Present Value of Future Cash Flows

[odds-on]

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.



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.

I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision?

In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this).

If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management.

Having said that, some people have obviously worked out how to accurately forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers?

On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.

Cheers

 

[craft]

I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision?

In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this).

If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management.

Having said that, some people have obviously worked out how to accurately forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers?

Hi Oddson

Probably a bit of an obscure response to your post – but

Any trading/investing success will ultimately be determined by your ability to take on risk when it is priced in favour of doing so.

Ability to take on risk is a circumstantial and personal attribute determined issue.

Seeing mispriced risk is a skill that can be achieved in a niche. (many different niches)

Specifically to your question about sustainable competitive advantage – You can estimate earnings and value companies that don’t have sustainable competitive advantages. You can’t estimate earnings for companies outside of your area of understanding.

On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.

Cheers

What would surprise me is if they let a target price too far removed from consensus out the door. It’s a business imperative for these guys to not stray too far from the pack. Regardless of how much faith they have in their forecasts it makes no business sense to isolate themselves with an outlier price target. Being wrong in unison is not a business threat for these guys – being wrong in isolation is.
Their imperative to stay near consensus despite any inconsistency of valuation logic gives rise to opportunity for private investors who have the ability to be wrong in isolation because it also gives rise to the ability to be right in isolation.

 

[KnowThePast]

I am in agreement that forecasting is quite an art, but if they are not accurate why look at them? Or even bother doing them? Surely looking at an inaccurate forecast could subconsciously influence an investment/trading decision?

In my view, about 1% (or thereabouts) of all businesses have a sustainable competitive advantage, which makes it possible to make a medium term forecast, thus allowing an intrinsic value calculation. Would you agree with 1%? If not, what do you think it is? (I would value other posters view on this).

If you are in agreement about 1%, what on earth do you do about the other 99%? The whole point of the game is to guess the future correctly! If a forecast is so inaccurate (basically a wild guess), it actually is a waste of intellectual effort … an investor/trader may as well just apply some simple entry/exit criteria and disciplined money management.

Having said that, some people have obviously worked out how to accurately forecast stockmarket returns. Read the articles on Statistical Arbitrage by Edward Thorp - http://edwardothorp.com/id9.html. Can the average investor/trader really compete against a card counting mathematics professor, who plays Bridge with Buffett and has access to supercomputers?

On a final point, related to your comment about the inconsistency of valuation logic applied by the research houses, I am really surprised that any professional organisation would let that out of the door.

Cheers

Hi odds-on,

Thank you so much for that link. Just read the first chapters, seems to be awfully close to what I am trying to do.

Really looking forward to reading the rest of it.

 

[Huskar]

Just wanted to butt in and say also: some real thought-provoking posts (and links).

I should be less of a listener and get more involved but I can never say it better than has already been said!

Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?

 

[craft]

Just wanted to butt in and say also: some real thought-provoking posts (and links).

I should be less of a listener and get more involved but I can never say it better than has already been said!

Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?

Hesking

I don’t have in-depth understanding of ASL and I don’t pay much attention to broker reports or their immediate market impacts so I have nothing sensible to add. (my only observation is that there is lots of earnings risk with ASL which makes forecasting earnings difficult even if you are an expert in the area)

One of SKC’s game plans seems to be around riding bow waves of big players in the market – perhaps he has some comments as to how to possibly profit from the ASL type research reports that seem contradictory between earnings and price targets.

As for your involvement – As somebody who should post less but loves the thought provocation from reading diverse views, can I just selfishly say, please do.

 

[skc]

Just wanted to butt in and say also: some real thought-provoking posts (and links).

I should be less of a listener and get more involved but I can never say it better than has already been said!

Does the uncertainty generated by the incongruence between valuation and price forecast on ASL make it a shorting opportunity though - in other words if you are not long, should you be short? Or is short analysis a completely different kettle of fish from "not long"?

Not long and short are very different.

When you buy something undervalued with substantial PV of future cash flow, you go long and you will profit if you are right. Even if the market NEVER price in a higher price, you will still profit from the growing future dividend stream that's above the cost of your capital.

When you short something that appears overvalued, you can lose even if you are right. The market can price shares at whatever price it wants, and when you short there isn't the future dividend stream (like the long case) that allows you to profit regardless of market price. So if you wanted to short something, not only do you need to be right, you need others to agree with you and act accordingly. Some examples may include UNS and Bitcoin(?).

BTW, I don't believe the uncertainty / incongruence in one broker house's valuation would create any shorting opportunity. Unless you can arbitrage against their insurance or something...

 

[odds-on]

Specifically to your question about sustainable competitive advantage – You can estimate earnings and value companies that don’t have sustainable competitive advantages. You can’t estimate earnings for companies outside of your area of understanding.

Hi Craft,

I am in agreement that I can’t estimate earnings for companies outside of my area of understanding, but I struggle l to see how I can make an intrinsic value estimate for a company that does not have a sustainable competitive advantage – surely, the competitive advantage enables one to forecast to future earnings (cash flows) with confidence?

If the earnings are volatile then trying to figure out Year 2 to Year 10 earnings is pointless. If there is no sustainable competitive advantage then all I can hang my hat on is Liquidation Value/NCAV.....or….are you trying to tell me that if I am to trying to value a company without a competitive advantage then I have to take into account that the Return on Capital will mean revert to the industry (or sector or market) mean over a cycle?

Also, what % of listed businesses do you think have a sustainable competitive advantage?

Cheers

 

[craft]

Hi Craft,

I am in agreement that I can’t estimate earnings for companies outside of my area of understanding, but I struggle l to see how I can make an intrinsic value estimate for a company that does not have a sustainable competitive advantage – surely, the competitive advantage enables one to forecast to future earnings (cash flows) with confidence?

If the earnings are volatile then trying to figure out Year 2 to Year 10 earnings is pointless. If there is no sustainable competitive advantage then all I can hang my hat on is Liquidation Value/NCAV.....or….are you trying to tell me that if I am to trying to value a company without a competitive advantage then I have to take into account that the Return on Capital will mean revert to the industry (or sector or market) mean over a cycle?

Also, what % of listed businesses do you think have a sustainable competitive advantage?

Cheers

Can’t be specific enough to assign a single % but it’s not many and if you interpret sustainable as infinite duration – then it’s none.

Only companies that are at a competitive disadvantage need to be valued eventually at liquidation value (unless somebody is silly enough to keep giving them capital.)

Companies with a neutral competitive position can make their cost of capital and do it quite sustainably over time – actually it is more inherently stable then a company with competitive advantage which will be under constant scrutiny as competition tries to think up ways to get their hands on the attractive returns.

Diminishing or increasing competitive positions mean you cannot get sensible valuations from static return valuation models.

Competitive advantage does not necessarily equate to smooth earnings – it equates to superior aggregate returns over a full cycle.

 

[KnowThePast]

Companies with a neutral competitive position can make their cost of capital and do it quite sustainably over time – actually it is more inherently stable then a company with competitive advantage which will be under constant scrutiny as competition tries to think up ways to get their hands on the attractive returns.

And this is an area that I usually play in.

A few studies have shown that for majority of companies, earnings in the long term tend to revert to mean. And so, using a PE ratio of average earnings over the last 5/10/20 years, may not be the worst way to value some companies.

An even better way may be to average out ROC over many years, to see what average earnings would be with the current asset base.

I don't think this kind of valuation would have a high accuracy rate (do any?), but using a scatter fire approach and buying companies with below average earnings should produce an above average result.

 

[craft]

Milestone are a good excuse to reflect.

I have noticed that I am about to come up on 1000 posts and in reflection I can’t justify that.

I’ve been a full time participant in the market in one form or another for nearly 15 years but the allocation of time is now more of a habit then a necessity. A habit I wish to break because there are so many other things in life that I could better spend the time on and I have some big ideas that I want to get achieved.

All I really need to do for my approach to investing now is keep on top of developments in the companies within the portfolio and prospect for potentially better investments – the analogy that jumps to mind is akin to a selector for the national cricket side. The process requires very little transaction time but a fair bit of research time.

Controlling the amount of time spent on research is a challenge for me as weirdly I really enjoy this aspect. I use the word prospecting for investments because I think I get the same buzz from uncovering something of value via business analysis as others might from uncovering a gold nugget.
I do know that I research best in isolation with candidates for closer examination picked up from my scans. Other stimulation leads to less productive use of research time.

With the aim of breaking established time use habits and using what time I do allocate to researching more productively I have decided to ensure I don’t make another 1000 posts. It is my intention to shortly delete my email and enter a scrambled password, effectively disabling my account and ensuring my actions follow through with my intent.

Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.

Happy Journeys

 

[skc]

Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.

Happy Journeys

Hi Craft, sorry to hear your decision. Many here will miss your crafty insights.

All the best with your endeavours.

 

[CanOz]

Hi Craft, sorry to hear your decision. Many here will miss your crafty insights.

All the best with your endeavours.

+1 - will miss you around here Crafty...i think i'll be joining you soon though, with the prospect of fulltime work looming large again i know i won't have the time to post much...

Good luck Craft, drop in and say hi once in while will you!

 

[Ves]

Hi craft

There was a discussion on this forum at some point in time last year where you were trying to explain the need for a person to have the “inner mongrel” to succeed.

I have often reflected on this.

Today I found the word that I am after.

Tranquility.

You will know what it means to be in this state in terms of your life, your actions and your core values and to be at peace with yourself when you look into the metaphorical mirror than life shoves in your face.

Without it there is only emotion, self-doubt and chaos amongst any attempts to be rational.

It is somewhat an oddity that the day of your leaving coincided with this discovery.

Thank you for all of your thoughts, and for answering many of my questions and providing lots of concepts and ideas to ponder.

All the best,
V

 

[odds-on]

Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.

Happy Journeys

Sad news for ASF. Let us know when you start teaching "The Art of Investment" at some University, I will sign up

Cheers

 

[nulla nulla]

Milestone are a good excuse to reflect.

I have noticed that I am about to come up on 1000 posts and in reflection I can’t justify that.

I’ve been a full time participant in the market in one form or another for nearly 15 years but the allocation of time is now more of a habit then a necessity. A habit I wish to break because there are so many other things in life that I could better spend the time on and I have some big ideas that I want to get achieved.

All I really need to do for my approach to investing now is keep on top of developments in the companies within the portfolio and prospect for potentially better investments – the analogy that jumps to mind is akin to a selector for the national cricket side. The process requires very little transaction time but a fair bit of research time.

Controlling the amount of time spent on research is a challenge for me as weirdly I really enjoy this aspect. I use the word prospecting for investments because I think I get the same buzz from uncovering something of value via business analysis as others might from uncovering a gold nugget.
I do know that I research best in isolation with candidates for closer examination picked up from my scans. Other stimulation leads to less productive use of research time.

With the aim of breaking established time use habits and using what time I do allocate to researching more productively I have decided to ensure I don’t make another 1000 posts. It is my intention to shortly delete my email and enter a scrambled password, effectively disabling my account and ensuring my actions follow through with my intent.

Despite not being able to justify the 1000 posts I don’t regret having the chance to chat with many people who I dare not mention for fear of missing somebody. Thanks all for setting the thought train in motion many a time.

Happy Journeys

Wisdom when imparted is often overlooked. And those providing that wisdom sometimes feel their contribution is of no import. Often their contributions are met with challenge and sometimes derision. However there is often a silent few that appreciate the merit of the contribution and more importantly the consistency of the quality of the contributions.

As a poster, you have proven to be one of a handful of quality posters that I consider as being worth reading. Thoughtful and sometimes challenging, your posts have always deserved consideration. I hope you will reconsider your decision as a 1000 post tally over a period of six years is not excessive. I'm sure the forum would continue to benefit from the quality of your posts, even if you elected to scale it back to accommodate your future plans.

Best regards in your endeavors and many thanks,

nulla

 

[Newt]

I hope you were just having a #@$! day Craft - don't do it - I'll miss the chance to learn from you and pretty sure many others would be dissapointed too.

Nothing wrong with rationing your future time though. Anything's possible in life as long as you sacrifice the time your could have spent achieving something else....

 

[VSntchr]

Have been re-reading this thread and its making alot more sense then the first time ~2yrs back.

I like the concepts of ROIC and ROIIC and I decided the best way to learn more is to put it into practice.

I wanted to prove the fact that incremental returns will pull up the overall returns over a longer period (which is clearly logical).

I used Resmed for my example.

First I calculated EBIT(1-t). Then I calculated invested capital by taking total assets, subtracting excess cash (which is a subjective number based on what I think they need to retain for WC purposes), then subtracted goodwill - while leaving in all other intangibles with finite (amortisable) lives, finally I subtracted the all other non-interest bearing CL to finally arrive at a figure for invested capital.
I also compared the result of the above to the shortcut method of Equity + debt - cash, and found that the result is within +/- 10%.

So for 2013 I arrived at a ROIC value for RMD of 25.5%. This compared to a ROIC in 2004 of 18.8%.
Taking a look at how RMD used their incremental capital over this period showed that they invested an additional ~$800m for an incremental EBIT(1-t) of $223m. This is a return on incremental capital of 28%. Pretty snazzy to be deploying additional funds over a 10 year period at that kind of rate and with the long run incremental rate higher than the overall rates of return - one might assume that the uplift will continue (enter here all assumptions about ability to deploy capital).
One factor that might need to be normalised is the fact that at the start of the period the company was paying a 32% effective tax rate, while most recently this was close to 20%.

Another area that this exercise has opened up for me is that RMD's invested capital base basically begun to stagnate over the last 4 years. This, however does not appear to be a lack of investment (capex is largely in-line with historical trends), but rather the company accelerating its capital return mechanisms.

As always, please critique as necessary

 

[craft]

So post 1000

Thanks to those above that posted some kind words and thanks to you VS for that last post – that somebody is working through some of the thoughts in this thread to see if they are of any use to them means a lot. (my critique )

So let’s try this with an in-moderation approach - a somewhat unusual concept for me. [please tell me if I’m not achieving this objective] If I ever make it to 2000 posts that mile stone will have be equitable with my investing time frame - long term.

Infrequent visits probably means disjointed discussions and missed question/posts –So I’ll just apologise now if it appears that I am being ignorant or snubbing anybody.

Seems there is some interesting posting occurring on the site at the moment – maybe that just means I listen better when not talking.

 

[Ves]

As always, please critique as necessary

Hey VS,

Companies that can employ excess capital generated into a franchise are obviously good long term plays (at the right price).

Often you will find that ROIC will grow in these types of companies because they are benefiting from increased scale and better asset utilisation (obviously revenue growth on a cost base that is somewhat fixed with do this). Most of the fixed capital is in place... so to add more capacity you might need to add less incremental capital to ramp up returns? I guess it would help to know what the incremental capital was used for as well.

With companies like Resmed that need to constantly innovate and create new products / features, it would be interesting to try to identify how much of the change in ROIC over this period was due to a changing product mix from new innovation etc. and how much, if any, was due to increase in scale / operational leverage? Were there any cyclical or structural factors within the industry that drove returns? Will these continue or is there risk of change? In other words we can see that the returns have increased, but what are the drivers? I think that will tell a story, and from that, you will most likely have a better idea of how sustainable it is and what assumptions need to be made for it to continue long-term.

You've hit the nail on the head. You know what to look for - now that you can find it, you can start asking new questions in your analysis. The more you know, well the more it turns out that you realise the less you know. Which helps you expand your base further again. The paradox of knowledge / espistemology.

 

[craft]

Stranded Franking credits

Currently a company whose long term FCF is equivalent to its NPAT has the ability to distribute all its franking credits. But under a 28.5% tax and 1.5% PPL levy arrangement we will have the situation where a company with 100M pre-tax profit will end up crediting the franking account with 28.5M but because they still only have 70M cash flow they can only distribute 27.9M of franking credits.

What’s the implications for valuation?

What companies are best placed to mitigate this absurdity?

Will something get legislated to overcome the situation? or does it exist already - can they frank above the tax rate etc?