Buffett's 5 second intrinsic value calculation

[TPI]

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]

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]

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):

1. It's a lose estimate (using Ben Graham's illustration of judging by inspection)
2. Emphasising a Margin of Safety is vital
3. 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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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?