Present Value of Future Cash Flows

[craft]

It’s hard to think of a few words that encompass a whole Investment Strategy – The name of this thread is as close as I could come.

Investing in undervalued companies to provide a future passive income stream is my strategy, a simple enough goal but one with many complexities in the detail. Are there any other forum members interested in discussing this approach to investing? I have read plenty of books but I would be interested to see what else could be learned through a more interactive dialogue.

So who’s out there that’s interested in discussing this or similar approaches.

Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.

 

[So_Cynical]

Re: Present Value of Future Cash Flows.

Happy to discuss under-value in broad terms, but the whole "value" investing criteria i find a little boring and rigid..iam also building a passive revenue stream using a low cost averaging strategy...FY 11/12 dividends and distributions already on target for 20%+ dollar growth.

 

[craft]

My idea of investing has a basic tenant that the purchase price must be solely justified by the cash flow produced by the asset.

I am solely focused on swapping a capital amount for a cash flow, with no reliance on swapping that cash flow back to a capital amount at a future date. That is not to say that I don’t ever sell, but selling for me is about an ‘option’ to commute future cash flows back to a capital amount, rather than the necessity to sell in order to vindicate the investment.

This option to ‘sell or not’ is incredibly powerful and facilitates the ability to sit through market price weakness and eventually take advantage of market strength to realise capital gains, the very thing that the strategy does not focus on and does not pay an ANY opportunity price for.

On the basis of my strategy, gold for example does not fit my definition as a suitable investment because the outcome is solely dependent on the sale price. If you buy gold now you need to pay a price of US$1,600 odd for the opportunity to hopefully be able to convert it back at some future stage to a larger amount of cash. This investment can only be vindicated on a future sale price. Because you must pay a large price for the opportunity to make a capital gain that puts you in a weak position to sit through market weakness because of the fear that you may never recover the upfront opportunity cost you had to pay to play the game.

As with gold, buying any stock where you are paying any upfront cost for the opportunity of making a capital gain on the sale does not suit my investment approach. The price I pay must be solely justifiable on my best estimate of its future cash flows. If I can’t estimate the cash flows because of a lack of knowledge on my part or a lack of predictability or clarity arising from the business then I’m not interested. (or at least I shouldn’t be).

 

[craft]

Re: Present Value of Future Cash Flows.

using a low cost averaging strategy.

Do you want to expand on what you consider a low cost averaging strategy to be?

How do you define low cost?

Why do you use averaging and what are you averaging - are you slowly deploying an initial lump sum?

 

[craft]

This is the sort of thing I’m attempting to do.

Consider buying DTL 8 years ago to the day. The price would have been $1.67 on the close following a run up from 90 odd cents in the previous 3 months.

This is not a data mining exercise to find a company that fits the strategy because although the date of 1 Sept 2003 is arbitrary I owned shares in the company prior to that date on an assessment of the then known information. I have held those shares continuously since then including the near 50% market price decline during 2008, because I hadn’t seen a compelling reason to commute the cash flows prior to the decline.

Cash Flows would be as follow (dividends grossed up to make them comparable to Interest returns)

0 -$1.67
1 .33
2 .27
3 .40
4 .51
5 .66
6 .71
7 .80
8 .54

Cash flow is simplified because it doesn’t take into account semi-annual dividend payment or any tax timing issues in relation to imputation etc – but you get the picture.

If you wanted to commute the cash flow today the market is offering a price of $13.36, taking advantage of this opportunity would give you a IRR of 43% CAGR over the last 8 years.

If you are not prepared to commute the cash flow now, you shouldn’t really include the market price in your cash flow because there is no saying that you will make a good decision on when to sell. Eliminating the sell price from the equation the cash flows themselves have returned a CAGR over the last 8 years of 22%. So long as DTL continues to deliver some cash flow into the future or it is eventually sold for a price greater than zero than the ultimate return on that initial $1.67 will be north of 22% CAGR. The next cash flow of 55 cents gross is due 30 Sept.

 

[McLovin]

Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.

What do you think it is?

 

[craft]

What do you think it is?

I’ll graciously allow you to go first because I won’t be persevering with a one person dialogue thread.

Cheers

 

[Macros]

Whilst I think that the idea is good in principle, you will have a major problem achieving long term success with this model.

I am solely focused on swapping a capital amount for a cash flow, with no reliance on swapping that cash flow back to a capital amount at a future date.

You say that your intent would be to never sell, but I think there are two problems with this concept.

Firstly, you are implicitly expecting exponential growth, which given the environment today is very unlikely as we are likely to face deflation in real terms. Therefore on this basis, this type of strategy is best applied earlier on in a long term bull market (e.g. 1980s onwards). We are facing massive credit deflation and this is going to impact us for years, with flow on impact on all types of investments.

Secondly, if you are speaking about investing in companies in Australia, then there is an issue of a growth ceiling. Given that there unlikely to be scalable opportunities for business growth overseas (experienced by most Aus companies), a successful company can grow only so large before the cash flows grow at a declining pace and eventually stagnate if not decline.

It is my view that this type of investment strategy is possible, but unlikely to be successful at this current point of time. When I say successful, it is a relative concept. The sort of environment that we are in is, in my view, best navigated by a adaptable strategy. As a value investor, I'm comfortable to change 100% of my positions at any point in time if I see a value shift up or down.

It seems that one should constantly be on the look-out for relative value because it is a volatile, dynamic and hazardous environment which is impacted by governmental influences throughout the world. If what I say is true, a static long term dividend growth investment philosophy is going to rely more on luck than insight.


I don't want to get bogged down on this subject, however you say:

gold for example does not fit my definition as a suitable investment because the outcome is solely dependent on the sale price

This is false. If you had gold, you could technically choose to lend it to someone (e.g. Russia) and receive interest in return, just like cash. However you face counter-party risk and are unlikely to ever get the physical asset back.

 

[craft]

Hi macros, thanks for your post. I've added some responses.

You say that your intent would be to never sell

My intent is to never build in the need to sell as part of the purchase equation. There is a big difference.

two problems with this concept.

Firstly, you are implicitly expecting exponential growth, which given the environment today is very unlikely as we are likely to face deflation in real terms. Therefore on this basis, this type of strategy is best applied earlier on in a long term bull market (e.g. 1980s onwards). We are facing massive credit deflation and this is going to impact us for years, with flow on impact on all types of investments.

I think this environment is more suited to the strategy then a protracted bull market. It gives me the chance to reinvest the dividends at a higher yield. At the heart of the strategy is investment for cash flow not capital gains.

Secondly, if you are speaking about investing in companies in Australia, then there is an issue of a growth ceiling. Given that there unlikely to be scalable opportunities for business growth overseas (experienced by most Aus companies), a successful company can grow only so large before the cash flows grow at a declining pace and eventually stagnate if not decline.

So long as you pay the right price you can make a good return without any growth. You just have to be careful how you re-invest the cash flow.

It seems that one should constantly be on the look-out for relative value because it is a volatile, dynamic and hazardous environment which is impacted by governmental influences throughout the world. If what I say is true, a static long term dividend growth investment philosophy is going to rely more on luck than insight.

I agree 100% that we should always be looking for relative value. That is why I draw the point that purchasing without basing it on the need to sell is not the same as never selling. Capital Gains Tax (well at least for me for the next 25 years) is a consideration on the costs of moving between relative values

If you had gold, you could technically choose to lend it to someone (e.g. Russia) and receive interest in return, just like cash

I take your point. If you want to lend your gold out to the Russians then more power too you. Gold remains outside of MY definition of an Investment. As does cash for that matter, even though it can be lent for interest, it still doesn’t actually produce anything in of itself.

 

[Ves]

As you know from our private discussions I am very interested in this method. My learning / knowledge is still in its infancy, but I will try to add my two cents worth if I see fit.

The idea originally appealed to me because I want to replace my employment income with passive income. Intuitively, it makes much more sense to do that with the aim for a growing income stream, rather than capital growth.

Whilst you could aim for capital growth (with the intention of "redeeming" capital when you need income), the process is complicated by tax, brokerage, lumpiness of returns etc (you have to wait until the market gets to your "sell price"). Dividends are far more tax effective. However, a growing dividend naturally leads to capital growth in the long term. Another important metric is "yield on cost" over the long-term. In this type of strategy I would prefer worrying about what the actual business is doing, rather than the whims of the market at the time. Therefore, it is logical to focus on the underlying security as future income stream.

Craft; Have you investigated / or used leverage at all with this strategy?

 

[Macros]

My intent is to never build in the need to sell as part of the purchase equation. There is a big difference.

My view is that there is always a need to sell if value is diminished or risks exceed the expected value to be gained. If the value that you thought existed, no longer exists, then a decision must be made as this impacts on future potential cash flows.

I think this environment is more suited to the strategy then a protracted bull market. It gives me the chance to reinvest the dividends at a higher yield. At the heart of the strategy is investment for cash flow not capital gains.

What I meant was that if you are constantly focusing on value, it is more important to protect and grow your purchasing power by improving your relative value, which should ultimately increase your future yield much more effectively than growing dividends. Since growing dividends are a function of business growth, it will depend on the growth of the business and the economic environment. Therefore the heart of the strategy still is reliant on earnings trajectory, as does value investment.

If you are investing for dividends over value, then you are not necessarily being optimal in your investment strategy and at worst could make decisions which do not conform to a value philosophy.

I agree that transaction costs and tax are an issue, but I think they a secondary consideration after value. At best, if I needed income and was not comfortable in relying on capital, then you could potentially do two things. First would be to add a minimum requirement of a %dividend yield. Second would be to increase the weighting benefit of payout ratio in calculating expected value to reward dividends.

In the end, you are relying on dividend growth through either reinvestment or organic growth. Dividends are a derivative of earnings power and are not guaranteed to increase. Therefore value must be a consideration of first order and dividends second order.

Gold remains outside of MY definition of an Investment. it still doesn’t actually produce anything in of itself.

It produces a store of value. It may not be prudent to be 100% invested at all times, especially if value cannot be found or if income is received and not immediately invested (i.e. waiting for greater value). In my view, gold as a store of value is infinitely better than cash at this point in time. Thinking about stores of value should be important for all investors in my view.

If you want to lend your gold out to the Russians then more power too you

I definitely would not consider such a thing! I don't actually hold gold at the moment, but if I didn't see significant value in my investments then I would do so.

 

[skc]

It’s hard to think of a few words that encompass a whole Investment Strategy – The name of this thread is as close as I could come.

Investing in undervalued companies to provide a future passive income stream is my strategy, a simple enough goal but one with many complexities in the detail. Are there any other forum members interested in discussing this approach to investing? I have read plenty of books but I would be interested to see what else could be learned through a more interactive dialogue.

So who’s out there that’s interested in discussing this or similar approaches.

Potentially lots to muse over like just what is ‘undervalued’ anyway and how do we know it when we see it.

On overall philosophy...

Depends on your overall objective. While it is certainly workable to say I want to invest for cashflow and I am so conservative that I ignore the sale price in the end, one have to question sensibly whether that is the best strategy to achieve your overall objective.

Now if your objective is to earn consistent cashflow without ever needing to sell (acknowledging that it doesn't mean you never sell) and without full time effort (i.e. sit in front of the screen all day), then your philosophy might be suitable.

My objective is simply to make the most money possible without too much risk. And that means I am open to any investment/trading style that offers the best risk-adjusted returns - subjected to boundaries like skill, knowledge, moral and legality etc etc. And on those objectives the ideal "philosophy" for me will always be short term and take into account of all cashflows.

On undervalue...

You can tell how much a house is worth by looking at the value of the houses around it. Same with businesses. The beauty of relative value consideration is that you more or less left the analysis of the industry to the market. Every bank is capitalised at 12% and that represent the average view of outlook for the banking industry. When you find a bank capitalised at 15%, you have identified relative value. The task then becomes finding out about this "undervalued" bank to make sure there are no skeletons in the closet.

I think relative value offers the highest possibility of out-performing the market. You won't necessarily achieve absolute performance, however.

On DTL...

I think IT companies in Australia are overall quite "undervalued" relative to other sectors. They often trade at PE 10 but with much consistent profit and growth even in downtrun. I held TNE for many years. TNE is right next door to DTL and I had a choice between the two and I picked TNE... only underperformed by ~5x

 

[craft]

My view is that there is always a need to sell if value is diminished or risks exceed the expected value to be gained. If the value that you thought existed, no longer exists, then a decision must be made as this impacts on future potential cash flows.

What I meant was that if you are constantly focusing on value, it is more important to protect and grow your purchasing power by improving your relative value, which should ultimately increase your future yield much more effectively than growing dividends. Since growing dividends are a function of business growth, it will depend on the growth of the business and the economic environment. Therefore the heart of the strategy still is reliant on earnings trajectory, as does value investment.

If you are investing for dividends over value, then you are not necessarily being optimal in your investment strategy and at worst could make decisions which do not conform to a value philosophy.

I agree that transaction costs and tax are an issue, but I think they a secondary consideration after value. At best, if I needed income and was not comfortable in relying on capital, then you could potentially do two things. First would be to add a minimum requirement of a %dividend yield. Second would be to increase the weighting benefit of payout ratio in calculating expected value to reward dividends.

In the end, you are relying on dividend growth through either reinvestment or organic growth. Dividends are a derivative of earnings power and are not guaranteed to increase. Therefore value must be a consideration of first order and dividends second order.

I pretty much agree with all of this. I think because of my criteria for the buy price not to rely on a selling, you are interpreting me to be a lot more reluctant to sell than I really am. If things change from what I was expecting, I act on the new information and if that means selling than that is what I do. If I have led you to believe I focus on dividends then I haven’t written very well. Dividends are secondary - My focus in determining value is Economic Free Cash Flow. I’m perfectly happy if the company retains that cash flow and invests it profitably.

It produces a store of value. It may not be prudent to be 100% invested at all times, especially if value cannot be found or if income is received and not immediately invested (i.e. waiting for greater value). In my view, gold as a store of value is infinitely better than cash at this point in time. Thinking about stores of value should be important for all investors in my view.

In relation to Gold. It simply does not suit my investment strategy. In relation to a store of value my defence is attack. I want to own income producing assets at the right price to build my wealth and I also want to own the exact same assets to preserve my purchasing power.

I agree that gold purchased at the right price is probably a better store of value than cash. The problem is that I don't know what the right price is and I really don't have much interest in learning, I'm happy to focus on income producing assets but have no problem that other prefer gold.

 

[craft]

Craft; Have you investigated / or used leverage at all with this strategy?

Short answer is No

I actually built my capital via much more active trading then outlined here. In that environment I felt that I was already exposed to enough risk and wasn’t comfortable holding debt. There was also enough reward potential to not need it. I did use leveraged instruments at time but always managed the risk as if the positions were fully funded. By the time I had adopted the investment strategy outlined here I had enough capital to not really need leverage. Additionally I have used up some headroom for taking on risk by the nature of the stocks I hold and my relative lack of diversity.

If I was younger, had a secure alternative source of income and needed leverage to secure my objectives I would consider using a moderate level of debt , tailoring my approach to take some other risks out.
I think you should probably seek advice from some others that do use leverage. I’m guessing there is more than just theory that comes into play in a situation where you are in serious drawdown or suffering a cash flow shock.

 

[craft]

and without full time effort (i.e. sit in front of the screen all day) :

That’s the whole objective - passive income ie retirement from active trading. Reality is that I still spend a lot of time researching businesses, but that’s because I enjoy it and use it to fill in free time. I do however have the freedom to turn off for a few months and still have an income.

My objective is simply to make the most money possible without too much risk. And that means I am open to any investment/trading style that offers the best risk-adjusted returns - subjected to boundaries like skill, knowledge, moral and legality etc etc. And on those objectives the ideal "philosophy" for me will always be short term and take into account of all cashflows.

Sounds robust to me.

On undervalue...

You can tell how much a house is worth by looking at the value of the houses around it. Same with businesses. The beauty of relative value consideration is that you more or less left the analysis of the industry to the market. Every bank is capitalised at 12% and that represent the average view of outlook for the banking industry. When you find a bank capitalised at 15%, you have identified relative value. The task then becomes finding out about this "undervalued" bank to make sure there are no skeletons in the closet.

I think relative value offers the highest possibility of out-performing the market. You won't necessarily achieve absolute performance, however.

I agree with all this, my personal focus however is is absolute not relative.


On DTL...

I think IT companies in Australia are overall quite "undervalued" relative to other sectors. They often trade at PE 10 but with much consistent profit and growth even in downtrun. I held TNE for many years. TNE is right next door to DTL and I had a choice between the two and I picked TNE... only underperformed by ~5x :banghead

With only two determining decision to focus on, what to hold and at what price - Stock selection is hopefully where the skill (some may say luck) comes in.

 

[Macros]

I pretty much agree with all of this. I think because of my criteria for the buy price not to rely on a selling, you are interpreting me to be a lot more reluctant to sell than I really am. If things change from what I was expecting, I act on the new information and if that means selling than that is what I do. If I have led you to believe I focus on dividends then I haven’t written very well. Dividends are secondary - My focus in determining value is Economic Free Cash Flow. I’m perfectly happy if the company retains that cash flow and invests it profitably.

Came across to me more as investment cash flow as opposed to economic cash flow. In this case, we are on the same page and therefore are really just looking at pure value investment and a snowball effect. However there seems to be an infinite amount of possibilities of how one goes about achieving this objective. Of course, there clearly isn't an infinite amount of possibilities that are all successful either.

 

[So_Cynical]

Re: Present Value of Future Cash Flows.

using a low cost averaging strategy.

Do you want to expand on what you consider a low cost averaging strategy to be?

How do you define low cost?

Why do you use averaging and what are you averaging - are you slowly deploying an initial lump sum?

My low cost averaging strategy is based around the fact that shares go up and down, the greater the time frame the greater the up and down movements..in general.

I buy shares when they are in the lower half/third of there price range or pulling back from an upswing...keeping in mind general market sentiment and the fundamentals of the company and how it makes money.

i average because its impossible to pick bottoms but find that in trying to buy bottoms and buying more if the SP falls significantly further, that invariably i end up "capturing" the bottom over the longer term, looking back.

ill post 2 of my older trades so you can see what i mean...keeping in mind i still hold shares in both stocks and have gross divi yields of around 10% on capital

-------------------

Unlike what your thinking of doing...i use capital growth to fund my next trade and grow my dividends by adding new stocks to my portfolio and re-entering stocks already held...i typically exit a trade with 75 to 85% of my original capital leaving the other 15 to 25% in with the profits that are typically between 7 to 15% ~ i grow my dividend and distribution yield by growing my capital and growing the number of shares and stocks held.

Last financial year 24% of my income was from trading and 8% dividends & distributions. this year that should grow by between 10 to 20%

 

[McLovin]

My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.

To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.

It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.

 

[doctorj]

My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.

To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.

It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.

Interesting approach, though I think you're being relatively modest. A DCF model isn't straightforward at all. Do you focus on a particular industry (you mention insurance?) or is your approach applicable across a range of sectors? Does this mean your universe of "investable" stocks becomes very small and your portfolio very concentrated?

I fully agree with the pen and paper approach - evaluating the risk in a company is a bit like looking for a needle in a haystack. Management will scream all the good news from the roof tops and bury the bad news in useless detail.

 

[McLovin]

Interesting approach, though I think you're being relatively modest. A DCF model isn't straightforward at all.

I sort of agree, however I find that doing the model does wonders in actually helping understand the nature of the business. In my previous employment I used to do a bit of of DCF modeling so I'm not completely "green" at it.

Do you focus on a particular industry (you mention insurance?) or is your approach applicable across a range of sectors? Does this mean your universe of "investable" stocks becomes very small and your portfolio very concentrated?

Not really, I have found that businesses with recurring revenue streams occur in almost every industry, to some degree. It's not an absolute must have, it's just something that I have found increases earnings visibility and thus reduces risk. I guess if you are looking for it you'll find it more often.

I fully agree with the pen and paper approach - evaluating the risk in a company is a bit like looking for a needle in a haystack. Management will scream all the good news from the roof tops and bury the bad news in useless detail.

Exactly. It's amazing what a few back of the envelope calculations reveals.