Buffett's 5 second intrinsic value calculation

[galumay]

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]

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]

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

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.

... 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]

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:

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

 

[luutzu]

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]

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]

... 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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

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]

.
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.