Present Value of Future Cash Flows

[McLovin]

It's just a mathematical representation of a known factor [earnings], and assuming it will do pretty similarly in the future... not literally saying it will be like so forever.

It's a completely rubbish representation that neither looks in the rear view mirror or the road ahead. It's just a static scenario that assumes the world stands still, and goes against virtually everything else you have said in your posts. If you can't at least make some base case assumptions then you're playing the wrong sport.

How well would your extrapolate to infinity approach have worked if you were buying in 2007?

There's so many snake oil salesmen out there who push these kind of holy grail formulas.

 

[DeepState]

So, in not being smart enough, i'll ignore future positions.. .just look at the current earning power, projected into infinity at my cost of capital... and if the price is approximately good enough, i'll take it else move on.

Presumably your cost of capital is something north of 8% or so. Projected to infinity, that company and all others that you value which have positive earnings, individually, will dominate the world economy and eventually become indistinguishable from the world economy itself.

Although estimation of value is not precise, this assumption is somewhat - shall we say - imprecise and not very smart. Yet, it will dominate your entire valuation. These are not firm foundations from which to pitch the arguments you have made.

 

[luutzu]

You are asserting things about us that are not correct to launch your attack on how we overcomplicate things. We are not interested in quarterly detail etc just the divers of long term valuation.

That nothing will change is in itself an assumption - Do you realise how many of those nothing will change assumptions are imbedded in a static earnings power calculation and how few companies such a valuation method is suitable for? How many of those price is 'approximately good enough' are a result of true under valuation or mis-valuation by you?

Accounting is just the language - estimating a valuation is a small end of process part of the picture. The entire focus is the business, despite what you may assert about our approach.

I'm not trying to attack you, i like you guys We might even be friends one day.

And true, I haven't read all the to and fro so will not know the details... BUT

But i know what you guys are doing, and i wouldn't say wrong, but the benefit it brings isn't... isn't economical.

 

[luutzu]

It's a completely rubbish representation that neither looks in the rear view mirror or the road ahead. It's just a static scenario that assumes the world stands still, and goes against virtually everything else you have said in your posts. If you can't at least make some base case assumptions then you're playing the wrong sport.

How well would your extrapolate to infinity approach have worked if you were buying in 2007?

There's so many snake oil salesmen out there who push these kind of holy grail formulas.

The formula, the approach, is a simple ordinary annuity, extended to perpetuity... or Ordinary Perpetuity.

It's not snake oil salesmanship, it's taught in my finance and investment textbooks... ok, take that back

The calculation is to find the value of an expected cashflow [ie Earnings], at a required interest rate, extending that to infinity [or a couple hundred years, depend on how precise you want]

ie. PV = lim(n to infinity) C/i x [1 - (1/(1+i)to n ] (i checked with a textbook)

When you extend n far enough into the future, (1/(1+i)to n approaches zero... leaving you with PV = C/i

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Yes, the formula is static... But as i've said, you review and reappraise it when changes require you to... and when you reappraise, a static formula, applied as and when needed, is no longer static but adaptive.

What are we revising?

The C [the earning power]... and the i [our required rate of return].


You expect the company's C to grow, in general... if next year it doesn't grow by your i, you look at the business and see if that's just part of business... new investments that you are quite certain will add higher earning soon enough etc.

You look at your i... if you find a better opportunity, if your cost goes up...

and you adjust and reappraise your valuation accordingly.

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So with PV = C/i.... your i is pretty static, relatively... but a company's earnings might not, and so it is really the only thing you look at.

If new products, new services, new market, better asset utlisation etc... If these and other factors have show signs of better earnings, higher C... your PV will change to a higher value accordingly... if C looks to be down for a foreseeable future, will this be the new normal, if so, what value would that be... and you make your buy/sell/hold decision accordingly


No one is suggesting you use this approach and go to sleep.

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What the Discounted Cashflow, dividend and all the combinations are doing is trying to do the same thing, but trying to be smarter.

If you can do it, if you can accurately predict the impact of higher interest rates, impact of industry A impacting your company, impact of this and that... If you can predict these factors, and these factors' impact on your company's earnings, then yea, it's the best way and the right way to go about it.

I just don't think i could, so what i do is look at the company's financial position, competitive position, its ranges of earnings... and assume that with a strong structure and good product, it's going to be alright and earn me what it has... and if it were to earn me higher next year, i'll value it higher.

In other words, I can guess possible influence and impact of some variables, but i won't use them until they appear on the PL, balance sheet.

I could be wrong and too late of course... but it's better that i don't discount future losses or future gains when that future hasn't yet happen, or if happen, hasn't affect my holdings to a degree the world thought it will.

And to be safer, i'll pay at a lower price than my worst case scenario...

Could still be wrong, could be sitting outside forever... but this approach is no more or less accurate than your detailed discount approach, it's much simpler and force people to really know what it is they're owning, not be moved by the wind.

 

[luutzu]

Presumably your cost of capital is something north of 8% or so. Projected to infinity, that company and all others that you value which have positive earnings, individually, will dominate the world economy and eventually become indistinguishable from the world economy itself.

Although estimation of value is not precise, this assumption is somewhat - shall we say - imprecise and not very smart. Yet, it will dominate your entire valuation. These are not firm foundations from which to pitch the arguments you have made.

7 or 8%, depends... could be 6 or 9...

But no, that's where i think there's a misconception about required rate of return and growth.

A required rate of return is return on capital, on equity, not growth in sales or growth in earnings by 8pc into infinity.

So if the company earn 8% next year... and kept it back, i expect it will reinvest that 8% and compound it at 8 or higher... if not, return to me, its owner in terms of dividends or whatnot so i can find other opportunities.

No company can grow sales, let alone earnings, by 8% or 10 or 20... and i don't expect companies i look at to do so.

So as long as the company keep its original equity [capital] base, its sales can be stagnant or grow with inflation and i get my required rate... and we're both happy.


It's insane to me that some analysts and fund managers expect a "growth" company to grow at 30% or 20% year on year and cut them when their industry is generally declining and they "only" grow by 18% in earnings, return only 40% on equity.

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Maybe it's because the smart monies are paid to look and produce smart reports, maybe they're paid by the hour, or maybe they have too much data they think it's useful information.

I've done those long complicated calculations, I could even code and program it and be so precise it won't even round the decimals until the final result... that kind of precision is good to impress, but useless because the inputs are best guesses.

 

[craft]

But i know what you guys are doing, and i wouldn't say wrong, but the benefit it brings isn't... isn't economical.

You had me rolling round the floor in stiches with this one- you are so funny (but you probably don't even realise it)

 

[craft]

Does your hurdle rate change over time? In particular, for interest rate changes?

Not really its been 15% pre tax for ages - but I don't use it as a discount rate - just the hurdle rate at which I would stay in cash rather then take a position.

Interest rates don't impact P/E's as much as I at least initially thought - most of the interest rate change is taken up in ERP's so have never needed to lower the 15% because of interest rates - If interest rates went high enough (like early 90"s) I would probably start ratcheting the hurdle up then.

 

[Ves]

Not really its been 15% pre tax for ages - but I don't use it as a discount rate - just the hurdle rate at which I would stay in cash rather then take a position.

OK, this statement actually makes a lot of other things that you have previously said make sense to me. I initially assumed (or misread) that your hurdle rate and discount rate were the same.

But what I do not understand is how you can have a different hurdle rate and discount rate in your valuation? I am thinking that it possibly has to do with the IRR you complete on the cash flows. Can you provide a little bit more information? It's probably really obvious - sorry if I'm a bit slow.

 

[craft]

OK, this statement actually makes a lot of other things that you have previously said make sense to me. I initially assumed (or misread) that your hurdle rate and discount rate were the same.

But what I do not understand is how you can have a different hurdle rate and discount rate in your valuation? I am thinking that it possibly has to do with the IRR you complete on the cash flows. Can you provide a little bit more information? It's probably really obvious - sorry if I'm a bit slow.

So I Calculate an IRR for my potential investments [IRR is just the interest rate where the NPV for a series of cash flows including the initial outlay = zero] if say there is only two opportunities that I understand well enough to be comfortable making assumptions about and they came out at an IRR of 14% and 12%, I would take neither because they are both below my hurdle rate of 15% - back to the drawing board to look for a better opportunity or wait for a better price.

If however the two returns were 18% and 23% - I take the 23% - I don't take both just because they are both above my hurdle rate - Investments are always competing for a spot in my team - I only want the best of what I have looked into and they have to be above 15% otherwise I will stay liquid and do more searching or wait for better opportunity.

Have I helped explain it at all?

I just evolved using different terminology and approach but its no different then using a fixed discount rate and taking the biggest Margin of safety.

 

[Ves]

Have I helped explain it at all?

I just evolved using different terminology and approach but its no different then using a fixed discount rate and taking the biggest Margin of safety.

Yes, that does make sense - the maths says that it is just a different way of completing the same calculation.

The only "grey area", and one that I am stilling working through myself is the terminal value.

If you are using a perpetuity (or a number based on a proportion of a perpetuity) that includes a discount rate which is equal to the cost of capital, wouldn't this effect the IRR? Should the discount rate on the perpetuity be the hurdle rate? There's a big difference for example 1 / 0.11 and 1 / 0.15 even if it is a far dated cash flow at the end of the calculations.

I guess what I am saying is that if your discount and hurdle rate are the same thing, then perhaps this isn't an issue?

Perhaps I am misinterpreting this part... please tell me if this is the case.

 

[craft]

Yes, that does make sense - the maths says that it is just a different way of completing the same calculation.

The only "grey area", and one that I am stilling working through myself is the terminal value.

If you are using a perpetuity (or a number based on a proportion of a perpetuity) that includes a discount rate which is equal to the cost of capital, wouldn't this effect the IRR? Should the discount rate on the perpetuity be the hurdle rate? There's a big difference for example 1 / 0.11 and 1 / 0.15 even if it is a far dated cash flow at the end of the calculations.

I guess what I am saying is that if your discount and hurdle rate are the same thing, then perhaps this isn't an issue?

Perhaps I am misinterpreting this part... please tell me if this is the case.

Seem to remember this discussion a few times now.

Does post 21 or 40 in this thread help at all with your thinking?

You have to be incredibly careful with terminal values. You only have to change the inputs by small margins to produce any number you like. Consider that if future perpetual growth is 5% and future cost of capital is 9% then the terminal value multiple is 25. Changing those two variables by just one 1% can produce multiples from 16 to 50 times.

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

 

[Ves]

I understand that bit (or maybe I don't as well as I think I do - we will see).

Let's say as an example you decide that the net replacement costs of the assets is $200.

Let's say that at the end of the forecast period you calculate that the entity have $100 discretionary free cash flow per annum.

Then say you do not want to factor in any growth. The range of your terminal value would between the net replacement cost of assets $200 and a perpetuity based on the cost of capital of 10%, which is $1,000. However, if the perpetuity is calculated at the hurdle rate of 15% it is $666.67.

If the company has a robust competitive advantage, and you believe it will out hold up for a long time, the TV, as you said will be closer to the perpetuity than the net replacement cost of assets (at least that is what I remember from our discussion via PM, that you alluded to in post 274). I can find the wording if it helps?

Maybe it is a matter of technicality, but wouldn't it have an impact on your thinking if the perpetuity was calculated on 10% vs 15%? Like anything else is this just a judgment call? Am I over-thinking this?

 

[craft]

I understand that bit (or maybe I don't as well as I think I do - we will see).

Let's say as an example you decide that the net replacement costs of the assets is $200.

Let's say that at the end of the forecast period you calculate that the entity have $100 discretionary free cash flow per annum.

Then say you do not want to factor in any growth. The range of your terminal value would between the net replacement cost of assets $200 and a perpetuity based on the cost of capital of 10%, which is $1,000. However, if the perpetuity is calculated at the hurdle rate of 15% it is $666.67.

If the company has a robust competitive advantage, and you believe it will out hold up for a long time, the TV, as you said will be closer to the perpetuity than the net replacement cost of assets (at least that is what I remember from our discussion via PM, that you alluded to in post 274). I can find the wording if it helps?

Maybe it is a matter of technicality, but wouldn't it have an impact on your thinking if the perpetuity was calculated on 10% vs 15%? Like anything else is this just a judgment call? Am I over-thinking this?

Yep your overthinking it and Yep it's judgement. Yet here's the ironic part, the judgement that simplifies everything and makes it all click into place will come from your current overthinking process.

 

[luutzu]

You had me rolling round the floor in stiches with this one- you are so funny (but you probably don't even realise it)

Na i know... i'm pretty good that way, haha

Anyway, from the notes in my finance textbook next to annuities, i wrote "Buffett's formula?"... then i went on ignoring it, got pretty close to full marks in the midterm, then my only HD at uni from this subject doing all these discounted cash flows.

 

[Ves]

Yep your overthinking it and Yep it's judgement. Yet here's the ironic part, the judgement that simplifies everything and makes it all click into place will come from your current overthinking process.

Maybe I am trying to make something, that in reality is fairly nebulous, situational, and mostly entirely arbitrarily defined (ie. it is more of an art) into something which can be distilled into a systematic application (scientific).

That's probably a stupid idea - because the more "unknown" it is the more I have to actively think about it each time I sit down and do a valuation, whereas the more systematic it becomes, the less thinking I will probably do.

Hmm.

 

[craft]

Maybe I am trying to make something, that in reality is fairly nebulous, situational, and mostly entirely arbitrarily defined (ie. it is more of an art) into something which can be distilled into a systematic application (scientific).

That's probably a stupid idea - because the more "unknown" it is the more I have to actively think about it each time I sit down and do a valuation, whereas the more systematic it becomes, the less thinking I will probably do.

Hmm.

V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic - I just reckon you should ask how much money they have made from the markets before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.

 

[craft]

Na i know... i'm pretty good that way, haha

Anyway, from the notes in my finance textbook next to annuities, i wrote "Buffett's formula?"... then i went on ignoring it, got pretty close to full marks in the midterm, then my only HD at uni from this subject doing all these discounted cash flows.

So an assumption about Buffett and a Uni subject - Is that all you bring to the table? I reckon you have at least read RM's book? What else?

 

[Ves]

V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic - I just reckon you should ask how much money they have made from the markets before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.

The thing that starts most of these dialogues (in my mind) and makes me pose questions (of myself and, then finally others) is because I get to the point where my natural tendency is to do just that make things easier and I start making decisions by either routine or auto-pilot (they just are because that is how I do it).

Eventually it gets to the point where I realise that this is happening, and I try to force myself to throw everything out the window and the start the thinking process all over again (which is much easier said than done if you have read anything about bias). Usually the first sign of this is boredom - if you are bored, your mind is probably somewhere else, and if it is somewhere else you are not thinking about what you are doing.

My natural mental tendency is law and order (system / science), and everything progresses towards this, probably because that is how we are taught from a young age in the modern Western society... but there is something else inside me that occasionally reminds me to actually think and question everything. It is the creative side that can get easily suppressed.

You once posted that people should read widely, and at the time I may have misinterpreted that, but I find that I read more non-investment books than investment books these days. And oddly enough, sometimes I will find things (to do with mindset and actually thinking) that really help with investing.

 

[McLovin]

V you've given me a warm fuzzy feeling. But that's only because you have stated my beliefs and many people will tell you it can be much easier and made systematic - I just reckon you should ask how much money they have made from the markets before you take their word as gospel. Actually don't listen to me either - everybody has to work out their own 'profitable' truth.

I actually used to think you had a very systematic approach, and would worry that my own "get a little wood on the ball" approach was too simple.

 

[craft]

I actually used to think you had a very systematic approach, and would worry that my own "get a little wood on the ball" approach was too simple.

Probably because I have spent a lot of time talking about the foundations rather then what I specifically do now.

The Don also benefited from a regime of regular practice as shown by the famous exercise in developing ball-sense he undertook with the golf ball and cricket stump against the water tank. Bradman stressed that “there is no substitute for hard work and practice if you want to be successful” in his own coaching manual.

Going out to get a "little wood on the ball" can result in either a century or a first ball duck. somewhat random from innings to innings but the career average is based on skill and preparation.