Present Value of Future Cash Flows

[Ves]

I've made a conscious effort as part of my New Financial Year's resolution to try and reduce the amount of crowd sourced opinions I listen to. I've found that in the past even when my thinking may be correct, having a roomful of other opinions will wash out my own. To be honest, I've found it liberating. I can see things with much more clarity or at least the things I think are important. Now if only I could get myself a nice villa on the beach in the Carribbean to "think".

Starting to become less and less reliant on other's opinions myself too. At least in saying that I mean it is easier to know when my own thinking is being influenced / persuaded by others. Said in another way - it would be much easier to "go missing into a dark room" and not feel too uncomfortable compared to a year ago.

I think the biggest problem for me, as I probably poorly explained in my first post, is the buzz of activity that reading / participating in discussion can bring on. With a lot of things in life - and the riddle of the media in particular - is that they only are perceived to become more important when there is more noise!

- - - Updated - - -

I make the same vows i.e. stay clear of this forum.

I think I have even posted on here before the Buffett quote that resonates with me the most..



Problem Is I keep ignoring it because the likes of you three above/below keep posting insightful things to spark the mind and I keep coming back for a fix and then read a little bit more then post......

Oh for some balance....or is it discipline?

Try again.

Sounds familiar. Doesn't look like I'm the only one. The feeling of missing something!

 

[odds-on]

Hi V,

I found this book particularly helpful in improving my thought process when dealing with the "noise"- http://www.amazon.com/The-Contrary-Thinking-Humphrey-Neill/dp/087004110X

Hope it helps.

Cheers

 

[odds-on]

I forgot to post...

After I read that book, I spent time reading old media articles/threads, the "opinion" of the "crowd" really shows, e.g. a year or so ago, everbody seemed to be negative about the future of JBH, excuse my language, but #%&*!#& h@ll, that has turned into one great investment over the last 12 months. The influence of the media and public opinion is not to be underestimated.

Cheers

 

[galumay]

Problem Is I keep ignoring it because the likes of you three above/below keep posting insightful things to spark the mind and I keep coming back for a fix and then read a little bit more then post......

Oh for some balance....or is it discipline?

Try again.

I agree, but i do think its balance, I believe my confidence and skill as an investor has been greatly enhanced by a number of posters on ASF, yourself, odds-on, vespuria, ROE, etc to name but a few.

The trick is to separate the decision making from the learning (at least thats true for me), so even when I hear 'noise' here, i go away and do my research and calculations separately, i then try to make final decisions about entry in a quiet, unemotional and clear space that is time separated from the research phase.

 

[Ves]

Posting here in case I forget about it:

http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall13.htm

Weekly podcast by Professor Damodaran based on his lecture course in valuation.

- - - Updated - - -

Hi V,

I found this book particularly helpful in improving my thought process when dealing with the "noise"- http://www.amazon.com/The-Contrary-Thinking-Humphrey-Neill/dp/087004110X

Hope it helps.

Cheers

Will see if I can get around to reading this - been on my list for a while.

Thanks Oddson!

 

[Ves]

Might try and have a rest from here for a while. Will check infrequently. Lots of financial statements to dig through and I've become too distracted by the disruptive kinds that often lurk on forums such as this one for little more than their own gratification.

 

[craft]

Might try and have a rest from here for a while. Will check infrequently. Lots of financial statements to dig through and I've become too distracted by the disruptive kinds that often lurk on forums such as this one for little more than their own gratification.

ASF's loss.

But boy I hear where you are coming from.

Think I'll join you.

 

[Ves]

Two related issues:

1. Property holdings vs lease /rent
2. Treatment of leases in DCF valuations

In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital (ROIC).

I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them), whilst others exclusively rent. The former may dilute ROIC (with consideration for future capacity requirements being important), because you only need to buy a property once (the rest should be picked up in depreciation / maintenance capex charges). Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt. This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.

Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation. I have been thinking about this a lot recently - and have not been convinced that what I am currently doing impacts on the accuracy of my valuation - I am picking up the impact of the leases in my cash flow upfront, rather than subtracting it from the NPV at the end (like you do with other debt).

Craft, McLovin, or any others that use DCF models, what do you do in practice?

 

[VSntchr]

Two related issues:

1. Property holdings vs lease /rent
2. Treatment of leases in DCF valuations

In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital (ROIC).

I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them), whilst others exclusively rent. The former may dilute ROIC (with consideration for future capacity requirements being important), because you only need to buy a property once (the rest should be picked up in depreciation / maintenance capex charges). Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt. This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.

Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation. I have been thinking about this a lot recently - and have not been convinced that what I am currently doing impacts on the accuracy of my valuation - I am picking up the impact of the leases in my cash flow upfront, rather than subtracting it from the NPV at the end (like you do with other debt).

Craft, McLovin, or any others that use DCF models, what do you do in practice?

This was something I brought up a few months ago in a seperate stock thread.
I have found that in most cases altering the DCF model to incorporate the operating lease commitments as debt does not change the valuation significantly...however, its clear to me that in certain situations (where there is a large amount of operating lease expense and perhaps a high differential in the cost of equity vs debt) the difference will be notable.

I guess once you start getting into these issues it becomes more of a fine art.
Some people just want a valuation to get the rough value of a company - after all we only want to invest if we have a substantial margin of safety so whats a few % here and there...
However, others would like to get the finer details correct in order to have a complete understanding of the company and to get as precise as possible. I think that I fall in this camp to a large extent as I feel that playing around with niche subjects like the treatment of operating leases allows me to spend more time on the company and hence form a deeper understanding.

Looking forward to reading the views of some of the more knowledgable valuation experts out there

 

[Ves]

This was something I brought up a few months ago in a seperate stock thread.
I have found that in most cases altering the DCF model to incorporate the operating lease commitments as debt does not change the valuation significantly...however, its clear to me that in certain situations (where there is a large amount of operating lease expense and perhaps a high differential in the cost of equity vs debt) the difference will be notable.

I guess once you start getting into these issues it becomes more of a fine art.
Some people just want a valuation to get the rough value of a company - after all we only want to invest if we have a substantial margin of safety so whats a few % here and there...
However, others would like to get the finer details correct in order to have a complete understanding of the company and to get as precise as possible. I think that I fall in this camp to a large extent as I feel that playing around with niche subjects like the treatment of operating leases allows me to spend more time on the company and hence form a deeper understanding.

Looking forward to reading the views of some of the more knowledgable valuation experts out there

The stock thread was UGL. I was reading my reply to your question a few days ago - I hope it didn't come across as dismissive at the time!

I pretty much agree with what you have said above. The imprecise nature of valuation, the preconceived biases that are impossible to stop from getting assimilated into the information we do or not not include in calculations, our mental processes to protect ourselves against ourselves yada yada.... you'd never survive if you came into it thinking it was a science and you'd have to be 100% right!

I would like to think that the more lines of thinking / different approaches that I can build up the more scope that I will have in various scenarios that I may come across in the future. It never hurts to constantly refine your art form. Anything that increases understanding is great to me.

 

[craft]

Two related issues:

1. Property holdings vs lease /rent
2. Treatment of leases in DCF valuations

In estimating the potential future return on incremental capital employed into a business we obviously use metrics such as Return on Invested Capital (ROIC).

I often find that some companies have some or all of their places of business / factories / shop fronts etc on their balance sheet (as they own them), whilst others exclusively rent. The former may dilute ROIC (with consideration for future capacity requirements being important), because you only need to buy a property once (the rest should be picked up in depreciation / maintenance capex charges). Leasing potentially understates ROIC (as it could be considered leveraged). Some in the finance field such as Professor Damodaran argue that future lease obligations (whether they are operating or finance leases) should be capitalised and treated as debt. This is the argument that lease obligations of a long-term nature are really a financing choice not an operating expense.

Currently I don't back out lease payments from cash flow and don't treat them as debt in a DCF calculation. I have been thinking about this a lot recently - and have not been convinced that what I am currently doing impacts on the accuracy of my valuation - I am picking up the impact of the leases in my cash flow upfront, rather than subtracting it from the NPV at the end (like you do with other debt).

Craft, McLovin, or any others that use DCF models, what do you do in practice?

I don’t think you need to capitalise the lease payments for valuation purposes – Big picture, doing so lowers returns but increases funds employed and valuation wise those two movements just counteract each other.
At a more detailed level some valuation differences may arise depending on depreciation rates, capitalisation rates etc chosen but overall unless management aren’t being diligent with ongoing lease/buy analysis and/or capital management policy then it should be fairly immaterial.

Of course if you don’t capitalise the leases and put every company on an equal footing than you can’t just compare return ratio’s when you’re considering financial economics of a business – you have to think a little more holistic.

For companies with high lease commitments I think it’s pretty important to consider their solvency metrics in terms of interest bearing debt PLUS lease liabilities.

 

[doctorj]

Looking forward to reading the views of some of the more knowledgable valuation experts out there

I don’t think it is possible to be a valuation ‘expert’. As you’ve said, it’s as much art as it is science, but one thing that is for sure is that whatever comes out is entirely theoretical and whether you get an answer of $100 million or $150 million, doesn’t really matter as that number exists nowhere but your meticulously crafted spread sheet.

My day job, amongst other things, involves valuing and investing in mostly unlisted companies. Spending the hours and hours building a model is nearly always a valuable exercise, but for me, it’s not something that I would base a valuation on. I find it valuable because it helps me understand the drivers of value in a business and the challenges it might face. I also use it to triangulate with other valuation tools so I can identify problems or potential value.

For me, valuation is only as good as what someone else is willing to pay for my shares and what other people are paying for similar companies. So I rely much more on a relative analysis of P/E, P/B and other sector-relevant multiples than I do on any other valuation tool. Compare valuations to comparable companies, understand why there might be differences and understand if there are drivers that might result in convergence.

 

[craft]

For me, valuation is only as good as what someone else is willing to pay for my shares

For me it’s the exact opposite.

Valuation to me is determined by what the company can generate in free cash over time. (A cow for its milk etc – not what I can re-sell the cow for next week/month/year.)

What someone else is willing to pay becomes an opportunity for extra return not a requirement to make a return – For me it’s a much simpler and stronger foundation to approach the market from.

 

[Ves]

I don’t think you need to capitalise the lease payments for valuation purposes – Big picture, doing so lowers returns but increases funds employed and valuation wise those two movements just counteract each other.
At a more detailed level some valuation differences may arise depending on depreciation rates, capitalisation rates etc chosen but overall unless management aren’t being diligent with ongoing lease/buy analysis and/or capital management policy then it should be fairly immaterial.

Of course if you don’t capitalise the leases and put every company on an equal footing than you can’t just compare return ratio’s when you’re considering financial economics of a business – you have to think a little more holistic.

For companies with high lease commitments I think it’s pretty important to consider their solvency metrics in terms of interest bearing debt PLUS lease liabilities.

Thank you, craft - my current thoughts are that capitalizing finance leases is probably more suited to DCF valuation of projects on a short to medium term basis by management or those who want a more detailed, “precise” fix on the sensitivity of the variables. Big picture – you are probably right, it all evens out in the long run, you add something to cash flow, you need to add something to the capital required to support those cash flows and vice versa. There is always equilibrium between both aspects. Again, it’s all about the viability of what management are presenting you in the numbers and the tales they are weaving into their accounting adjustments - the cash flow statement will eventually catch them out if they are trying to over-state reality.

The second part is more interesting – and in a sense I’m looking at it from the wrong side. Whilst not the exact point that you made care should probably be taken with those companies that have vast amounts of property holdings. Cash flow is important and the main focus… but do you agree that the properties should be to some extent added to the bottom line of the NPV? For instance look at HVN. It has $1.7 billion of property holdings on its balance sheet. Should the proportion of those that are being used in the operating business (as separate from those that are leased to third parties) be added to the NPV of the cash flows? The current market multiple that HVN is trading on vs peers seems to indicate that this is the widely held view.

For example, I definitely add PMV's holding in BRG to the bottom line of the DCF valuation (as long as it seems reasonably priced by the market, I may knock some off the top if I'm not comfortable).

Great point about solvency metrics too – completely agree. Leases are generally fixed obligations just like debt repayments.

 

[Ves]

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.

Quick question on this for anyone who can answer.

So 1/15% as Craft said gives an EV/EBIT of 6.6.

If the entity can achieve profitable growth (ie. ROIC > cost of capital) can you use the following formula:

(1+ profitability growth rate) ^ length of growth phase / Hurdle Rate


Eg. you estimate that 5% per annum growth can be achieved from excess returns on capital for a growth phase of 10 years before the company enters a no growth phase for perpuity.

((1 + 0.05) ^ 10) / 0.15 = 10.86.

Am I correct in saying that an investor would achieve a return of 15% per annum if these conditions were met and the stock was purchased at an EBIT multiple of 10.86 or less? or are the maths more complicated than this "short cut"?

Disclaimer: I'm certainly not advocating that this should be used as a valuation method, but more for making sense of market scans etc.

 

[craft]

Quick question on this for anyone who can answer.

So 1/15% as Craft said gives an EV/EBIT of 6.6.

If the entity can achieve profitable growth (ie. ROIC > cost of capital) can you use the following formula:

(1+ profitability growth rate) ^ length of growth phase / Hurdle Rate


Eg. you estimate that 5% per annum growth can be achieved from excess returns on capital for a growth phase of 10 years before the company enters a no growth phase for perpuity.

((1 + 0.05) ^ 10) / 0.15 = 10.86.

Am I correct in saying that an investor would achieve a return of 15% per annum if these conditions were met and the stock was purchased at an EBIT multiple of 10.86 or less? or are the maths more complicated than this "short cut"?

Disclaimer: I'm certainly not advocating that this should be used as a valuation method, but more for making sense of market scans etc.

For your example to achieve 15% return would require selling multiple to be maintained at purchase multiple plus entire EBIT to be paid out in addition to the 5% growth being achieved.

I'm not sure whether you are meaning 5% is the growth rate or if 5% is the excess return above cost of capital. A shortcut that gets sorta close would need both as inputs.

 

[Ves]

For your example to achieve 15% return would require selling multiple to be maintained at purchase multiple plus entire EBIT to be paid out in addition to the 5% growth being achieved.

Hmm you're right I've made a mistake - it's not 15% per annum return.... it's simply growth rate at that purchase multiple that needs to occur to achieve a 15% earnings yield on EV at purchase (year 0) at the end of year 10.

Something more realistic for that scenario would be....

Assuming you paid an EBIT multiple of 10.86 the EBIT yield at year 0 is 1/10.86 = 9.2%

If the company pays 50% of their EBIT as a fully franked dividend (which grows at 5% per annum) and you held for 10 years the cash flows look like this (assuming the EBIT multiple is still 10.86 at time of sale).

Year 0 -$1.000
Year 1 $0.069
Year 2 $0.073
Year 3 $0.076
Year 4 $0.080
Year 5 $0.084
Year 6 $0.088
Year 7 $0.093
Year 8 $0.097
Year 9 $0.102
Year 10 $1.735 (F/F Div $0.107 + Sale $1.628)

IRR 11.90%

I'm not sure whether you are meaning 5% is the growth rate or if 5% is the excess return above cost of capital. A shortcut that gets sorta close would need both as inputs.

Scratch that idea. By the time you chew through a lot of these numbers (which let's face it, is fairly hard to do on an extensive list of companies that come up in a market scan without wasting copious amounts of time) you may as well start working out proper long-term assumptions and plug them into a DCF.

Thanks for responding to my somewhat silly question.

 

[craft]

Something more realistic for that scenario would be....

Assuming you paid an EBIT multiple of 10.86 the EBIT yield at year 0 is 1/10.86 = 9.2%

If the company pays 50% of their EBIT as a fully franked dividend (which grows at 5% per annum) and you held for 10 years the cash flows look like this (assuming the EBIT multiple is still 10.86 at time of sale).

Year 0 -$1.000
Year 1 $0.069
Year 2 $0.073
Year 3 $0.076
Year 4 $0.080
Year 5 $0.084
Year 6 $0.088
Year 7 $0.093
Year 8 $0.097
Year 9 $0.102
Year 10 $1.735 (F/F Div $0.107 + Sale $1.628)

IRR 11.90%

Hi V

With those cash flows you can't gross up the dividends if you don't subtract the tax payment from the EBIT

Scratch that idea. By the time you chew through a lot of these numbers (which let's face it, is fairly hard to do on an extensive list of companies that come up in a market scan without wasting copious amounts of time) you may as well start working out proper long-term assumptions and plug them into a DCF.


Thanks for responding to my somewhat silly question.

I'm not so sure you should scratch the idea - I regard a short cut valuation method that I use as probably the most useful tool in my bag.

 

[Ves]

Hi V

With those cash flows you can't gross up the dividends if you don't subtract the tax payment from the EBIT



I'm not so sure you should scratch the idea - I regard a short cut valuation method that I use as probably the most useful tool in my bag.

I was actually thinking on the train on the way home.... something that I did not mention was the impact of debt on both the purchase and the sale cash flow. I assume that the figures that I used in my example are probably only technically correct if the company had zero debt as they assume that 100% of the EBIT flows to equity. In which case my thinking would be that you could then add back the franking credits?

If you believe that a short-cut valuation tool would be useful then I will continue exploring whilst things are a little more subdued on the market.

 

[Value Hunter]

I think one kind of back of the envelope calculation that is useful in some situations (I use it sometimes) is payback period. Payback period is sometimes also used in small business valuations. Depending upon interest rates and the riskiness and quality of the business the payback period your willing to accept varies.

There are 2 methods to calculating payback period.

If you think the company can in the long term generate a return on equity equal to or above your required rate of return on future retained earnings (i.e. if your happy with a 12% return and you think the company can retain earnings at a 15-20% return) then you calculate payback period based on earnings/maintainable cash flow (operating cash flow minus maintenance capex).

For example if a company's shares (a good company as per the paragraph above) are trading at $9 and you estimate over the next 8 years the company will generate $9 of maintainable cash flow/earnings then your payback period is 8 years.

If you think the company is a low quality business and will reinvest earnings below your required rate of return (e.g. you want a 10% return and think the company will only generate 6-8% returns on retained earnings) then you calculate payback period based purely on the dividends you think the company will pay you and ignore retained earnings (because they are worth far less than $1 to you). This approach is conservative and rightly penalizes the valuation of inferior companies.

I think in the current interest rate environment a payback period of 3-6 years for high risk companies (e.g. onthehouse, Icar asia, AHZ, Quickflix, etc) is fair, a payback period of 7-10 years for medium risk companies (e.g. Credit Corp, Thorn Group, Data 3, etc) and a payback period of 12-15 years for lower risk companies (e.g. Woolworths, Dominos Pizza, Seek, etc). I think as a rule of thumb in the current environment they can be a reasonable guideline.

I don't like EV/EBIT or EV/EBITDA type calculations (I understand their comparison value) because I'm an equity investor I'm only buying the equity in the company not the equity and the debt. If I was buying both the equity and debt of a company I might use it but usually I'm not.

Besides valuing a business from a control perspective when you don't control the assets or the company (i.e. minority shareholder) is not always wise. e.g. if you buy a small business below liquidation value in a distressed sale you have the power to liquidate the assets, however as a minority shareholder in a listed company if you buy below liquidation value the management might keep running the company and rack up further losses, so in reality you have to form an opinion of the likelihood of liquidation, asset sales, or a takeover. Same idea with EV/EBIT and debt how likely is the company to pay off the debt?

In my opinion debt does affect the valuation of a company (from the perspective of a minority shareholder) by changing the equity risk premium (i.e. you would want a higher return for buying the equity of a highly geared company compared to the buying the equity of an otherwise identical but un-geared company due to higher earnings and solvency risk.) If you buy shares as a minority shareholder in a geared company the management may choose to never pay off the debt so using a control based EV/EBIT valuation doesn't make sense unless you are buying a controlling/influential stake in the company. Control valuation does have its uses e.g. calculating the takeover/strategic value of a company you think may get taken over, when an activist investor gets on board and shakes things up, etc

I remember Steve Keen in one of his presentations once talked about how payback period is a conservative valuation methodology compared to other things like DCF because it focuses you on nearer term cash flows (i.e. you focus on getting your money back sooner as for most businesses the longer the time horizon the more likely the business will stuff up, go into stagnation or decline, or go broke (how many companies you buy today would survive the next 30 years?). The further into the future the more uncertain/risky the cash flow. Also its more sophisticated than a simple p.e. because it looks at future growth/decline in earnings.