Australian (ASX) Stock Market Forum

Present Value of Future Cash Flows

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humblelearner said:
Hi Oddson/all,

Sorry if this has been asked someone else before but would you mind pointing me to the article/study you referred to regarding the Z-score?

Is there a good financial data mining package that someone could recommend where you could test your own ratios/analytical strategies? (I'm curious as to what James Montier's team uses in his books for their analysis)

Thanks very much!

Cheers
humblelearner
Click to expand...

Hi humblelearner,

Altman papers

http://people.stern.nyu.edu/ealtman/papers.html

I read - Predicting Finanical Distress of Companies: Revisiting the Z score and ZETA models.

Do not know of data mining packages that you could use for backtesting.

Cheers

Oddson
 
I'm finding myself using EV / EBIT a lot more than something like P/E these days as it looks at the whole capital structure not just the equity. You often see EBITDA quoted by analysts, but I would rather remove depreciation from the equation, especially with capital intensive businesses. EBITDA seems as if it can be used to manipulate earnings streams to make them look 'cheaper' than they actually are.

Do any of you guys have a rough system in your head for back of the envelop calculations and comparison (obviously based on your own arbitrary conditions and hurdle rates) where you equate an EV / EBIT multiple as being cheap? For instance I have seen Buffett as quoted saying an EBIT multiple of under 7x for a fantastic company that can grow 8-10% for many years is where he looks.

It obviously varies - an EBIT of 12x for a company with no growth prospects is clearly different to one that can grow at 15% p.a on the same multiple.

Are there any rules of thumb?
 
Ves said:
I'm finding myself using EV / EBIT a lot more than something like P/E these days as it looks at the whole capital structure not just the equity. You often see EBITDA quoted by analysts, but I would rather remove depreciation from the equation, especially with capital intensive businesses. EBITDA seems as if it can be used to manipulate earnings streams to make them look 'cheaper' than they actually are.

Do any of you guys have a rough system in your head for back of the envelop calculations and comparison (obviously based on your own arbitrary conditions and hurdle rates) where you equate an EV / EBIT multiple as being cheap? For instance I have seen Buffett as quoted saying an EBIT multiple of under 7x for a fantastic company that can grow 8-10% for many years is where he looks.

It obviously varies - an EBIT of 12x for a company with no growth prospects is clearly different to one that can grow at 15% p.a on the same multiple.

Are there any rules of thumb?
Click to expand...

For a no growth business flip your pre-tax required return.

ie if you want 15% return before tax then 1/15% gives a EV/EIBT of 6.6.

If the business is growing then you can pay a higher multiple where the return on incremental re-investments is higher than your required return, if the return is lower than you will need to pay a lesser multiple to achieve your required return. The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.

ps

Its understanding what happens between EBITDA and EBIT lines and how the accounts reflect or distort the economic reality that can really give you an analyse edge.
 
craft said:
For a no growth business flip your pre-tax required return.

ie if you want 15% return before tax then 1/15% gives a EV/EIBT of 6.6.

If the business is growing then you can pay a higher multiple where the return on incremental re-investments is higher than your required return, if the return is lower than you will need to pay a lesser multiple to achieve your required return. The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.

ps

Its understanding what happens between EBITDA and EBIT lines and how the accounts reflect or distort the economic reality that can really give you an analyse edge.
Click to expand...
Thanks craft

I knew there was some maths behind it somewhere - but I couldn't calculate it myself. There's so much stuff on his site that it is quite intimidating. I will need to trawl though it until I find what I am looking for. Thanks for the starting point. :)

I agree with your last line about entries between EBITDA and EBIT - I think you provided a good example for instance in the FWD thread. There are so many problems with the "accounting reality" and what actually happens. Estimating cash flow is a fine art. I can't say I'm any where near being good at it yet. :)
 
McLovin said:
Sorry it opens in the frame (who still uses frames!)...

Here's correct link.

http://people.stern.nyu.edu/adamodar/pdfiles/papers/returnmeasures.pdf
Click to expand...

My take :2twocents

If the current years R&D wasn’t expensed it would have been capitalised and had an equivalent boost to profit. Amort of R&D is the reverse. The net is the effect on profit.

The net effect of profit recognition foregone by R&D acounting is then divided by capitalised amount of R&D to get an estimated return on R&D investment on the balance sheet.

Changes in levels of R&D spend/capitalisation/amort would affect a 1 year calculation but averaged over a few years or on consistent R&D spend it is more useful.
 
craft said:
Changes in levels of R&D spend/capitalisation/amort would affect a 1 year calculation but averaged over a few years or on consistent R&D spend it is more useful.
Click to expand...

Thanks craft

I think this might have been the bit confusing me. If you look at a single year it will obviously be very affected by the current year's R&D spend.

So basically, you're measuring the uplift in profitability from the change in recognition and understanding that the value of the R&D spend is captured by the company over several years. I think I understand now.
 
craft said:
The exact math gets a bit more complicated for growth scenario’s – with experience you can judge it pretty well but if you want to calculate it initially refer to Aswath Damodaran texts.
Click to expand...
At the more complicated end of the spectrum, say you wanted a two or three stage multiple calculation for EBIT multiples (high growth, steady, some sort of residual or no growth), aren't you basically doing a DCF?

This little exercise has shown me why WOW and CCL and some others trade at their current multiples. The market seems to use perpetuity-like EBIT multiples and forecast GDP or GDP+1% growth (and some adjustment for risk, of course). The results are remarkably close to the current EV/EBIT for both of these if you do such a simple calculation... however, don't be fooled it's more complicated obviously.
 
Ves said:
At the more complicated end of the spectrum, say you wanted a two or three stage multiple calculation for EBIT multiples (high growth, steady, some sort of residual or no growth), aren't you basically doing a DCF?

This little exercise has shown me why WOW and CCL and some others trade at their current multiples. The market seems to use perpetuity-like EBIT multiples and forecast GDP or GDP+1% growth (and some adjustment for risk, of course). The results are remarkably close to the current EV/EBIT for both of these if you do such a simple calculation... however, don't be fooled it's more complicated obviously.
Click to expand...

Hi V,

Have you seen this? http://www.moneychimp.com/articles/valuation/graham.htm

The maths should be the same for EV/EBIT.....i hope.

Cheers

Oddson
 
The GDP deflator (broadest measure of Inflation in the economy) for the last few quarters are interesting.

Sept 2011 0.6%
Dec 2011 -0.4%
Mar 2012 -0.9%
Jun 2012 0.4%
Sept 2012 -0.3%

That’s YOY deflation, wonder if it will have an impact on RBA decision today.
 
I was doing some more thinking on the EBIT vs DCF scenarios in valuation. There is obviously not any right or wrong answer - in the end they are both just vehicles from presenting assumptions that either do or do not become approximentations of the eventual reality.

However, I was considering the following...

I'll keep it simple. Assume the assumptions are sound. Say, you wanted a before tax return of 12.5%. You see Woolworths trading on an EBIT multiple of 8. Your assumption (and this is hypothetical and has nothing to do with any actual opinion formed) is that Woolworths can maintain its current profitability over the long term and you would only sell if this view changed.

Under what circumstances would you guys still do a DCF valuation? Do you always use a DCF for valuation for long-term holds? Or do you occasionally use EBIT multiples if it looks clear cut?

The advantage of a DCF valuation is that you have greater control and scope over the inputs (obviously this is a disadvantage if your inputs are way off what eventually happens in the future). For instance, you can modify the perpetuity component of the valuation to something more conservative, such as replacement costs of assets or a multiple of this figure. You can modify the earnings cycle and the timing of payments. It comes with high flexibility.

Any thoughts would be appreciated - I find the philosophy of valuation interesting to say the least.

edit: I am away there are many more valuation models in existence, feel free to bring those into the mould too. However, I am not really talking from a systematic stand point, rather a stock picker's view point. I think that has a much different answer!
 
Ves said:
I was doing some more thinking on the EBIT vs DCF scenarios in valuation. There is obviously not any right or wrong answer - in the end they are both just vehicles from presenting assumptions that either do or do not become approximentations of the eventual reality.

However, I was considering the following...

I'll keep it simple. Assume the assumptions are sound. Say, you wanted a before tax return of 12.5%. You see Woolworths trading on an EBIT multiple of 8. Your assumption (and this is hypothetical and has nothing to do with any actual opinion formed) is that Woolworths can maintain its current profitability over the long term and you would only sell if this view changed.

Under what circumstances would you guys still do a DCF valuation? Do you always use a DCF for valuation for long-term holds? Or do you occasionally use EBIT multiples if it looks clear cut?

The advantage of a DCF valuation is that you have greater control and scope over the inputs (obviously this is a disadvantage if your inputs are way off what eventually happens in the future). For instance, you can modify the perpetuity component of the valuation to something more conservative, such as replacement costs of assets or a multiple of this figure. You can modify the earnings cycle and the timing of payments. It comes with high flexibility.

Any thoughts would be appreciated - I find the philosophy of valuation interesting to say the least.

edit: I am away there are many more valuation models in existence, feel free to bring those into the mould too. However, I am not really talking from a systematic stand point, rather a stock picker's view point. I think that has a much different answer!
Click to expand...

Multiples are fine – but you need a DCF type valuation mindset initially to determine what the multiple should be if you are interested in absolute valuation. If you are interested in relative valuation then you can make comparisons for a grounding.

With the WOW example a couple of things that would be really important to me in selecting the appropriate multiple would be how much capital it can utilise at its consistent profitability and what that consistent profitability is compared to my required return.

If the profitability is changing fairly consistently then picking the multiple gets a lot tricker and I would be much more likely to be doing some trickier math.

If the profitability is all over the place - I give up - too tough for me.
 
craft said:
Multiples are fine – but you need a DCF type valuation mindset initially to determine what the multiple should be if you are interested in absolute valuation.
Click to expand...
I think this (and what follows it) sums up perfectly what I was thinking! All of these models rely on you intimately know the assumptions that you are making - there is no way around that.

No matter what you do, you still have to do all of the ground work (ie. hard work). :)
 
Question about ROIC. Generally I take out goodwill (and most other intangibles from this equation - and adjust the EBIT for them if need be) from these calculations.

However, a lot of people businesses are not truly scalable. Advertising / marketing firms, compliance firms, some IT firms etc are good examples. Organic growth is limited so you often find that they have large amounts of goodwill on the balance sheet and in most cases this will continue to grow.

SAI and SGN have been good examples of this over the last decade. Excess capital and / or debt is generally used to fund acquisitions that will hopefully grow earnings. Say ROIC was 25% (EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities (creditors etc.)). This is not uncommon I have found. However, if you leave historic Goodwill in this equation the result is closer to the cost of capital, somewhere around 8-12%.

To me it makes more sense that capital employed going forward in businesses with limited organic growth potential, that grow via acquisition, will achieve returns closer the 8-12% on any invested free cash flow. Interesting to point out that a lot of acquisitions are made at EBIT multiples of 5-8 times.

Implied growth with ROIC 25% and 25% retained earnings is 6.25%.
Implied growth with ROIC 10% and 25% retained earnings is 2.5%.

Certainly makes a big difference on a long-range DCF calculation!

What are other's thoughts?
 
Ves said:
Question about ROIC. Generally I take out goodwill (and most other intangibles from this equation - and adjust the EBIT for them if need be) from these calculations.

However, a lot of people businesses are not truly scalable. Advertising / marketing firms, compliance firms, some IT firms etc are good examples. Organic growth is limited so you often find that they have large amounts of goodwill on the balance sheet and in most cases this will continue to grow.

SAI and SGN have been good examples of this over the last decade. Excess capital and / or debt is generally used to fund acquisitions that will hopefully grow earnings. Say ROIC was 25% (EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities (creditors etc.)). This is not uncommon I have found. However, if you leave historic Goodwill in this equation the result is closer to the cost of capital, somewhere around 8-12%.

To me it makes more sense that capital employed going forward in businesses with limited organic growth potential, that grow via acquisition, will achieve returns closer the 8-12% on any invested free cash flow. Interesting to point out that a lot of acquisitions are made at EBIT multiples of 5-8 times.

Implied growth with ROIC 25% and 25% retained earnings is 6.25%.
Implied growth with ROIC 10% and 25% retained earnings is 2.5%.

Certainly makes a big difference on a long-range DCF calculation!

What are other's thoughts?
Click to expand...

PM sent.
 

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