Buffett's 5 second intrinsic value calculation

TPI · 14 October 2014

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 · 14 October 2014

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 · 14 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

Interesting insight. Thanks, RY.

TPI · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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 · 15 October 2014

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.

Buffett's 5 second intrinsic value calculation

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