



## McLovin

Interesting insight. Thanks, RY.


----------



## TPI

DeepState said:


> Two or three-stage valuations can be very materially different from one which capitalizes using a terminal growth rate alone.  Differences of 10% - 20% would routinely be found.  I think this is material.  *However, if the long and shorter term rates of growth are seen to be close, it will converge of course.  Generally, something is going on to near term earnings for a company to move outside of fair value bands*.  Hence it is generally (but not uniformly) better to use more than one stage.




Ok sure thanks RY, I think I will need to do a full DCF at some stage to explore this further.


----------



## luutzu

DeepState said:


> ... are also considered from within the 3-way accounts examination and consensus figures.  Everything is compared to everything else whose price moves. *Then there is all the qualitative stuff which actually takes up 90% of the day.*
> 
> Much of the effort day to day work is really focused on how relative EPS (expectations) will move over the next 2 years unless valuation considerations are overwhelming or a corporate action occurs.  This is generally the greater influence in stock prices of this type of horizon.




How do you guys define these "qualitative stuff" that takes up to 90% of the day?

With all these emphasis on macro forecasts, earnings projections on the national, the sectorial, the industry and then the individual company level; with the, I imagine, necessity to look closely at each company's earnings and structure to then estimate its share of the industry's pie to then estimate its future earnings and performance... How do you guys do that in 80 minutes a day, or 4 hours a week in a 40-hour week... with no lunch or toilet breaks, no youtube and news scouring.

Unless qualitatives takes 10% of the day but seems like 90% because it's very hard and hard things make stretches the internal clock. The insanity man.

Would managerial analysis, like integrity, honesty, team cohesion among key executives... would that be considered qualitative or do you quantify it, or are these already quantified through the earnings?

Good to have insight into the workings of those who manages our nation's retirement security and savings...


----------



## DeepState

luutzu said:


> How do you guys define these "qualitative stuff" that takes up to 90% of the day?
> 
> With all these emphasis on macro forecasts, earnings projections on the national, the sectorial, the industry and then the individual company level; with the, I imagine, necessity to look closely at each company's earnings and structure to then estimate its share of the industry's pie to then estimate its future earnings and performance... How do you guys do that in 80 minutes a day, or 4 hours a week in a 40-hour week... with no lunch or toilet breaks, no youtube and news scouring.
> 
> Unless qualitatives takes 10% of the day but seems like 90% because it's very hard and hard things make stretches the internal clock. The insanity man.
> 
> Would managerial analysis, like integrity, honesty, team cohesion among key executives... would that be considered qualitative or do you quantify it, or are these already quantified through the earnings?
> 
> Good to have insight into the workings of those who manages our nation's retirement security and savings...




You seriously have no idea which way is up or down.


----------



## luutzu

DeepState said:


> You seriously have no idea which way is up or down.




Let's not get personal. I thought I was asking legitimate questions.

You've been arguing the need to forecast and project... I thought those are hard things to get right but others with better brains and effort could do it... then you said you guys spend 90% on qualitative stuff, the other 10% looking at peer estimates for consensus and forecasting the future, I'm guessing.

So what are those qualitatives.

I think it'd be quite interesting to know how analysis of qualitative stuff could give you guys confidence in forecasting that company C will grow earnings by 5.24254325% next year, then  5.63452125842% the year after, then 3.12451% constantly; that interest rates will be this and that and that etc. etc.

Does having a good vibe from qualitatives give confidence in estimates pulled together in an hour?


----------



## burglar

luutzu said:


> Let's not get personal ...




I don't believe he was being personal, ... I believe he was being critical.

I have been body surfing in the Southern Ocean!
When tumbled by the big ocean rollers, I couldn't tell up from down.
The secret is to control the panic for a few seconds.


----------



## luutzu

burglar said:


> I don't believe he was being personal, ... I believe he was being critical.
> 
> I have been body surfing in the Southern Ocean!
> When tumbled by the big ocean rollers, I couldn't tell up from down.
> The secret is to control the panic for a few seconds.




I can't swim so only allow water up to my belly, it gets above the shoulders when I dog paddle but yea, head always above water 

Anyway, best to always question conventional wisdom and practices for they often do not make much sense when you think about it.


----------



## burglar

So here we are, embroiled in psuedo-intellectual
argument about a 5 second calculation.

Do we agree that we use a 5 second calculation to 
filter and correctly abandon companies that will not fit our criteria?

Do we agree that we will use something more fitting 
for those companies which become candidates?


Down to basics as burglar sees them.

You go long on a company to make a return.
Buy a good company, cheaply.
If you hold in faith, you will want a dividend with YOY growth.
You will want the company to stay solvent.
You will want the Share price to oscillate towards true value.
You will want the true value to hold. (Think JBH)


Alternatively:

If the Share Price exceeds IV, that would be a bonus.
If the IV grows, that would be a bonus.

So then you could sell to crystallise the bonus.
But then you need to pay CGT
So it comes down to your personal Income Tax position.

And now you need to await another opportunity.


----------



## galumay

You are not far off the mark for mine Burglar! 

I have slightly developed my strategy as I go, now the first glance at something that catches my eye is to consider the 'catastrophic risk', if the company makes it past that, its a bit of research to see if I understand what they do, if it makes it past there then its worth doing a bit more analysis.

I cant do DCF in my head, so I have a bit of look at earnings, current year, past years, and look at growth in earnings predictions. If i like everything I see I punch some numbers into my DCF calculator which is a 2 stage one with a couple of MoS additions, that punches out an IV that is almost always LOWER than the current price!

I do a scan of the cash flow and enter the basics in a spreadsheet that in the end gives me a FCF/share value which I then divide by a % to give me an IV based on cash flow - its nearly always even lower than the DCF IV!

I also enter operating margin, ROE, ROC and interest cover and debt/equity on the spreadsheet just so i capture them and check them.

All of that probably takes me 10 minutes or so, if a company gets through all of that with a price thats not wildy at odds with my IV's then it goes on my watch list. Then either when capital becomes available, or there is a clear correction in the market, I will consider buying into the company.

I really dont mind paying more than the IV, if I had a strict rule about waiting for the price to be below IV I would not have bought one company on my watchlist in the last 2 years! 

I also read everything, everywhere I can find it, about the companies on my watch list, I really like to be very comfortable with my decision to buy before I click the button.

I think one of the best things about a bit of a drawn out process is that it limits impulsive buying!

So its not a 5 second calculation, its also a dynamic process - I am learning all the time as I read books on finance, economics and investing. I also learn continuously from the high level of discussion on ASF's, my inclusion of cash flow calculations is part of that learning and directly related to ASF.


----------



## skc

luutzu said:


> So what are those qualitatives.
> Does having a good vibe from qualitatives give confidence in estimates pulled together in an hour?




You can think about the qualitative stuff as someone doing a due diligence on takeover. Key questions to ask include:

- What is the overall market size and projected growth? 
- Are there major regulatory changes impacting on the business? E.g. MMS.
- Are there major material contractual relationships? E.g NVT and Macquarie U.
- What are the industry power dynamics? E.g. Porter's 5 forces analysis.
- What are the likely competitor or supply response? E.g. QAN vs VAH capacity war.
- Are there new disruptive technology?
- Do management have the right plan and financial discipline?
- Do management have the right experienced people executing those plans?

All these help shape the forecast and define degree of confidence in the valuation process. It is an art, it will not be precise, but it doesn't mean it is useless.


----------



## DeepState

luutzu said:


> Let's not get personal.




The entity which wrote the prior entry which you are referring to has no idea which was is up or down.  Any resemblance to you is purely coincidental and unintended.  Nonetheless it could still be you.




luutzu said:


> Good to have insight into the workings of those who manages our nation's retirement security and savings...




The system continues to enjoy the benefits of your financial contribution into the markets as negative expected alpha.  Give 'til it hurts. It's even tax deductible.




luutzu said:


> I thought I was asking legitimate questions.




Thinking doesn't make it so.




luutzu said:


> You've been arguing the need to forecast and project... I thought those are hard things to get right but others with better brains and effort could do it...




Better brains and effort requires a basis of comparison to be meaningful.  The sentence structure implies the reference basis is you.  If so, then a resounding "yes" they can do it. 




luutzu said:


> So what are those qualitatives.




I don't know.  What exactly are "qualitatives"?  Is that the term for when someone mistakes growth for RoE?  Or is unable to discern growth from discount rate in a Gordon model?  And yet wants to critique it in this fashion? Don't know it.  Never had to learn it.




luutzu said:


> I think it'd be quite interesting to know how analysis of qualitative stuff could give you guys confidence in forecasting that company C will grow earnings by 5.24254325% next year, then 5.63452125842% the year after, then 3.12451% constantly; that interest rates will be this and that and that etc. etc.
> 
> Does having a good vibe from qualitatives give confidence in estimates pulled together in an hour?
> ...




It's more than the vibe.  It's the Constitution.  It's the Mabo.  When we have those, it actually takes about 10 minutes if you aren't building the template from scratch.  If we don't have the Mabo, it takes about 30 mins.  If we don't have the Constitution or the Mabo then, yes, the full hour is needed to obtain sufficient confidence.  Gaining confidence generally consists of repeating "I can do it!" over and over whilst listening to an Anthony Robbins recording.  Just before placing the trade, we walk over hot coals to prove our confidence.


SKC is fresh to the conversation. I refer you to him. Like McLovin, he's top shelf stuff on many matters.


----------



## skc

DeepState said:


> SKC is fresh to the conversation. I refer you to him. Like McLovin, he's top shelf stuff on many matters.




No! I refuse your generous offer. I already regreted posting in this thread 

You may be familiar to the concept of a "stop loss" in trading. I employ a very tight stop loss when it comes to forum posting: 3 posts maximum in hopeless debates. It has saved my head from exploding on more than a few occassions.


----------



## luutzu

DeepState said:


> The entity which wrote the prior entry which you are referring to has no idea which was is up or down.  Any resemblance to you is purely coincidental and unintended.  Nonetheless it could still be you.
> 
> The system continues to enjoy the benefits of your financial contribution into the markets as negative expected alpha.  Give 'til it hurts. It's even tax deductible.
> 
> 
> Thinking doesn't make it so.
> 
> 
> Better brains and effort requires a basis of comparison to be meaningful.  The sentence structure implies the reference basis is you.  If so, then a resounding "yes" they can do it.
> 
> 
> I don't know.  What exactly are "qualitatives"?  Is that the term for when someone mistakes growth for RoE?  Or is unable to discern growth from discount rate in a Gordon model?  And yet wants to critique it in this fashion? Don't know it.  Never had to learn it.
> 
> 
> It's more than the vibe.  It's the Constitution.  It's the Mabo.  When we have those, it actually takes about 10 minutes if you aren't building the template from scratch.  If we don't have the Mabo, it takes about 30 mins.  If we don't have the Constitution or the Mabo then, yes, the full hour is needed to obtain sufficient confidence.  Gaining confidence generally consists of repeating "I can do it!" over and over whilst listening to an Anthony Robbins recording.  Just before placing the trade, we walk over hot coals to prove our confidence.
> 
> 
> SKC is fresh to the conversation. I refer you to him. Like McLovin, he's top shelf stuff on many matters.




OK, so you don't know. You just pick and choose the best models to go with a consensus, depending on the mood and market sentiment.

You know how absurd it is to have a bunch of different models to measure the one thing?

You're like an accountant where if a guy comes to you and ask what's 2 + 2, you'll say "depends on how much you want it to be. If you want to use the two stage model, with these assumptions, it'll be this; if you use a Gordon dividend with constant growth assumption, it'll be that; if you use CAPM to measure risk and market volatility blah blah to get the expected return at your risk level with earnings growth at that and blah blah, it'll be something only god and I know."

All these fancy models and Nobel prizes, sounds really smart, sounds like they're worth billions in fees a year... yet they all boils down to - we don't know.

If your industry performance are anything to go by, if periodic financial crises are partly the master of the universe's doing... they speak louder than some dumb logic right?

-------

It just show you haven't a clue how your models work. You only look at the surface and got too busy trying to look smart to really register the implications of each assumptions you're picking up from some database and plug straight into a spreadsheet.

How many ways can reported earnings grow (expand)?
1. Inflation - larger reported earnings, no real growth;
2. Due to retaining more earnings, hiring more people, buy more machineries, lowering profit margins, increase output and sales... report higher earning figures, but lowering margins;
3. Funny accounting;
4. Withhold essential repairs and replacement of PPE; etc. etc.

So the brilliant 1 or 2 or 3 stage DCF models add earnings growth assumptions, interest rates etc. etc., yet somehow forget to assume that earnings can be gained by means other than simply a business getting more efficient; assumes that sales and increase earnings automatically grows while input costs or capital base either remain the same or increase at the same rate.

---

If a company I own "grows" its earnings in size, but returns a lower percentage on my investment, can that company still be said to be growing? According to you it has grown, according to my simple math, I put more cash into the business and making a lower return for my trouble.

Put it simpler, if I had $100 in the bank and earn $10 a year; I kept that $10 in the same account and add in another $20... next year I got $11 in return... is that $11 a $1 gain (growth) or a $2 loss?

But oh, when you guys plug in the earnings and its growth estimates... you've already taken into account inflation rates, interest rates, costs of capital, pricing fluctuations, business cycles, technological advances... all these estimates done for next 5 years, and done in 4 hours or less, depending on coffee and toilet breaks.

Ever ask what happen if your estimates are wrong? In the long run it will work itself right, right?

----

*The false zero-growth assumption regarding a perpetual annuity approach.*

If I know the company very well and find it to be in a strong financial position, happy with its historical and current market position, its competitiveness, happy with its profit margins, happy with its ability to adapt... all these and more so that based on my best case/worst case scenarios... it earns E, it could return to me E per year on average.

Almost by definition, a good company must be able to raise its price with rising costs and inflations (at the least); my definition, a good business is one competitors will have a hard time knocking it around - its reputation, its networks, its margin etc. would mean that it could, say, lower its profit margin a little to increase sales and still earn E.

Will this company grow its earnings without additional capital? Probably, its management and workforce may be more efficient... But by how much I don't know, by 2 or 3 or 5% I have no idea, when that efficiency will come I don't want to guess. 

So the other 'growth' by size... where I have to put up more cash from my pocket or from retained earnings... If such growth in magnitude were achieve at the same rate of return, makes little difference to me since profitability is the same - could be good or bad depends on my other opportunities; But if earnings grow in size and I make less profit, that's a loss.

So there are 3 possibilities: expand earnings through efficiency; expand through new capital and achieve same rate of return; expand earnings but with new capital and returning at lower rate for it.

The first possibility might not happen - the company's history and size tend to suggest that kind of great growth to be possible but might also not be possible to a certain degree that I'd want to pay for upfront;

The second possible is the same E as far as I am concern. It could lead to greater efficiencies etc., but let's way and see... I'd paid more when that happen;

The third is a loss, hopefully temporary and will be made up for soon.

So under these 3 scenario for growth, with the fourth being simply adjustment to inflation and costs to earn the same... The estimated E, while appearing to be a zero growth model is not. If it neglect anything beneficial, it neglects the first possibility of greater earnings through luck and ingenuity, something we can't predict and always a happy surprise to not have to pay for upfront.


With an estimate of earning power E for next few years... what would a bond, a company, a bank account etc. etc... be worth today if my cost of capital is r -  It'd be Price = E/r.

But dude, what if interest rate change... Why must my required rate of return move in perfect alignment with the bank's rate? If i need 10% or 15% return, seeing the general economic environment, I don't need much adjustment, I can be happy at my rate and we're all fine. 

----

So laugh at its simplicity, quote Buffett and read into his words or imagine him the Oracle if you like... there is a sound logic to it. Much sounder than plugging in endless assumptions and get it precisely wrong.


----------



## DeepState

luutzu said:


> OK, so you don't know. You just pick and choose the best models to go with a consensus, depending on the mood and market sentiment....
> 
> [Stuff]
> 
> It just show you haven't a clue how your models work.
> 
> [Stuff]
> 
> ....If a company I own "grows" its earnings in size, but returns a lower percentage on my investment, can that company still be said to be growing? According to you it has grown, according to my simple math, I put more cash into the business and making a lower return for my trouble.
> 
> ....Put it simpler, if I had $100 in the bank and earn $10 a year; I kept that $10 in the same account and add in another $20... next year I got $11 in return... is that $11 a $1 gain (growth) or a $2 loss?
> 
> [Stuff]
> 
> ...Much sounder than plugging in endless assumptions and get it precisely wrong.




Are we there yet?


----------



## Ves

Hi everyone,

I was just passing through after a bit of an absence and noticed this interesting thread.

There was something relevant to perpetuity formulas that I was pondering recently and haven't been able to solve.

Can someone mathematically inclined tell me how (if it is possible) to convert a perpetuity to an equivalent "growth" cash flow series with duration (say for any period eg. 5, 10, 20 years)?  NPV / IRR should be the same on both. 

Martin Liebowitz touches on this in one of his books (Franchise value),  but I've never been able to understand the maths.


----------



## DeepState

Ves said:


> Hi everyone,
> 
> I was just passing through after a bit of an absence and noticed this interesting thread.
> 
> There was something relevant to perpetuity formulas that I was pondering recently and haven't been able to solve.
> 
> Can someone mathematically inclined tell me how (if it is possible) to convert a perpetuity to an equivalent "growth" cash flow series with duration (say for any period eg. 5, 10, 20 years)?  NPV / IRR should be the same on both.
> 
> Martin Liebowitz touches on this in one of his books (Franchise value),  but I've never been able to understand the maths.




Ves, it's absolutely wonderful to hear from you again.  

Which page(s) of the book are you referring to?

Best wishes

RY


----------



## Ves

DeepState said:


> Ves, it's absolutely wonderful to hear from you again.
> 
> Which page(s) of the book are you referring to?
> 
> Best wishes
> 
> RY



Hi RY,

Are you familiar with the book?   

If you are,  you may know his whole method is based on TV  (tangible value of current earnings) + FV (franchise value of future known opportunities) = EV (enterprise value).     This can also be converted into an adjusted P/E ratio.

This method should only be used for firms with a competitive advantage (adjustments can be made for return fade).

The TV component is a perpetuity  (Earnings / discount rate).

FV  is an equivalent growth perpetuity.    It is basically the estimated NPV of the investments a firm can deploy into future opportunities at a profitability (ROIC) margin above the firm's cost of capital (COC) multiplied by a "Franchise factor"."   These can happen across any time-frame,  so using this approach you are circumnavigating the need to estimate the precise timing of the firm's profitable growth. In a way it's a book value multiple proxy for estimated future firm investments based on incremental ROIC.  But you do need to be careful,   the ROIC spread above COC will increase the multiplier exponentially.

On pg 124 he starts discussing the concept of a "duration based approximation." The concept makes sense to me,  but the maths doesn't.  He is comparing the FV equivalent growth perpetuity to a duration based investment. Say an alternate investment with the same NPV as the FV (above)  earning 20% for 10 years or 15% for 20 years.

The maths is in appendix 4.   I'm afraid it loses me.


----------



## gordon2007

luutzu said:


> So laugh at its simplicity...




In all honesty, you're  not comprehending this.  And what is befuddling to many, curious to others and just downright frustratingly funny to a fair few, is that you don't even realise that you're not understanding this. 

To quote a rather simple man of long ago, 'the problem with your thinking, is that you don't even understand that there is a problem with your thinking'.


----------



## burglar

luutzu said:


> ... You know how absurd it is to have a bunch of different models to measure the one thing? ...




We could start a whole new thread on this "one thing", 

INTRINSIC VALUE
intrinsicvalue.asp


> DEFINITION OF 'INTRINSIC VALUE'
> 1. The actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Value investors use a variety of analytical techniques in order to estimate the intrinsic value of securities in hopes of finding investments where the true value of the investment exceeds its current market value.




No two companies are alike so why use the same model for each?


The cruncher is this :- 
Value Investors are like Train Controllers. They love to compare sizes!


----------



## galumay

burglar said:


> Investors are like Train Controllers. They love to compare sizes!




Fixed for you, Burglar.


----------



## DeepState

Ves said:


> Hi RY,
> 
> Are you familiar with the book?




I am now.  




Ves said:


> If you are,  you may know his whole method is based on TV  (tangible value of current earnings) + FV (franchise value of future known opportunities) = EV (enterprise value).     This can also be converted into an adjusted P/E ratio.
> 
> This method should only be used for firms with a competitive advantage (adjustments can be made for return fade).
> 
> The TV component is a perpetuity  (Earnings / discount rate).
> 
> FV  is an equivalent growth perpetuity.    It is basically the estimated NPV of the investments a firm can deploy into future opportunities at a profitability (ROIC) margin above the firm's cost of capital (COC) multiplied by a "Franchise factor"."   These can happen across any time-frame,  so using this approach you are circumnavigating the need to estimate the precise timing of the firm's profitable growth. In a way it's a book value multiple proxy for estimated future firm investments based on incremental ROIC.  But you do need to be careful,   the ROIC spread above COC will increase the multiplier exponentially.




Yep.  Needed a couple of coffees. This has some similarities to the processes created by HOLT Value Associates which is now owned by Credit Suisse.




Ves said:


> On pg 124 he starts discussing the concept of a "duration based approximation." The concept makes sense to me,  but the maths doesn't.  He is comparing the FV equivalent growth perpetuity to a duration based investment. Say an alternate investment with the same NPV as the FV (above)  earning 20% for 10 years or 15% for 20 years.
> 
> The maths is in appendix 4.   I'm afraid it loses me.




More coffee.  This was excruciating.

I think you might have become gummed up on pp. 277-278.  These require an understanding of chicanery called the Taylor series expansion and another bond concept called Macaulay Duration.

I can take you through that, but this is basically an EVA valuation wrapped in a ton of maths and concepts that are not likely to be used in practice. They are simply unintuitive from a valuation perspective although the maths works out. 

The basic concept here is that, when you allow different rates of return for different investments rather than assuming a uniform return, a firm's value consists of TV and then the combined value of a bunch of projects with different rates of return in perpetuity (which is the equivalent of the value of the actual project) which are then multiplied by a weird factor (FF) to help derive a P/E multiple contribution.  The FF itself is adjusted for the duration of the perpetuity! That's gymnastics.

If you had the information necessary to produce the inputs, it's still much more visible and intuitive to conduct an EVA (or straight NPV).  It would require less transformations for a project cashflow into perpetuity equivalents and duration adjustments to the FF to give it value.  Just calculate the EVA at k for each project and value them! Or just value the total cashflow as per standard FCF. If you apply these methods, all the maths will then adjust those into a theoretically equivalent but less intuitive outcome and then give you the same result.


----------



## TPI

RY,

What are your thoughts on these comments from the Alice Schroeder video, excerpt/summary taken from http://gregspeicher.com/?p=65 :



> Unlike most investors, Buffett did not create a model of the business. In fact, based on going through pretty much all of Buffett’s files, Schroder never saw that Buffett had created a model of a business.
> Instead, Buffett thought like a horse handicapper. He isolated the one or two factors upon which the success of Mid American hinged. In this case, sales growth and cost advantage.
> He then laid out the quarterly data for these factors for all of Mid Continent’s factories and those of its competitors, as best he could determine it, on sheets of a legal pad and intently studied the data.
> He established his hurdle of a 15% return and asked himself if he could get it based on the company’s 36% profit margins and 70% growth. It was a simple yes or no decision and he determined that he could get the 15% return so he invested.
> According to Schroder, 15% is what Buffett wants from day 1 on an investment and then for it to compound from there.
> This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)
> There was a big margin of safety in the numbers of Mid Continent.
> Buffett invested $60,000 of personal money or about 20% of his net worth. It was an easy decision for him. No projections – only historical data.
> He held the investment for 18 years and put another $1 million into the business over time. The investment earned 33% over the 18 years.




Do you not believe what she says about how Bufffet values a business?


----------



## Ves

DeepState said:


> I am now.
> 
> 
> 
> 
> Yep.  Needed a couple of coffees. This has some similarities to the processes created by HOLT Value Associates which is now owned by Credit Suisse.
> 
> 
> 
> 
> More coffee.  This was excruciating.
> 
> I think you might have become gummed up on pp. 277-278.  These require an understanding of chicanery called the Taylor series expansion and another bond concept called Macaulay Duration.
> 
> I can take you through that, but this is basically an EVA valuation wrapped in a ton of maths and concepts that are not likely to be used in practice. They are simply unintuitive from a valuation perspective although the maths works out.
> 
> The basic concept here is that, when you allow different rates of return for different investments rather than assuming a uniform return, a firm's value consists of TV and then the combined value of a bunch of projects with different rates of return in perpetuity (which is the equivalent of the value of the actual project) which are then multiplied by a weird factor (FF) to help derive a P/E multiple contribution.  The FF itself is adjusted for the duration of the perpetuity! That's gymnastics.
> 
> If you had the information necessary to produce the inputs, it's still much more visible and intuitive to conduct an EVA (or straight NPV).  It would require less transformations for a project cashflow into perpetuity equivalents and duration adjustments to the FF to give it value.  Just calculate the EVA at k for each project and value them! Or just value the total cashflow as per standard FCF. If you apply these methods, all the maths will then adjust those into a theoretically equivalent but less intuitive outcome and then give you the same result.



Thanks RY

Liebowitz was at Salomon Brothers for along time if I recall.   He's now at Morgan Stanley.  Has worked or had relationships with a lot of the big firms on the Street.

The real reason that I am pursuing the mathematical gymnastics behind these concepts is that knowing the ins-and-outs allows me not only to understand them better,  but to modify them on a situational basis, where required.

Looks like I have some more reading to do. I will follow up on the Taylor series and the Macaulay Duration when I get a chance.    Beware,  I'm pretty slow to absorb this stuff sometimes,  so I might take a while to ask any questions.  

The approach that he discusses in his book clicked with me in the way that the formula is presented.  You are essentially arriving at the same thing (an NPV)  but the formula forces you to focus on two things:  sustainable return from existing assets,   potential return from future opportunities.  It's flexible in the fact that the two are separable,  and it fits right in with my big picture thinking on competitive advantage....  where I try to look at things in terms of long-term cycles,  not the year-by-year estimation that often puts people off DCF.

Maybe this is the wrong word... but I find it more intuitive than other valuation models.  The need for exact precision in models is a form of fear,   our deep worry that we will be wrong and cannot control the future outcome. You still need to make judgments and big picture assumptions - there's no getting around that. But I feel as if this model allows me to move away from stressing over the "minor details"  (like how much capital will be invested in year 5)  Which I believe galumay and a few others have expressed concern about.  That book was a real lightbulb moment for me and fits exactly to my style of thinking (especially that not everything goes up and down in a straight line, in a routine fashion like you see in so many models).

However,  as Liebowitz says,  no matter the valuation method,  it's only based on known possibilities.  It's the unknown, unseeable upside and downside that you cannot write into any model.


----------



## DeepState

Ves said:


> Thanks RY
> 
> Liebowitz was at Salomon Brothers for along time if I recall.   He's now at Morgan Stanley.  Has worked or had relationships with a lot of the big firms on the Street.
> 
> The real reason that I am pursuing the mathematical gymnastics behind these concepts is that knowing the ins-and-outs allows me not only to understand them better,  but to modify them on a situational basis, where required.
> 
> Looks like I have some more reading to do. I will follow up on the Taylor series and the Macaulay Duration when I get a chance.    Beware,  I'm pretty slow to absorb this stuff sometimes,  so I might take a while to ask any questions.
> 
> The approach that he discusses in his book clicked with me in the way that the formula is presented.  You are essentially arriving at the same thing (an NPV)  but the formula forces you to focus on two things:  sustainable return from existing assets,   potential return from future opportunities.  It's flexible in the fact that the two are separable,  and it fits right in with my big picture thinking on competitive advantage....  where I try to look at things in terms of long-term cycles,  not the year-by-year estimation that often puts people off DCF.
> 
> Maybe this is the wrong word... but I find it more intuitive than other valuation models.  The need for exact precision in models is a form of fear,   our deep worry that we will be wrong and cannot control the future outcome. You still need to make judgments and big picture assumptions - there's no getting around that. But I feel as if this model allows me to move away from stressing over the "minor details"  (like how much capital will be invested in year 5)  Which I believe galumay and a few others have expressed concern about.  That book was a real lightbulb moment for me and fits exactly to my style of thinking (especially that not everything goes up and down in a straight line, in a routine fashion like you see in so many models).
> 
> However,  as Liebowitz says,  no matter the valuation method,  it's only based on known possibilities.  It's the unknown, unseeable upside and downside that you cannot write into any model.




I hear you on wanting to use an approach that helps to assess competitive advantage and not moving in straight lines. It's an excellent mindset.  In my view, the best approach for you is EVA.  Using this, each project can be modeled as a return from competitive advantage over a period of time before that advantage is eroded.  It also takes into account the amount of money you can deploy.  Financing it is also considered endogenously.  The recommended book here is "Valuation: Measuring and Managing the Value of Companies", 5th Edition by Koller et al.

You can simplify an EVA in many ways.  Say you think the company enjoys the ability to reinvest and potentially lever up into growth, this is easily done and you can specify the competitive advantage period and amount for each deployment or assume a series of deployments for a certain period and a different set as time goes through.  This approach is pretty common.  You then see it as an explicit and intuitive outcome.

The Leibowitz approach bends this intuition into a growth factor and FF.  They work, but they are not as intuitive.  Any gain you might get from the disciplines of implied ROE etc are more directly obtainable via EVA. 

In any case, there are many Taylor series expansions.  This is the one which is relevant for this case:


----------



## DeepState

TPI said:


> RY,
> 
> What are your thoughts on these comments from the Alice Schroeder video, excerpt/summary taken from http://gregspeicher.com/?p=65 :
> 
> 
> 
> Do you not believe what she says about how Bufffet values a business?




Ultimately there are two things to note:
1.Warren Buffett assumes a non-zero growth rate for companies that experience growth.
2.He is conducting a multistage DCF valuation.

Key points from the link that you provided include:
1.paragraph 12 indicates that she never saw Buffett create a model of the business (as a detailed forecast template).
2.she goes on to say that he focuses on a small number of factors upon which the success of the company is based.
3.paragraph 15 is key because it relates to a company with 36% profit margins and 70% growth. She asks if such a company could receive a 15% return. The 15% clearly relates to Buffett’s hurdle rate.
4.in paragraph 17 she says that this is how *Buffett does a discounted cash flow*. There are no models. He simply looks at detailed long-term historical data and determines the price he has to pay for it based on a 15% return minimum expectation. It is for this reason that Munger has said he had  never seen Buffett do a discounted cash flow model. It is because the model is very simple as I’ve previously explained. You can, literally, do it in your head.

Key points in the annual letter to shareholders in 2014 include:
1.He needs to calculate a normalised return. In order to have a normalised return you need to start from normalised earnings. He uses an example on page 17 which includes expectations that productivity and crop prices would improve in relation to a 400 acre farm that he purchased. In other words he forecasts or projects. But these need not be complicated. You do not need to produce a detailed model to create a valuation.
2.As if to highlight that expectations for the future are being formed, on page 19 he goes on to say that the ability to estimate future earnings for a range of five years out or more is an important factor for his decision-making.

From the link that you provided, the example given was for a company growing at 70% growth with 36% profit margins.  If that growth rate was maintained indefinitely it will quickly become the entire world economy. The price for this is literally infinite. Clearly that’s a ridiculous situation to use as a perpetuity. As a result Buffett would be extrapolating this for a short period of time but feeding it into a longer term return which does not produce such a ridiculous outcome. This is what a multistage DCF looks like.

To conclude, I believe what Alice is saying. She’s saying the same thing as I have been outlining on this thread.  Warren Buffett uses a multistage DCF valuation which includes forward-looking forecasts/projections and growth rates which are certainly not zero on a blanket basis. The model is simple enough to calculate in his head, probably within five seconds.


----------



## Ves

Hi RY,

Had a quick look at Economic Value Added (EVA) on the Stern business site  (Aswath Damodaran).

The most basic formula  is  (ROIC - COC) x  New Investments.     To make it a perpetuity you simply divide by the required return.

The franchise factor (FF) from Liebowitz (without modifiers) as I understand it is very similar:   (ROIC - COC) / Discount Rate.   You then multiply this by the new investments.   

The major difference that you seem to be pointing out is that you can use EVA on both a time frame basis and a perpetual basis   (Liebowitz also has a section to factor in return fade etc and returns under leverage,  which modifies the formula).

Would I be correct in saying that both of these methods are really the same thing with slight modifications to suit the situation by adding whatever mathematically gymnastics you need?

Cheers


----------



## DeepState

Ves said:


> Hi RY,
> 
> Had a quick look at Economic Value Added (EVA) on the Stern business site  (Aswath Damodaran).
> 
> The most basic formula  is  (ROIC - COC) x  New Investments.     To make it a perpetuity you simply divide by the required return.
> 
> The franchise factor (FF) from Liebowitz (without modifiers) as I understand it is very similar:   (ROIC - COC) / Discount Rate.   You then multiply this by the new investments.
> 
> The major difference that you seem to be pointing out is that you can use EVA on both a time frame basis and a perpetual basis   (Liebowitz also has a section to factor in return fade etc and returns under leverage,  which modifies the formula).
> 
> Would I be correct in saying that both of these methods are really the same thing with slight modifications to suit the situation by adding whatever mathematically gymnastics you need?
> 
> Cheers




Hi Ves

They are identical.  They are just transformations of each other.  Same with FCF. EVA and Leibowitz are closely related. 

I believe EVA is more intuitive as it gets there via explicit modeling. Liebowitz adjusts EVA streams into various combinations of factors. In particular, G and FF.  This imposes a degree of structure to the valuations (it gives you less degrees of freedom.  Less assumptions to make, but less ability to express what is going on) and reduces their intuition (please explain to me in 30 seconds exactly what an FF adjusted for duration actually means...you get the picture).

The benefit of structure, I think, is small relative to EVA.  In EVA you can also assign value of initial investment, competitive advantage and time frame. You don't have to get cute or overfit a all. The perpetuity example you provided is highly restrictive and would not be used exclusively for valuations because competitive advantages are sustained indefinitely and nor is capital deployed into projects. However, you can constrain as much as you like too.  At its most flexible, each cashflow/investment/distribution is explicit and thus very visible.  In Liebowitz, you convert these into something which fits, but which is not what is going on in terms of direct observation.  That's why I labeled it 'gymnastics'.  To me, it's twisting something direct and obvious into something which is skillfully contorted.  Can I use Picasso??  

You can merge the two methods if you like.  If a particular project happens to have characteristics that make it easy to value by Leibowitz, you can value it and tack it on to a EVA.  The reverse is also true.  Hence some sort of blend is possible.  In my view, when something is easy to value by Leibowitz, it will be easier to value it via Gordon Growth and embed it within EVA.

Anyway, my comments are obviously from my point of view.  If you see things differently and find it more intuitive to pursue Leibowitz, then go for it.  What matters is getting a fair estimate given what we know and some intuition about what matters about getting to that figure and sensitivity to changes in assumptions.  Take the path to Rome which seems clearest to you. 

Cheers

RY


----------



## burglar

galumay said:


> Fixed for you, Burglar.




Which part did you fix ... exactly?


----------



## galumay

burglar said:


> Which part did you fix ... exactly?




I took out the word "Value" 

Sorry if it was a bit obtuse!


----------



## Ves

Thanks again RY,  you've been very helpful.   I can see a few more possibilities that I wasn't aware of this morning by reading your posts.

I like adding new tools to my valuation arsenal.   It allows me to attempt to view more  business situations and have the maths to evaluate them.

My most important rule in investing and valuation is that I need _to think_ every time I approach a new company.   I'm a big believer that making an Excel spread sheet with a standard DCF model and using it routinely every time or using whatever whizz bang formula you come up with effortlessly is the wrong way to go about it.  The world isn't full of round pegs and round holes to put them in!

The only real comparison between company models that you need is on an IRR basis - buy the highest expected return on current price from all of your candidates that meet your hurdle rate.


----------



## McLovin

Is this the same way that the Walter (RM) model works too? By squaring the ROE/r you end up putting a finite time on growth and there's an assumption that high ROE companies will only have their growth persist for a shorter period.

Nice to see Ves back too.


----------



## DeepState

Ves said:


> I like adding new tools to my valuation arsenal.





If this keeps up, we're going to have to start negotiating for a unilateral disarmament for the sake of national security.


----------



## Ves

McLovin said:


> Is this the same way that the Walter (RM) model works too? By squaring the ROE/r you end up putting a finite time on growth and there's an assumption that high ROE companies will only have their growth persist for a shorter period.




Sort of.   What you are doing is estimating what you think are the present value of the firm's total future opportunities to deploy capital into a franchise in current dollars and multiplying it by a profitability factor.   

The difference is that it can be sourced from any where (whereas Walter only assumes retained earnings). This could be many multiples of what the current retained earnings policy could generate over the next decade etc.  The assumption is that a firm with a strong profitable franchise will be able to get finance as there are limited opportunities for such franchises to exist in the first place, so capital supply should be no issue.

Liebowitz does show ways in which you can add a return fade, or duration,  and there is also an alternate formula based on sales growth and incremental margin (best for multinationals).

I think it's well worth a read.



> Nice to see Ves back too.



Thanks!


----------



## Ves

DeepState said:


> If this keeps up, we're going to have to start negotiating for a unilateral disarmament for the sake of national security.



Lol.


----------



## McLovin

Ves]I think it's well worth a read.[/QUOTE]

Had a quick look at it said:


> Take a look at how large the valuation associated with their example is relative to the zero growth (bond) component.  This is how big the approximation of the zero growth proposition is being distorted....and this is typical.  Zero growth assumptions are not really an effort at valuation for the purpose of investment.  They are crash-and-burn calculations in some cases. But which ones?  Because they are too optimistic for many.  So it doesn't even serve the crash-and-burn purpose:
> 
> View attachment 59821
> 
> 
> The idea is a close cousin to Ben Graham's approach, which also allows for growth and market/judgment discount rates.
> 
> It is a cut down version of Buffett's methods, but you'll see that his approach is not too much more sophisticated.




Hey RY

Is there a simple explanation as to why ^2 is used in that calculation?

TIA.


----------



## DeepState

McLovin said:


> Hey RY
> 
> Is there a simple explanation as to why ^2 is used in that calculation?
> 
> TIA.




Looking at it again, I think it is because they are essentially fading NROE into RR via magic home-brew formula.  The alternative of this perpetually reinvested component of the formulation, where NROE exceeds RR, is for the present value of the accumulated of assets to progress to infinity.  

Their method at least allows for value creation when NROE exceeds RR.  More value is created when that gap is bigger.  However that fade prevents the development of those situations where the company becomes the world.

The fact that they assume a single fade rate for all industries and all companies is obviously an alarm bell.

You cannot tell if this is a conservative formula because it depends on the situation which it is being applied to.  It is not quite a single period type analysis in that the growth rates decline on some magic glidepath, so you could cheekily call it an infinite stage DDM.  However, the more fitting description is a model which uses only initial conditions for all situations where the premium to required return multiplier is faded at the same proportional rate to the NROE/RR ratio (equaling 2 x the ratio of NROE/RR).  Bottom line is that it is just a (Gordon) growth multiplier that has an equivalent single period growth rate which actually converges to a feasible value - not necessarily a sensible one.  The relationship between their multiplier and the Gordon Growth formula equivalent exists, but it's not like I can point to some economically coherent argument linking them.  You can just calculate it.

Anyway, on the upside, it is simple.  It allows for a positive growth rate.  It would also be reasonable when comparing two similar companies.  It would be much less useful for an absolute valuation.


----------



## McLovin

DeepState said:


> Looking at it again, I think it is because they are essentially fading NROE into RR via magic home-brew formula.




Home brew does seem to be how they arrived at it. I guess it would be nice to have some sort of foundation as to why ^2 is better than ^1.5 or ^2.5 etc. I guess you could adjust the exponential but then you're really just getting out into a world of stick your finger in the air and write down a number. It's also strange the way it implies fast growth than then goes to zero at some period in the future (which is determined by roe/r).


----------



## luutzu

gordon2007 said:


> In all honesty, you're  not comprehending this.  And what is befuddling to many, curious to others and just downright frustratingly funny to a fair few, is that you don't even realise that you're not understanding this.
> 
> To quote a rather simple man of long ago, 'the problem with your thinking, is that you don't even understand that there is a problem with your thinking'.




Yea man, guessing the future then pay at a price that is right if all that future comes true... I sure don't understand why people do that.


----------



## luutzu

burglar said:


> We could start a whole new thread on this "one thing",
> 
> INTRINSIC VALUE
> intrinsicvalue.asp
> 
> 
> No two companies are alike so why use the same model for each?
> 
> 
> The cruncher is this :-
> Value Investors are like Train Controllers. They love to compare sizes!




How many scale, weighing machine do you need to weigh bananas, then apples, then oranges?

I understand where you're coming from, that depends on the nature of the business, certain interpretations must be use for the same items - e.g. liabilities like deposits is good for a bank, liabilities generally not preferable in other businesses.

At the end of all these, there is only one way to measure a business' worth: how much money does it return to its owner after all expenses.

Those who think they can predict the future go for speculation disguised as intelligence.


----------



## luutzu

DeepState said:


> Ultimately there are two things to note:
> 1.Warren Buffett assumes a non-zero growth rate for companies that experience growth.
> 2.He is conducting a multistage DCF valuation.
> 
> Key points from the link that you provided include:
> 1.paragraph 12 indicates that she never saw Buffett create a model of the business (as a detailed forecast template).
> 2.she goes on to say that he focuses on a small number of factors upon which the success of the company is based.
> 3.paragraph 15 is key because it relates to a company with 36% profit margins and 70% growth. She asks if such a company could receive a 15% return. The 15% clearly relates to Buffett’s hurdle rate.
> 4.in paragraph 17 she says that this is how *Buffett does a discounted cash flow*. There are no models. He simply looks at detailed long-term historical data and determines the price he has to pay for it based on a 15% return minimum expectation. It is for this reason that Munger has said he had  never seen Buffett do a discounted cash flow model. It is because the model is very simple as I’ve previously explained. You can, literally, do it in your head.
> 
> Key points in the annual letter to shareholders in 2014 include:
> 1.He needs to calculate a normalised return. In order to have a normalised return you need to start from normalised earnings. He uses an example on page 17 which includes expectations that productivity and crop prices would improve in relation to a 400 acre farm that he purchased. In other words he forecasts or projects. But these need not be complicated. You do not need to produce a detailed model to create a valuation.
> 2.As if to highlight that expectations for the future are being formed, on page 19 he goes on to say that the ability to estimate future earnings for a range of five years out or more is an important factor for his decision-making.
> 
> From the link that you provided, the example given was for a company growing at 70% growth with 36% profit margins.  If that growth rate was maintained indefinitely it will quickly become the entire world economy. The price for this is literally infinite. Clearly that’s a ridiculous situation to use as a perpetuity. As a result Buffett would be extrapolating this for a short period of time but feeding it into a longer term return which does not produce such a ridiculous outcome. This is what a multistage DCF looks like.
> 
> To conclude, I believe what Alice is saying. She’s saying the same thing as I have been outlining on this thread.  Warren Buffett uses a multistage DCF valuation which includes forward-looking forecasts/projections and growth rates which are certainly not zero on a blanket basis. The model is simple enough to calculate in his head, probably within five seconds.




haha... 

Munger and Schroder, literally, told you that they have never seen Buffett do a DCF modelling... you interpret that to mean that he must have, he does, he does it in his head.

When Buffett agrees with Munger that he had never use a DCF modelling... because the results will be too close anyway... That is taken to mean he does, he just does it somehow.

When Buffett and Munger, I'm sure you have read this in annual reports or interviews... when they say they cannot, have not, been able to predict the future and won't start now... That is taken to mean... mean the future is more than 5 years away.

Ever wonder if you read into things what you want to read into it?


----------



## burglar

galumay said:


> I took out the word "Value"
> 
> Sorry if it was a bit obtuse!




Humorous!

There was me, looking for a new thread!


----------



## burglar

luutzu said:


> Yea man, guessing the future then pay at a price that is right if all that future comes true... I sure don't understand why people do that.




"Work with it. It's the best we got!", Ross the Boss





> INVESTOPEDIA EXPLAINS 'VALUE INVESTING'
> The big problem for value investing is estimating intrinsic value. Remember, there is no "correct" intrinsic value. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept to value investing is that of "margin of safety". This just means that you buy at a big enough discount to allow some room for error in your estimation of value.
> 
> Also keep in mind that the very definition of value investing is subjective. Some value investors only look at present assets/earnings and don't place any value on future growth. Other value investors base strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, it all comes back to trying to buy something for less than it is worth.


----------



## luutzu

burglar said:


> "Work with it. It's the best we got!", Ross the Boss




How does a business person value and buy businesses or financial assets before these DCF models? Before the central banks, interest rates, CAPM, beta... before the investment industry and financial analysts and their MBAs?

It's only natural in business to puff yourself up , to make things seems harder and more difficult than they really are - and only you and people with your training and brainpower could do what you're being paid to do. The investment industry has been very good at this... just I think some in it hasn't read the memo saying it's just to fool the public and not themselves.


----------



## Wysiwyg

luutzu said:


> It's only natural in business to puff yourself up , to make things seems harder and more difficult than they really are - and only you and people with your training and brainpower could do what you're being paid to do.



 Mate that is so so true. Our CEO favours the word "challenge". There is "extremely" challenging, "to say the least" challenging and plain old challenging. Record production last FY yet we face challenging times ahead. At over 7 million a year you want the share holders to see you (not the workers) putting in the hard yards.


----------



## DeepState

luutzu said:


> haha...
> 
> Munger and Schroder, literally, told you that they have never seen Buffett do a DCF modelling... you interpret that to mean that he must have, he does, he does it in his head.
> 
> When Buffett agrees with Munger that he had never use a DCF modelling... because the results will be too close anyway... That is taken to mean he does, he just does it somehow.
> 
> When Buffett and Munger, I'm sure you have read this in annual reports or interviews... when they say they cannot, have not, been able to predict the future and won't start now... That is taken to mean... mean the future is more than 5 years away.
> 
> Ever wonder if you read into things what you want to read into it?





It lives. 

I know you think Buffett is an idiot and all.  Further, he doesn't do what I have implied.  So, let's just dig up some records from this moron and read his actual words.  I'll also add some simplification to assist.




Apparently he expects that (unreported) earnings will be fully reflected in the intrinsic business value through capital gains.  Whoa.  If he expects capital gains and that these reflect expectations embedded in the intrinsic value...gosh...he must be factoring in growth.  That's intrinsic as opposed to market growth too...so it's not about looking for movements in prices to zero growth estimates or something as silly as that.  Do you understand that? Yes, that was rhetorical.  If true to form, you are still going to bang on about how:
1. he factors in zero growth as a central estimate [which is not feasible unless you think the above is a forgery or you have developed your own branch of maths which stands apart from the fabric of space time...yet again.  Where is your Nobel?]; and/or
2. He's doing it wrong.  



luutzu said:


> Ever wonder if you read into things what you want to read into it?




Not really.  Perhaps it's because I can read. How about you?   There seems to be rather a lot of feedback being provided around the place along such lines.  Perhaps they are all wrong too. 

(Sigh) Let's move on.

Here's two huge, earth moving, revelations from the above:
1. Intrinsic value is a discounted values of the cash that CAN be taken out...
2. It is an estimate.



luutzu said:


> But dude, what if interest rate change




Dude, apparently Buffett moves the intrinsic value. Did the earth move for you too?  

Did he use the word "forecast" and the phrase "of future cashflows" in there as well.  My gosh! I thought forecasting was stupid and discounting future expected cashflows to arrive at an intrinsic value was absolutely the dumbest, stupidest, most ridiculous thing you could do.

Maybe so.  Maybe not.  LuuTzu vs [Buffet, Graham, McKinsey, Leibowitz, HOLT Value Associates, Clime...and on it goes because we could list them out for page after page].  Hmmmm.  Give me 24 hrs before I make up my mind ok?

Actually, don't bother.



luutzu said:


> Anyway, best to always question conventional wisdom and practices... .




Not really.  It depends on many things, not least of which is who is doing the questioning.




luutzu said:


> ...And if Buffett does what you are doing, he too is wrong




What a joke.




luutzu said:


> As Buffett says, it's better to be approximately right than precisely wrong.




Do you understand what that even means and implies? Yes, another rhetorical question. In this exchange on valuation, it is (hmmm, should be) clear you do not even vaguely approximate Buffett.  That makes you precisely wrong. Or, we could express is as Buffett is precisely wrong.  Tough choice.




luutzu said:


> I have said that I never work in the investment industry. So if what I say do not make sense, people can see that.




You don't say.  But you do say.




luutzu said:


> a zero growth would return me zero




This is garbage from an investment viewpoint unless you started with zero in the first place....hang on a minute....you might be on to something here.


----------



## luutzu

DeepState said:


> It lives.
> 
> I know you think Buffett is an idiot and all.  Further, he doesn't do what I have implied.  So, let's just dig up some records from this moron and read his actual words.  I'll also add some simplification to assist.
> 
> View attachment 59923
> 
> 
> Apparently he expects that (unreported) earnings will be fully reflected in the intrinsic business value through capital gains.  Whoa.  If he expects capital gains and that these reflect expectations embedded in the intrinsic value...gosh...he must be factoring in growth.  That's intrinsic as opposed to market growth too...so it's not about looking for movements in prices to zero growth estimates or something as silly as that.  Do you understand that? Yes, that was rhetorical.  If true to form, you are still going to bang on about how:
> 1. he factors in zero growth as a central estimate [which is not feasible unless you think the above is a forgery or you have developed your own branch of maths which stands apart from the fabric of space time...yet again.  Where is your Nobel?]; and/or
> 2. He's doing it wrong.
> 
> 
> 
> Not really.  Perhaps it's because I can read. How about you?   There seems to be rather a lot of feedback being provided around the place along such lines.  Perhaps they are all wrong too.
> 
> (Sigh) Let's move on.
> 
> Here's two huge, earth moving, revelations from the above:
> 1. Intrinsic value is a discounted values of the cash that CAN be taken out...
> 2. It is an estimate.
> 
> 
> 
> Dude, apparently Buffett moves the intrinsic value. Did the earth move for you too?
> 
> Did he use the word "forecast" and the phrase "of future cashflows" in there as well.  My gosh! I thought forecasting was stupid and discounting future expected cashflows to arrive at an intrinsic value was absolutely the dumbest, stupidest, most ridiculous thing you could do.
> 
> Maybe so.  Maybe not.  LuuTzu vs [Buffet, Graham, McKinsey, Leibowitz, HOLT Value Associates, Clime...and on it goes because we could list them out for page after page].  Hmmmm.  Give me 24 hrs before I make up my mind ok?
> 
> Actually, don't bother.
> 
> 
> 
> Not really.  It depends on many things, not least of which is who is doing the questioning.
> 
> 
> 
> 
> What a joke.
> 
> 
> 
> 
> Do you understand what that even means and implies? Yes, another rhetorical question. In this exchange on valuation, it is (hmmm, should be) clear you do not even vaguely approximate Buffett.  That makes you precisely wrong. Or, we could express is as Buffett is precisely wrong.  Tough choice.
> 
> 
> 
> 
> You don't say.  But you do say.
> 
> 
> 
> 
> This is garbage from an investment viewpoint unless you started with zero in the first place....hang on a minute....you might be on to something here.




I never run from a fight so don't think I've shied away if I don't reply right away.

I think I've said all there is to say on the matter actually... Anyway, keep doing what you do buddy... One day I might even establish a few prizes and some grants to support these lines of thought - as Buffett once wrote, it helps when the competition aren't even trying, or tries too hard.

Seriously though, you haven't look at any company closely in your career. If you had taken a close examination of any business, be it the local corner store or a multi-billion corporation, you would have known that future forecasts and estimates are either unnecessary or impossible.

But then it's other people's money and you're paid to look smart so we do what we must right?

Anyway, keep up with the wizardry...


----------



## burglar

luutzu said:


> How does a business person value and buy businesses or financial assets before these DCF models? ...




Businesses were simpler. 

Less "Intellectual Property", 
less Intangibles, 
less everythings 

Bakeries made bread, ...
Farriers shod horses, ...







luutzu said:


> ... Before the central banks, interest rates, CAPM, beta...





Rice Futures Market
Regional banks, branches and agents.


----------



## luutzu

burglar said:


> Businesses were simpler.
> 
> Less "Intellectual Property",
> less Intangibles,
> less everythings
> 
> Bakeries made bread, ...
> Farriers shod horses, ...
> 
> View attachment 59930
> 
> 
> 
> Rice Futures Market
> Regional banks, branches and agents.




I think all businesses are fundamentally the same: One invest money, time and effort to create products/services; market, sell and distribute that in order to make a profit.

As an investor, a capitalist, we simply examine how much profit that business can make now and into a foreseeable future; discount that back at our cost of capital and that is the price.

As you have cited, valuation can be subjective. But subjective in that my understanding of the business might not be as good as yours so I can only see it earn E while you see it could earn E+10; subjective in that I only need 10% return on my capital and you require 12% to make it worthwhile... These two differences will results in a different valuation but they are both of the one model. That is it.

All the intangibles, the brands, the secret recipes, the large sales network and branches... all these are to indicate the business viability and competitiveness; indicate its ability to continue earning what it currently does by not losing market share, by not having its product/services replaced or made redundant, by being able to adjust its price to inflation and other costs... all these so that we're more confident that its *real earning* from now and into the future is likely to be what it has been regardless of changing economic and technological forces.

If a business had been around for a while, have long established its brand, networks and operations etc. and through the years it had return 10% on equity... how likely is it to suddenly return 11% or 12% on its equity once we bought it? If through some luck it could increase that earning power, is that a permanent shift? If yes then it now worth more, but can we honestly predict that shift? Should we pay for it before it happen?

These fancy DCF models use maths to replace sensible thinking. That since you can't assume a business could grow at 2% or 5% indefinitely else it will take over the world, lets assume it will grow at 2 or 5% for first few years then assume no growth into infinity. Doesn't that just make the results into what you want it to be?

Not only is that mathematically and logically incorrect, it's also dumb in a business sense. What the DCF and its various growth stages tell you is this... that the business is worth $X because next year it will earn E1, then E2, then E3... by E growing at g rate, and by the interest rate and required rate of return being this and that... if you then to discount that imaginary future growth, discount that back at these imaginary rates, you'd pay $X.

An obvious question is: that if those figures are just imaginary? Imagine again and we'd be right next time?


----------



## TPI

Great contributions to this thread. 

On balance, I am sticking to simplified approaches like I = E / r as wells as the Montgomery/Clime approach, with my own slight twists to them.

Might revisit full DCF calculations a bit later, just can't bring myself to do it right now... give me time .


----------

