Present Value of Future Cash Flows

[luutzu]

8-9% dividend yield - you obviously don't expect much..

I actually found one Think it was last October... probably was 7.5% dividend yield.
I put around 40% of my savings into it... don't want to go more in case the reports are wrong, or i might've missed something.


What are your plans with the website there?

A blog or newsletter/research service?

 

[Ves]

Hmmm You are right. Some sort of geometric thing going on with compounding maybe?

Do you know if there is a formula to calculate the right conversion given the reinvestment rate? My brain can't stretch far enough to work it out backwards.

Big thanks.

I've started some digging, but most sources that I have found from the academic world seem to indicate that there is no reliable way of converting a post-tax discount rate into a pre-tax discount rate, because there are too many variables to incorporate.

This paper is interesting, written by Australians, with some further resources in the bibliography that I haven't had the chance to locate.

http://kevindavis.com.au/secondpages/workinprogress/Pre and Post Tax Discount Rates.pdf

Damodaran seems to also stress post-tax cash flows in the writings that I have searched so far.

 

[DeepState]

My required rate of return and the company's ability to meet or surpass it are independent....

....You cannot make plans that says: I will whoop their hind if they first go to A, then act as B, then they will move to C then victory will be mine. But if they move to A, then for strange reasons ignore B and move to B+1, then i'm wrong.

"The Warriors of old act only when it is profitable to do so;
"He only engage in battle when victory is all but guaranteed.
- Sun Tzu.

That's exactly what you guys are doing with detailed discounted cash flow modellings.

All the best with that...err....I'm off this discussion thread too. Cheers.

"Very funny, Scotty. Now beam me down my clothes."
- Captain Kirk, Starship Enterprise

"He who laughs last thinks the slowest!"
- Anonymous discussant on ASF thread

 

[craft]

I've started some digging, but most sources that I have found from the academic world seem to indicate that there is no reliable way of converting a post-tax discount rate into a pre-tax discount rate, because there are too many variables to incorporate.

This paper is interesting, written by Australians, with some further resources in the bibliography that I haven't had the chance to locate.

http://kevindavis.com.au/secondpages/workinprogress/Pre and Post Tax Discount Rates.pdf

Damodaran seems to also stress post-tax cash flows in the writings that I have searched so far.

Thanks for the link VES.

 

[craft]

All the best with that...err....I'm off this discussion thread too. Cheers.

I hope you are just knocking that discussion on the head and not the entire thread, Luutze is not representative of the normal discussion here. I and I'm sure others would like to see you stick around.

 

[DeepState]

I hope you are just knocking that discussion on the head

Just the discussion.

Let's consider the pre and post-tax valuation discount rates where there is no reinvestment. In that circumstance the Pre-Tax cash flows will be 10/7 times Post-Tax flows and stay like that consistently. The after tax PV (excluding franking here - as for an overseas company) is say, 70. The pre-tax valuation = 10/7 x Post-tax valuation. Now, what the heck interest rate gives you that effect? Now, the irony, let's say these two streams are perpetuities with zero growth. PV(AT FCF) = 70/i(after tax). PV (BT FCF) = 100/i(pre tax). Then if PV(after tax)=PV(before tax) we get i(after tax) = 7/10 x i(pre-tax). Just as Ves expected.

As soon as you add reinvestment, you have a problem. If attempting a valuation under pre-tax terms, the valuation is mixed up. You are discounting the pre-tax cashflow, but reinvestment occurs on post tax terms. As a result of this, things get mushed and you begin to see how pre-tax DCF just cannot be made to equal post-tax DCF via some simple ratio between pre/post-tax discount rates. This ratio will depend on the reinvestment rate through the forecast horizon, rate of growth and one one of the discount rates. You can derive it from manipulation of the Gordon Growth Model. If you have different rates of reinvestment through the horizon, get your Excel Solver out...because there is no good solution which can be derived using algebra.

Ultimately, source of truth is the post-tax DCF with NOPLAT adjustments and thus assuming it is fully equity financed and an allowance for distributed franking value. All companies will be free of finance chicanery when analysed on this basis. In the insto market, the general allowance for franking is 60% as a reflection of the proportion of the market that actually derives value from it. Given you value it, it is entirely fine and correct to assume 100% because that is the valuation that is right for you.

Another wrinkle...try discounting dividends. I think you'll find that PV dividends (without franking) is below PV after tax FCF at the same discount rate. The discount rate for dividends should actually be lower than applied to FCF unless you are fully paying out. So if you are doing DDM, you need some arbitrarily lower discount rate than when using DCF on AT FCF. How much arbitrarily lower will depend on payout rate, ROIC, the FCF discount rate....

James T Kirk
Captain, USS Enterprise

 

[Ves]

Thanks for the link VES.

The Lonergan paper that most of these other papers seem to reference can be accessed as a free PDF here.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1435128

Here is another paper on the same topic that shows some examples of how you may use a pre-tax discount rate. It strongly suggests NOT to simply divide the post-tax discount rate by the post-tax rate unless you are using a no-growth perpetuity.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1655691

In general, not many websites / guides / books, focus on this kind of thing. It's mainly the academics from what I have seen and it seems that the prevalent view, from my basic research agrees with RY's post above (thank you by the way). A lot of non-academics have just accepted that doing it on a post-tax basis is much easier? Either most people who follow their lead don't understand the concept or haven't thought about it and they just do what they were taught (with in most cases seems to be based on post-tax cash flow).

Australia is also fairly unique when compared to most other countries, in that the franking credits need to somehow to be incorporated into the valuation. This seems to muddy the pre-tax / post-tax argument compared to places such as the USA.

 

[craft]

So here is an example of the pre/post discount rate issue at @ 90% retention. The future value of the terminal value is not the issue (and you would logically discount both back at the same discount rate) but the PV of the stream does fluctuate.

 

[craft]

And @ 10% Retention

 

[craft]

Back to my gut reaction that it didn’t matter with fully franked dividends and the reason I thought I had isolated only the effect of the PPL in original response to VES.

My underlying logic is that I want my hurdle rate to be 15% before tax. In other words what I want my hurdle rate to be is a grossed up return in my hands of 15% that I will then be liable for tax on.

It seems to me that this hurdle rate in my hand can be transferred directly to Pre-tax cash flows from the business perspective. (In the case of full franking). Less than full franking and the PPL levy does have an impact.




No differences between pre tax rate in my hand and business pre-tax rate.

 

[craft]

Changing only the imputation rate to 28.5% to represent the impact of the PPL. I should isolate only the impact of the levy impact and not be impacted by the Pre/Post issue RY raised

Or am I missing something?

 

[Ves]

For the NPV of the stream with the franking credits can you please try a discount rate of 12.6083% and post the excel screenshot?

PS: Think we all crossed posts before above your Excel screenshots.... just in case you missed the posts.

 

[craft]

For the NPV of the stream with the franking credits can you please try a discount rate of 12.6083% and post the excel screenshot?

PS: Think we all crossed posts before above your Excel screenshots.... just in case you missed the posts.

Just looking at that now - thanks

12.6083? Is this what you want, what is your thinking

 

[Ves]

Just looking at that now - thanks

12.6083? Is this what you want, what is your thinking

View attachment 58100

It only works for the cash flow at the end of year 1. I was trying to reverse engineer it using algebra (it won't show up properly in your spreadsheet because there are decimals missing).

Basically $1 of pre-tax FCF is equivalent to $0.979021 after you take into account that it is franked at a tax rate of 28.5%.

I think I also screwed up the maths slightly.

1 / 0.15 = $0.869565. So you need to find the post-tax discount rate to match this number.

$0.869565 = 0.979021/(1+x)
$0.869565 + $0.869565x = 0.979021 (multiply both sides by (1+x))
$0.869565x = 0.109456 (take away $0.869565 from both sides)
x = 0.125874 (divide by sides by $0.869565)

If you apply this as the discount rate to $0.979021 you will get 0.869565 (the same 1 / 1.15 in the pre-tax equation).

Do the same for your first post-tax cash flow of $0.179748 at year 1 of your spreadsheet. The two amounts should match.

However, I believe that the equations for the later dated years probably have to take into account whatever the year is to the power of itself.

ie. (1+x) ^2

I can't think of a short hand way of doing it at the moment.

You would have a different discount rate for each year to allow for the compounding....

 

[craft]

HI ves

There’s a couple of issues that we could probably get all crossed up here if we are not careful.

Personally I am attached to EBIT to isolate the business performance – I only look to valuing the ‘equity’ itself after I have decided on the business

My focus has been on whether the PPL levy should change my pre-tax profit approach or minimum hurdle. So suspect I could be going off on a tangent to the points RY is making as I am considering things mainly as they pertain to me.

Some other mitigating factors for why I'm sticking with pre-tax, is that my hurdle target is actual set based on pre-tax in my hand that transfers across to the business level(under full franking) without the problems of having an after tax figure that I try to impose on the pre-tax environment. I also don’t use the hurdle rate as a discount rate, my risk is throwing a opportunity away that may come up higher on a full equity valuation that fails the 15% pre-tax hurdle - but it doesn't really matter if it isn't the best available opportunity pre-tax anyway.

I'm stuck in my ways

Now with my excuses for doing things differently than normal out of the way.

For valuing all aspects of equity most faithfully I fully agree with this and if you are reviewing your processes, post tax makes sense unless have some reason sorted in your head for doing something else.

Ultimately, source of truth is the post-tax DCF with NOPLAT adjustments and thus assuming it is fully equity financed and an allowance for distributed franking value. All companies will be free of finance chicanery when analysed on this basis. In the insto market, the general allowance for franking is 60% as a reflection of the proportion of the market that actually derives value from it. Given you value it, it is entirely fine and correct to assume 100% because that is the valuation that is right for you.

Unless you have a specific after tax discount rate that you want to achieve and you specifically want to use only pre-tax analysis – it’s probably better to side step the complexity. (anything to avoid algebra)

 

[DeepState]

Luu

I have screened the ASX for companies:
1. whose Last Reported EPS, capitalized at 9%, exceed the current stock price; and
2. whose dividends exceed 8% on an historical basis.

Here is the list for your further investigation:



Just be careful with how you use this, OK? A lot of these companies are experiencing operating difficulties, declining expectations or otherwise have some risk to their underlying asset base as they are essentially investment holding companies whose reported earnings are not of the same kind as for operating companies.

RY

 

[luutzu]

Luu

I have screened the ASX for companies:
1. whose Last Reported EPS, capitalized at 9%, exceed the current stock price; and
2. whose dividends exceed 8% on an historical basis.

Here is the list for your further investigation:

View attachment 58111

Just be careful with how you use this, OK? A lot of these companies are experiencing operating difficulties, declining expectations or otherwise have some risk to their underlying asset base as they are essentially investment holding companies whose reported earnings are not of the same kind as for operating companies.

RY

Appreciate the patience RY... I'm not going to change anyone's mind, and I am definitely sure you guys aren't going to change mine either.

Not because i'm hardheaded, but because I know where you guys are coming from, what you guys are trying to do, and I just don't see the sense in it.

Out of respect, let me try to put what i'm saying another way.

Firstly, I don't look at a company's current or previous, or even average the previous few years' reported earnings then simply assume that's how it is into eternity.

I spent a great deal of effort to try and understand the business in its entirety... though I haven't done this to the extend i needed yet, I aim to understand the business financial, competitive position, operational performance etc etc... understand to the point where I can say... OK, this company could earn this much right now. BUT, but due to a couple of hick ups, due to this and that, last year, maybe this year and the next... it would most likely earn less than its true earning capacity... .But once these issues, which are relatively minor etc etc... got out of the way, this is how much this company actually earns, right now.

Again, not what it has, not what it just reported, not what its current earnings will grow to be soon... it's current power to earn.

Once I am confident I know that, I do not use the banks' or the market's rate of return... I use my own required rate of return... this could be the same as the banks', it could be the rate at which another opportunity that I can take could return to me etc etc.


Why you guys think doing that is easy or simple I don't know. well, i do know, but that would just be me guessing.

--------

A good story that illustrates what I am trying to do:


During China's Three Kingdoms period, Zhuge Liang, the Prime Minister of Liu Pei's Shu Han Kingdom to the south west was at a small city on the frontier between his and Tsao Tsao's Wei Kingdom to the North. The young Wei King sent his top general, Sima Yen to take the city.

Liang, known throughout the world for his genius, his foresight... some even call him a God because they have seen him again and again predicting the future with almost absolute accuracy... hearing that Sima Yen was marching onto his city, and having just sent his generals and most of his troops elsewhere days ago.. .know he cannot hope to get out of the situation - that he cannot run, and know he cannot fight.

But he knows Sima Yen, he knows the political structure of Wei, the knows the history of Sima Yen and his position, he know the guy and his ambition.

Knowing this, he flung the city gates wide open, sat on the wall and play music.

Having march his soldiers to the gates, Sima Yen halted them, and listen to the music... trying to see from the tune if Zhuge Liang is setting up a trap or pulling a fast one.

Wei's generals urge Sima to attack, they say their spies have reported no sizable troops in the city... that the other generals has gone here and there.. .if only they march in, they will take the city, take Zhuge and the Kingdom of Shu Han will be no more.

Sima says no... that Liang is very clever, he's setting a trap... this and that and ordered his troops back away from the city... running away from it in case the enemy attack from behind... then half a day later, thought otherwise and turned back but Liang and the city's civilians has escaped.

----
A simple look at this story and we just say that Sima is just a cautious coward, that Zhuge Liang is taking a great risk because he have no other choice.

That is not the case.

Zhuge Liang know that Sima does not want to take the city, does not want to capture him and end the war.
He know this because Sima is a brilliant man with great ambition, and Wei's founder, Tsao Tsao, would have told his son to not use or give Sima any power lest the Kingdom is lost to him.

But without Sima, no one else have had a chance of defeating Zhuge Liang... no other generals had come close. And the only reason the Wei King gave Sima this commission was to end Zhuge, after which Sima will be forced to retired... and retired long before he have the chance to build up his army from his commands.

So as long as Zhuge is alive, the Wei King will eventually call on Sima Yen... and with time, he will gain the trust and influence from the army... without Zhuge Liang, Wei will take Liu Pei's, then will take the kingdom of Sun and Sima will have no chance of usurping Wei then eventually reunited China and establish the Jin Dynasty.

But how do you give a guy who doesn't want to fight a good reason to not fight and not be punished by his King? You play on your genius and fame to give the guy reasonable grounds to not fight... .after all Sima Yen did eventually "realised his mistakes" and return to take the city.

-----

What I am trying to tell you is that once you know your subject intimately - know its structure, its thinking, its management, its financial strength, its possible opportunities and possible downsides... you can make decisions in minutes and seconds without crazy forecasts of future cash flows or tax policies or dividend policies

So if you spend time and get to know a business well - and again i don't mean know every single manager or every dollar and cents and assets... but where you can say with good certainty that this business has been able to earn this under difficult circumstances, its product and services are in good demand... this is what it could normally earn, and being a financially strong, profitable business with an enviable position in its industry... chances are in the future it will do as well if not better.

But what that future earning and income stream is, I don't know... and so I won't include it in my valuation.

So by getting its current earning power, you are not simply looking at a reported EPS... and by eyeing the future, you are not trying to be the gods and guess it with accuracy... you simply say, after a lot of hard work and research, say this company currently earns this much, I require this percentage return to take over the world, is the offering price good enough to enable me to do that, good enough to compensate for my possible mistakes...

If yes, you just buy... if not, you go and watch X-Men: Days of Futures Past and try to forget you've just wasted $20 and a couple hours on Spiderman 2.



But you guys obviously think Buffett is a genius because he could do discounted cashflow modelling on top of his head, could recall and forecast all growth rates and possibilities.. and do so with pen and paper while you guys are also geniuses but a bit better because you know how to use a computer and spreadsheets.

I have actually tried to do what you guys are doing just because I want to know how the real professionals would do it, but couldn't bring myself to finish the module because it's just nonsense to me.
And just in case i say that because I can't programme it, I tried it on something else just as complicated and i'm not too bad.

anyway...

 

[DeepState]

Appreciate the patience RY... I'm not going to change anyone's mind, and I am definitely sure you guys aren't going to change mine either....

...But you guys obviously think Buffett is a genius...

I have actually tried to do what you guys are doing just because I want to know how the real professionals would do it, but couldn't bring myself to finish the module because it's just nonsense to me.

anyway...

Luu

Some day, you are going to learn about the difference between a projection and a forecast. That day will be a great one.

We all work off normalised earnings. You seem to think it's just some regression. It is not. We can read financial statements, analyse industries and meet management / competitors / suppliers and customers...at least as well as you can to achieve such aims.

There is a reason why the professional industry - and Buffett - does things the way they do. It is a big call for you to say that it is all nonsense and it might give you pause. But you are nonetheless free to meet them/us in the market and test your mettle. The market is a test of beliefs. The most successful combinations will win out over time.

So I guess we'll see.

Tread carefully alright?

RY

 

[DJG]

I actually found one Think it was last October... probably was 7.5% dividend yield.
I put around 40% of my savings into it... don't want to go more in case the reports are wrong, or i might've missed something.


What are your plans with the website there?

A blog or newsletter/research service?

Without a doubt there would be a few around, would want to be critical of any capital loss outweighing the dividend though. Is the dividend sustainable?

Um.. at the moment busy with other commitments but would eventually like to put my trades, trade journal, thoughts and insights on it. If people follow it, so be it but regardless will still post on it.

 

[luutzu]

Luu

Some day, you are going to learn about the difference between a projection and a forecast. That day will be a great one.

We all work off normalised earnings. You seem to think it's just some regression. It is not. We can read financial statements, analyse industries and meet management / competitors / suppliers and customers...at least as well as you can to achieve such aims.

There is a reason why the professional industry - and Buffett - does things the way they do. It is a big call for you to say that it is all nonsense and it might give you pause. But you are nonetheless free to meet them/us in the market and test your mettle. The market is a test of beliefs. The most successful combinations will win out over time.

So I guess we'll see.

Tread carefully alright?

RY

I obviously have no economic or financial industry experience, so as far as i'm concerned, projections and forecasts is just a guy [myself if i were to do it] telling me something about the future.

And if I am being asked to pay for an asset at a PV where if growth were this in year 1, that in year 2... and if interest rates or the market's required returned can be assume r1, then maybe r2.. .and then after a few years of these growth figures, let's just assume it will be the same indefinitely... If all these ifs, which are based on other ifs I and the guy who's selling me might not be aware of...

What would a person say to that?
I'd asked, what if one or two of your forecasts are off?

If the future don't work out as we forecasts/projected, well you'd pay too high or too low, but we'll fine tune as we go along.

A more important question is: why is it that I have to put money out now, and will only get a return on it later, once, and if, the sun, the moon and the planets aligned?

I mean, i understand the need to wait, to be patient... but to do that and also to hope and pray that i have guessed the future right too?


---

You guys are obviously experienced and well educated in investments, finance and things... me, i'd like to make money on things that doesn't need me to get the future correct, and I'd like to think I have already made money the moment I bought the business - just need to wait for others to agree...

I mean others could already be way ahead of me but i try to not do things I can't reason out.

If corporations are people, I'd like to hang around good people. I can't quantify how beneficial it will be from year to year and if all that benefits will be worth my time, i just know it's not going to be too bad for me.