Buffett's 5 second intrinsic value calculation

[skc]

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]

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.

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.

I thought I was asking legitimate questions.

Thinking doesn't make it so.

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.

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.

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]

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]

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]

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]

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]

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]

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]

... 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]

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

Fixed for you, Burglar.

 

[DeepState]

Hi RY,

Are you familiar with the book?

I am now.

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.

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]

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]

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]

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]

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]

Fixed for you, Burglar.

Which part did you fix ... exactly?

 

[galumay]

Which part did you fix ... exactly?

I took out the word "Value"

Sorry if it was a bit obtuse!