Present Value of Future Cash Flows

[McLovin]

What are other's thoughts?

I'm pretty simple with these sort of things and just leave the goodwill in. The way I see it, it's where the growth comes from. I guess the way I see it is goodwill on the balance sheet represents historic decisions but if the business plan is to grow through acquisition then the goodwill associated with those acquisitions should be included when measuring performance.

I actually think you could probably amortise goodwill associated with these sort of "people businesses". In many of the companies being acquired there is real key man risk and any moat is around a few individuals (usually the founders) rather than the company.

 

[Ves]

I'm pretty simple with these sort of things and just leave the goodwill in. The way I see it, it's where the growth comes from. I guess the way I see it is goodwill on the balance sheet represents historic decisions but if the business plan is to grow through acquisition then the goodwill associated with those acquisitions should be included when measuring performance.

I actually think you could probably amortise goodwill associated with these sort of "people businesses". In many of the companies being acquired there is real key man risk and any moat is around a few individuals (usually the founders) rather than the company.

Thanks McLovin - I think it is a case of organic cashflow growth within a franchise which has the potential for excessive returns of ROIC vs acquisitions for the sake of "profit growth" (which are either dilutive or value neutral) and should not be treated in in a DCF calculation as achieving anything but growth at a rate equal to the firm's cost of capital going forward.

In essence it becomes a question of whether the company and any of the businesses it has been acquiring are truly scalable beyond the initial cashflow stream of their acquisition. I think there is a big difference in the cashflow profile going forward of something like RFG and the two I mentioned SAI and SGN (at least as far as the historic trend evidence to this point in time would indicate).

Craft - I replied to your PM.

 

[McLovin]

Thanks McLovin - I think it is a case of organic cashflow growth within a franchise which has the potential for excessive returns of ROIC vs acquisitions for the sake of "profit growth" (which are either dilutive or value neutral) and should not be treated in in a DCF calculation as achieving anything but growth at a rate equal to the firm's cost of capital going forward.

In essence it becomes a question of whether the company and any of the businesses it has been acquiring are truly scalable beyond the initial cashflow stream of their acquisition. I think there is a big difference in the cashflow profile going forward of something like RFG and the two I mentioned SAI and SGN (at least as far as the historic trend evidence to this point in time would indicate).

Craft - I replied to your PM.

I think we agree. On first glance SGN can look pretty good, but the nuts and bolts of it are fairly poor. I guess they might benefit from any cyclical upswing in advertising. I compared SGN to Interpublic, Lamar and Omnicom and found that those three also had the same strategy of buying growth. I think this probably comes down to the fact that if you're a good copywriter/PR person/marketing strategist you can earn a hell of a lot more working for yourself and the startup costs are minimal (computer and a desk, working from home), so the industry ends up very fractured. That's the reason I said you could make the argument for amortising the goodwill, because sooner or later the brains behind the business will probably up and leave and start again.

The scalability issue you bring up is a great point. My own perspective is that these "creative" industries are much, much harder to scale than people businesses that work from a documented process/system. So it is easier to scale a management consulting business where a few consultants use a tried and tested method versus an ad company where it's significantly hard to teach someone to come up with a jingle that will increase the sales of those scented things you stick in your toilet.

 

[craft]

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?

Using SAI as an example.

For simplicity I’m making the assumption that depreciation approximates economic reality to come up with a free cash flow of 239 Million over the last 9 years.

In that last 9 years they have invested 524 Million – so first thing to do is throw out implied type growth calculation (unless of course you are going to sell valuation software based on it)

Of that 524 Million, 96 Million was invested at the level above Invested capital –ex good.

The remaining 428 million was goodwill.

Funding was 213 million net debt, 239 million cash flow and 72 Million net additional equity (capital raising minus dividends)

For 2011 ROIC (ex goodwill ) was 64% ROE was 12.5% and ROA was 7.14%

This is the historical perspective of what you need to know to do a valuation

Now History is all well and good. It does show what precedents have been set if the management hasn’t changed – but it in no way dictates the future.

You need to make assumptions about the future – will it replicate the past? Is their ROIC protected by a competitive advantage or will it decay under competitive forces. Will they stop acquiring new enterprises and instead only invest in the higher return but smaller pool of organic growth and pay down debt and/or make net distributions to equity holders? Has the previous enterprise purchases increased the future organic growth opportunities. You need these assumptions about the future before you can allocate growth to the different return rates that apply to different ways of utilising discretionary cash flows.

 

[Ves]

Hi craft - thanks for all the effort you put into the calcs. I calculated between 50-60% ROIC for SAI (without bothering to go into it in any depth) - which isn't too far off what you have come up.

You need to make assumptions about the future – will it replicate the past? Is their ROIC protected by a competitive advantage or will it decay under competitive forces. Will they stop acquiring new enterprises and instead only invest in the higher return but smaller pool of organic growth and pay down debt and/or make net distributions to equity holders? Has the previous enterprise purchases increased the future organic growth opportunities. You need these assumptions about the future before you can allocate growth to the different return rates that apply to different ways of utilising discretionary cash flows.

This is gold - I tried to say something similar, but I lack some of the necessary understanding to successfully convey it into such fine words at this point!

The implied growth at SAI's current cash flow retention rate of about 20% demonstrates the importance of the quoted text:

Implied growth with ROIC 60% and 20% retained earnings is 12%.
Implied growth with ROIC 10% and 20% retained earnings is 2%.

Without detracting from the theoretical discussion too much:

Current EV is about 1 billlion ($750 MC + $250 Debt). It will generating around $70-80 mil EBIT in 2013. Which is an EBIT multiple of about 13. In my opinion, you would need to demonstrate that it can achieve close to historical returns on invested cashflow to justify such a multiple.

 

[craft]

Hi craft - thanks for all the effort you put into the calcs. I calculated between 50-60% ROIC for SAI (without bothering to go into it in any depth) - which isn't too far off what you have come up.

Hmmm -not much effort - just ripped the info off data supplier and didn't take much care either, I picked up the NOPLAT return (ignores interest and amortisation) to get 64%. The FCF return is more like 42% for 2011.

Implied growth with ROIC 60% and 20% retained earnings is 12%.
Implied growth with ROIC 10% and 20% retained earnings is 2%.

Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.

 

[odds-on]

Hi Craft and V,

The following links might be of interest.

http://aswathdamodaran.blogspot.co.nz/2012/05/how-much-are-you-paying-for-growth.html

http://aswathdamodaran.blogspot.co.nz/2012/05/how-much-is-growth-worth.html

…..plus there is a downloadable spreadsheet!

Cheers

 

[Ves]

Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.

Are you talking about the calculation of the retention rate? And yes, I agree financial leverage that doesn't cost a cent is always desirable if it is backed by sustainable cashflow.

PS: Thanks for clarifying how you arrived at 64% by the way - I was wondering what you had added back.

 

[Ves]

I think I can see what you are referring to craft - businesses that can afford to payout a very high proportion of their earnings because they source funding for new investment from constantly expanding negative working capital balances.

Wouldn't you pick this up though if you used Retention ratio as function of earnings / cashflow less maintenance capex and change in working capital funding (obviously this is added back if negative)?

 

[craft]

I think I can see what you are referring to craft - businesses that can afford to payout a very high proportion of their earnings because they source funding for new investment from constantly expanding negative working capital balances.

Wouldn't you pick this up though if you used Retention ratio as function of earnings / cashflow less maintenance capex and change in working capital funding (obviously this is added back if negative)?

I’m easily bamboozled – you might need to spell out what you are saying with an example.

I’m trying to say that your implied growth rate calculation will lead to an incorrect assumption for companies like NVT which can pay out all Discretionary Cash Flow and still fund growth.

Your formula would say ROIC xx% multiplied by 0% retained = zero growth.

 

[Ves]

I’m trying to say that your implied growth rate calculation will lead to an incorrect assumption for companies like NVT which can pay out all Discretionary Cash Flow and still fund growth.

Your formula would say ROIC xx% multiplied by 0% retained = zero growth.

I agreeing with you - but also saying that the "retention ratio" of these businesses needs to be modified - if a business such as NVT receives income in advance of earning it and can use this to fund growth - then their cashflow profile is telling me that there is some retention occuring, regardless of whether the earnings show it.

I'm sure Damodaran has a formula to calculate this somewhere. It involves adjusting earnings for maintenance capex and working capital.

If a firm has negative working capital then their real earnings would increase over what is actually reported - so the payout ratio is less than 100% and the retention ratio is more than 0%.

 

[craft]

I agreeing with you - but also saying that the "retention ratio" of these businesses needs to be modified - if a business such as NVT receives income in advance of earning it and can use this to fund growth - then their cashflow profile is telling me that there is some retention occuring, regardless of whether the earnings show it.

I'm sure Damodaran has a formula to calculate this somewhere. It involves adjusting earnings for maintenance capex and working capital.

If a firm has negative working capital then their real earnings would increase over what is actually reported - so the payout ratio is less than 100% and the retention ratio is more than 0%.

I think we are on the same page.

There is no retention of earned income and no retention of equity.

However, on a cash basis there is retention – the balance sheet expandeds with other peoples interest free money.


Are we on the same page?

 

[Ves]

I think we are on the same page.

There is no retention of earned income and no retention of equity.

However, on a cash basis there is retention – the balance sheet expandeds with other peoples interest free money.


Are we on the same page?

Correct. If I have $100 of earnings, but I also received a further $20 in unearned income I have $120 real earnings if the assumption can be proven that my business model allows me to maintain this relationship between accounting earnings and real cashflow going forward. NVT is a really good example (so far).

Of course the reverse is also true. Accounting earnings can be over-stated in businesses with strenuous working capital requirements and / or via under-stated depreciation. Some businesses make an accounting profit year in year out, but any actual economic profit is questionable. Airlines are often a good example.

$100 paid out divided by $120 real earnings is 83.333% payout. If ROIC is 40% then implied growth is 6.7% p.a. The equity line hides this as you alluded to above.

Unfortunately this is much harder to work out in practice.

 

[craft]

$100 paid out divided by $120 real earnings is 83.333% payout. If ROIC is 40% then implied growth is 6.7% p.a. The equity line hides this as you alluded to above.

V

A question for you

What is NVT’s ROIC (ex goodwill)?

In case 'other acquired intangible assets' cloud the picture – What was NVT’s ROIC in any of the years prior to 2011?

 

[Ves]

What is NVT’s ROIC (ex goodwill)?

This one has always puzzled me - so I know why you ask. The company presentations say 60% for 2010. It isn't explicity stated any where, but I believe that this is in after-tax terms.

My personal calculation is higher as I use EBIT. With some adjustments for amortisation and other minor items I get a ROIC of 85% for 2010. Cash flow is lower than EBIT in 2010, but I believe that this was due to timing differences in the debtors uplift (the current assets look a little bloated on 30 June 2010). So potentially ROIC may be higher.

Now for the interesting part - this figure also does not offset the unearned income in the liabilities section. If you substract this from the net assets employed the end result is that they have negative assets employed. They are effectively borrowing assets off others interest-free and using them to generate very high rates of return.

I don't know of any other businesses like this.

 

[craft]

Now for the interesting part - this figure also does not offset the unearned income in the liabilities section. If you substract this from the net assets employed the end result is that they have negative assets employed. They are effectively borrowing assets off others interest-free and using them to generate very high rates of return.

That’s the point. Any return on negative operational invested capital gives a negative ROIC. How do you apply the implied growth formula to a negative ROIC?

Thats why I said

Be careful with this calc - it will tell you that a negative working capital business (generally a desired business model) has no growth potential - seems to be a common fallacy.

ps
Don't get me started with my full list of peeves about the calculation and how it is used and abused.

 

[Ves]

That’s the point. Any return on negative operational invested capital gives a negative ROIC. How do you apply the implied growth formula to a negative ROIC?

Thats why I said




ps
Don't get me started with my full list of peeves about the calculation and how it is used and abused.

Point taken. What metrics do you model for NVT then? Revenue growth and margins as a product of student growth?

And please do list peeves. It's a good way for others to learn.

 

[Ves]

I prefer to discount only the cash flow horizon I can have some certainty about and then calculate a terminal value based on the replacement cost of tangible assets and possible some multiple of that if the business has a true sustainable competitive advantage.

Sorry for grave-digging old posts, but would it be possible for you to elaborate on how you arrive at the multiple of tangible assets for perpetuity calculations that have a sustainable competitive advantage?

Is there a mathematical method involved? My thoughts are that the multiple must be higher when the business has higher ROIC compared to lower ROIC.

 

[craft]

Sorry for grave-digging old posts, but would it be possible for you to elaborate on how you arrive at the multiple of tangible assets for perpetuity calculations that have a sustainable competitive advantage?

Is there a mathematical method involved? My thoughts are that the multiple must be higher when the business has higher ROIC compared to lower ROIC.

I consider the excess return [investment return – cost of capital]
The amount of capital that can be invested at the excess return rates
And how sustainable is the competitive advantage to maintain the excess return over time.

I then use my much beloved SWAG method to determine the multiple.

The maths is so sensitive to the variables that any precision is illusionary; nonetheless my guesses are grounded on the math.
As per usual my favourite source for valuation maths is Aswath Damodaran.

 

[Ves]

I consider the excess return [investment return – cost of capital]
The amount of capital that can be invested at the excess return rates
And how sustainable is the competitive advantage to maintain the excess return over time.

I then use my much beloved SWAG method to determine the multiple.

The maths is so sensitive to the variables that any precision is illusionary; nonetheless my guesses are grounded on the math.
As per usual my favourite source for valuation maths is Aswath Damodaran.

Thanks I will have to start reading through his site some more - there is so much stuff on it that I can imagine one could use a lot of different methods to combine and shape their own principles and rules (granted that they pass logic of course!).

edit: your post shows me that I am at least somewhere in the ballpark, just need to start looking for the home plate now.