Present Value of Future Cash Flows

[craft]

Thanks for your post Value Hunter.

I think all the models are attempting to do basically the same thing – determine what a share is worth based on what the business can produce. And that’s the big pig picture..... the models are just tools and it’s really the model input assumptions we make in light of the big picture, that informs us – not the model or its output.

To me investing is the foregoing of purchasing power now in order to obtain more at a later date.

That definition drives how I think about so many things: Inflation; Taxation; Transaction Costs; Earnings Risk; Competitive Advantage to protect Margin; Growth Potential; Valuation Model........

I suspect most, who find any value in this thread will share the big picture concepts on investing, but we will all probably address the detailed questions with different and varied tools and perspectives and that’s a good thing.

Look forward to some more post from you.

 

[Value Hunter]

One valuation formula which I useful in some situations is Brian Mcniven's valuation formula as set out in the book 'a concise guide to value investing" and his other book "market wise":

-IV = Intrinsic Value
-E = Equity Per Share
-ROE = Return on Average Equity (the average amount of shareholders equity throughout the financial year)
-RI = Reinvestment Ratio (this is equals one minus the dividend payout ratio) i.e. if the dividend payout ratio is 60% the reinvestment ratio is 40%
-D = Dividend Payout Ratio
-RR = your required rate of return for the particular investment

Formula: [(ROE/RR)*RI] + D
-------------------------
RR*E
Note: All the figures (inputs) are based on your long-term future estimates for each variable (the only figure which is a current figure and not a future estimate is the Equity per share)

So If a company has a future forecast ROE of 20% and pays out three quarters of earnings and you want to get 12% return the valuation would be as follows
[(20/12)(5) + 15]/12 = 1.944 times the equity per share

This valuation is appropriate for stable relatively non-cycle companies where earnings growth is correlated to retained earnings and incremental return on equity is relatively stable and predictable and similar to past return on equity e.g. Woolworths (WOW).

It does not work well for companies where earnings are not really related to the amount shareholder's equity e.g. Platinum Asset Management (PTM).

It also does not work well for companies whose incremental return on future equity will be markedly different from return on existing equity.

It also does not work particularly well for highly cyclical companies.

To be honest valuation formula's are to me at least sometimes an academic exercise when something is a screaming bargain it will be obvious you won't need to use a valuation formula as such, as the value will hit you in the face. If you need to fiddle around with formula's its not an obvious bargain.

 

[craft]

One valuation formula which I useful in some situations is Brian Mcniven's valuation formula as set out in the book 'a concise guide to value investing" and his other book "market wise":

-IV = Intrinsic Value
-E = Equity Per Share
-ROE = Return on Average Equity (the average amount of shareholders equity throughout the financial year)
-RI = Reinvestment Ratio (this is equals one minus the dividend payout ratio) i.e. if the dividend payout ratio is 60% the reinvestment ratio is 40%
-D = Dividend Payout Ratio
-RR = your required rate of return for the particular investment

Formula: [(ROE/RR)*RI] + D
-------------------------
RR*E

Brian Mcniven’s model is a restatement of the Walter Dividend Model. Roger Montgomery’s first foray into stock valuation software at Clime used this formula and credited it to McNiven. His second foray also uses the same formula except now he claims credit, because he has disguised it in a table and applied a 10% reduction to the valuation of the retained component.

It’s great to see you accommodating the limitations of the formula.

Here’s the limitations that Walter was very upfront about when he formulated the model in an attempt to assess the question of dividend policy.

https://www.aussiestockforums.com/forums/showthread.php?t=20847&p=762415&viewfull=1#post762415

To be honest valuation formula's are to me at least sometimes an academic exercise when something is a screaming bargain it will be obvious you won't need to use a valuation formula as such, as the value will hit you in the face. If you need to fiddle around with formula's its not an obvious bargain.

The herd does not leave obvious screaming bargains - by definition you will only find screaming bargains if you see things differently to the majority. An understanding of valuation can help you stay grounded in the face of current popular trends and see things a little different.

 

[Ves]

Sorry guys... I've been a bit aloof on this thread since my last few posts. Your thoughts are very appreciated and whilst I have thought long and hard on them, I don't really have anything useful to add at this very point in time. Valuation, as craft and a few others often say, is more art than science, and I have come to totally respect that point of view over time.

At the moment my main concern is risk management.... valuation is part of that (of course I'm still refining my full valuation and "short cut" valuation methods), but it is only a cog in the bigger picture as things currently stand in my mind. Earnings hits to companies such as FGE have really opened my mind to my prior consideration of proper process and critera before investing in a company and I'm really trying to hone in on my own process at the moment in respect to this.

 

[VSntchr]

I've been playing around with a few options in the last few months.

Basically I take the FCFF (or whichever you use) from the last period of your cash flow analysis and divide it by some sort of risk-adjusted cost of capital for the firm (usually between 11% and 15%).

So say at year 10 you had cash flow of $1 a share and I thought the cost of capital should be 12% for UGL. TV at year 10 would be $8.33. Discounted back to year 0 at 15% (my required rate of return before tax) this'd be $2.06. as I said I would personally adjust this based on my confidence in the enduring competitive advantage of the business. So for instance.... $2.06 x 50% = $1.03. It's pretty arbitrary as all valuation is, but it makes you think about the competitive advantage and how far above the replacement cost of assets you are willing to pay for it in today's dollars.

Here's a comparison of the same for 5 different scenarios using $1 as the base earnings at year 10. Discount rate from year 10 to year 0 is always 15% in all scenarios.

Scenario A B C D E
TV Disc 11% 12% 13% 14% 15%
TV $9.09 $8.33 $7.69 $7.14 $6.67
Year 0 $2.25 $2.06 $1.90 $1.77 $1.65

Scenario A is 36% higher than scenario E. B is 25%, C 15% and D 7%.... which demonstrates that discount rates impact the result pretty quickly.

We were off-topic from UGL, so perhaps better to discuss here...

Your approach is interesting and in many ways similar to mine.
Is your 15% discount rate universal amongst all stocks? Or does it differ based on your perception of company risk? I ask only because you appear to be adjusting for risk in other parts of your valuation - so accounting for it again in the discount rate may be over-punishing the company?
However, if you are only discounting the excess terminal value based upon the competitive advantage that you feel applicable then my point may not be worthy..

I don't have my head 100% around your approach so I'm sorry if I'm off the mark here...

 

[Ves]

We were off-topic from UGL, so perhaps better to discuss here...

Your approach is interesting and in many ways similar to mine.
Is your 15% discount rate universal amongst all stocks? Or does it differ based on your perception of company risk? I ask only because you appear to be adjusting for risk in other parts of your valuation - so accounting for it again in the discount rate may be over-punishing the company?
However, if you are only discounting the excess terminal value based upon the competitive advantage that you feel applicable then my point may not be worthy..

I don't have my head 100% around your approach so I'm sorry if I'm off the mark here...

It's a universal discount rate of 15%pa.

It's basically saying that if the company passes all of my risk management tests in the first place, I will value it based on a set of assumptions about the future, perhaps make some further risk adjustments. Once I've got a valuation the company needs to trade at such a level that I think I will be able to get 15%pa before tax (hence the discount rate) before I would consider buying it.

Each month I usually just sort through my valuations and pick the one offering the biggest return / discount to it's value. If there's none I just stay in cash. Obviously there's position sizing requirements on top of that... I won't go higher than 10-12% of my portfolio in one company. I try to average in, rather than time my entries. Set day each month - if I miss out I miss out, but I'd rather not snatch at entries randomly.

 

[VSntchr]

It's a universal discount rate of 15%pa.

Yep, this makes sense to me.

It's basically saying that if the company passes all of my risk management tests in the first place, I will value it based on a set of assumptions about the future, perhaps make some further risk adjustments. Once I've got a valuation the company needs to trade at such a level that I think I will be able to get 15%pa before tax (hence the discount rate) before I would consider buying it.

Yep, I have spreadsheet that provides me with my own IRR based on my modelling and current price.

Each month I usually just sort through my valuations and pick the one offering the biggest return / discount to it's value. If there's none I just stay in cash. Obviously there's position sizing requirements on top of that... I won't go higher than 10-12% of my portfolio in one company. I try to average in, rather than time my entries. Set day each month - if I miss out I miss out, but I'd rather not snatch at entries randomly.

Seems like a pretty good method.
I'm far more aggressive in my approach. I am not too worried about approaching 30% in one company. I understand the additional risk but at a young age I am in a situation that allows me to take it on.

 

[Ves]

I'm far more aggressive in my approach. I am not too worried about approaching 30% in one company. I understand the additional risk but at a young age I am in a situation that allows me to take it on.

I was thinking along those lines too - but then I did the maths, if I can get 10-12% per annum returns at my current savings rate (which is pretty high) I'll have a very tidy sum of money after 10-15 years. Hence why I'm pretty conservative in general

 

[VSntchr]

I was thinking along those lines too - but then I did the maths, if I can get 10-12% per annum returns at my current savings rate (which is pretty high) I'll have a very tidy sum of money after 10-15 years. Hence why I'm pretty conservative in general

and thats what it's all about isn't it - personalising your plan for YOUR situation!

 

[Ves]

and thats what it's all about isn't it - personalising your plan for YOUR situation!

Spot on!

 

[TheUnknown]

Has anyone been successful to build cash flow from shares and an income from shares that produces them a wage per week?

 

[craft]

Has anyone been successful to build cash flow from shares and an income from shares that produces them a wage per week?

Now there's a question just begging the respondents to make themselves look like egotistical fools - but that's probably the perception of me already and it’s probably a common query - so tosser mode on – here goes.

Current dividend stream is greater then I imagine I could be making now in any other career. (Aged early 40’s) The initial capital was savings from pretty average sort of employment up until about age 30. Some of the increases in capital has been from trading (especially early on) but the majority in $ terms has grown by investing with a cash flow focus.

The aim now is to try and not blow it whilst continuing to invest in the style I do – because investing turns out to be more about doing something I enjoy rather then something I do to make money.


now - don't ask again - its rude.

 

[craft]

It's funny that the market is pushing new recent highs, yet a few of the stocks I follow closely are near recent lows.

VSntchr made this comment in the DTL thread. I’m just going to make some random thoughts that jumped into my head when I read it.

The market seems driven at least in the short term by current earnings.
I’m a long term investor – my job really is to arbitrage over time the difference between current earnings and true economic earning potential.

I think about how the market is currently pricing for example DTL compared to GXL and market price seems defensible on current earnings and analyst extrapolated forecasts but to me both prices seem wrong in relation to the long term economics of the businesses.

My disagreement with some market pricing is opportunity that will be realised over the long term. If I’m right its opportunity that will be translated into profit, if I’m wrong it its opportunity that will be translated into loss. If you think you’ve got an edge in evaluating long term performance of business’s then celebrate the markets appetite for earnings momentum and instant gratification.

What about the opportunity costs of not going with the market momentum to make shorter term wins and compound them yourself? Its zero sum for outperformance – It’s extremely crowded – It incurs lots of transaction costs, it requires more screen time & monitoring. I don't have the hunger anymore to compete consistently in a very competitive/time consuming game which is zero sum and has the drag stacked against you.

Outperformance by picking quality at a sensible price and avoiding crap at expensive prices seems much simpler to me and far easier to scale. You just have to worry about the correct allocation of your initial capital and dividend stream. Good businesses take care of some of the compounding for you.

 

[skc]

I think about how the market is currently pricing for example DTL compared to GXL and market price seems defensible on current earnings and analyst extrapolated forecasts but to me both prices seem wrong in relation to the long term economics of the businesses.

If you think you’ve got an edge in evaluating long term performance of business’s then celebrate the markets appetite for earnings momentum and instant gratification.

I think Buffet is an advocate of "extrapolation" of earnings and performance. However, his overarching premise is about predictable earning streams and sustainable competitive advantage. It feels like analysts there days simply adopted the "extrapolate" mantra yet failed to improve their skills in assessing the actual business.

Oh yeah and they get their performance assessed on a short term basis anyway so there's little reason to focus on the long term.

One thing on my to-do list is to run a NPV analysis on TCL. All their assets have finite lives. Some are to be returned back to the government on a debt free basis. I struggle to see how there's much value in today's term. My guess is that the analysis forecast only goes 3-5 years out so they literally can't see the end of the tunnel (pun intended).

What about the opportunity costs of not going with the market momentum to make shorter term wins and compound them yourself? Its zero sum for outperformance – It’s extremely crowded – It incurs lots of transaction costs, it requires more screen time & monitoring. I don't have the hunger anymore to compete consistently in a very competitive/time consuming game which is zero sum and has the drag stacked against you.

Outperformance by picking quality at a sensible price and avoiding crap at expensive prices seems much simpler to me and far easier to scale. You just have to worry about the correct allocation of your initial capital and dividend stream. Good businesses take care of some of the compounding for you.

The short term and long term are actually pretty symbiotic. Without short term sellers driving down the price (of DTL for instance), you won't have as many opportunities to acquire assets on the cheap.

 

[craft]

I think Buffet is an advocate of "extrapolation" of earnings and performance. However, his overarching premise is about predictable earning streams and sustainable competitive advantage. It feels like analysts there days simply adopted the "extrapolate" mantra yet failed to improve their skills in assessing the actual business.

On Buffett - if a person fails to comprehend the significance he puts on "sustainable competitive advantage" - especially the sustainable part then the majority of the story will be missed. he's tended towards predictable (as in smooth) because he's leveraged through the insurance float, otherwise from what I have read he would favour maximising return over minimising volatility.

Oh yeah and they get their performance assessed on a short term basis anyway so there's little reason to focus on the long term.

That short term performance is a logical pursuit for so many market players is probably the very thing that keeps long term investing viable.

The short term and long term are actually pretty symbiotic. Without short term sellers driving down the price (of DTL for instance), you won't have as many opportunities to acquire assets on the cheap.

That says better what I was trying to say. Celebrate the opportunities because without the opportunities it doesn't matter how good you are - an efficient market with no opportunities means no scope to outperform.

Celebrating the opportunities is sometimes hard when you have become attached to the paper profits from much earlier buying. Holding good companies for the long term can incur 50% drawdowns from peak even when nothing has changed with the competitive advantage. You have got to be able to see it for what it is not what your emotions are screaming at you - temperament is so important especially when earnings have a cyclical nature.

 

[craft]

For those interested Buffett's 2013 annual Letter is out.

http://www.berkshirehathaway.com/letters/2013ltr.pdf

 

[skc]

Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill.



So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.

IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.

So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.

Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!

 

[craft]

Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill.

View attachment 57050

So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.

IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.

So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.

Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!

Interesting post.

I don’t understand how Broking houses get their price targets either and care factor for me is zero - though I do like it when I disagree with them.

2016 forecast earnings for ASL in this environment to a decimal place no less – righto.

 

[odds-on]

Whilst we are on the topic of short term-ism of the market (btw there's no doubt I am a contributor to such -ism), I came across this from a major research house on ASL, Ausdrill.

View attachment 57050

So EPS forecast to bottom out at 11.1c in FY14 then rising to 16.7c in FY15 and 22.1c in FY16. On the otherhand, the price objective is downgraded to 85c (vs ~94c currently). I struggle to make sense of this.

IF the EPS forecast is to be realised in FY16, what would be the market price for the share based on 2 years of rising EPS, >7% dividend yield? Even if you just put on a 8-10x PE multiple you'd get a share price in FY16 of $1.7 to $2.2... in 2.5 years time. If the price objective today is 85c, then the return by FY16 would be something like 100% per year.

So what does it mean?! Either the price objective is grossly wrong based on their current EPS forecasts, or their EPS forecasts are grossly wrong as it certainly doesn't support the price objective. Or may be, they are saying that their EPS forecasts are so variable you need 100%p.s. discount rate to account for the risk, which means the forecasts are not worth the electronic ink that it is printed on.

Or may be they are saying that the EPS is what it is but the price objective is where they believe the market will price ASL share... in which case they might as well just show a price chart with a trendline!

Are there any academic papers on the accuracy rate of the EPS and Price forecasts produced by Brokers/Research houses? I wonder if they are more accurate than TAB punters? If they are less accurate, how can they justify their salary?

Or is the stockmarket really that difficult...
http://www.afr.com/p/national/how_alan_woods_beat_the_odds_1WYIMYctxSivusBw06fcJJ - How can one be so good at forecasting horse races yet so bad at forecasting the stockmarket?

 

[skc]

Are there any academic papers on the accuracy rate of the EPS and Price forecasts produced by Brokers/Research houses? I wonder if they are more accurate than TAB punters? If they are less accurate, how can they justify their salary?

Forecasting is quite an art so I've never expected them to be correct most of the time. The accuracy will depends largely on the industry (is it relatively steady or cyclical? Predicting the top and bottom of cyclical industries are difficult) as well as how far out the forecast is projected.

The current period consensus (i.e. average or median amongst several analysts) can sometimes be useful... if nothing else, you expect a large company to make some sort of market guidance announcement when they discover that their earnings will vary significantly from current range of analyst forecasts.

Interesting post.

I don’t understand how Broking houses get their price targets either and care factor for me is zero - though I do like it when I disagree with them.

2016 forecast earnings for ASL in this environment to a decimal place no less – righto.

What is interesting in this case is that the forecast and the price objective seems completely incongruent. Their forecast may or may not be right but at least they should apply those input consistently. May be they simply said too much risk therefore assume price target of 30% of NPV or something like that. Which again means all the forecast is a complete waste of time if the analyst simply ignores the answer it gives him/her.