Present Value of Future Cash Flows

DJG said:

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.

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I think it's sustainable. Have looked very closely at its capital structure, current assets, cash flows, payout ratio... its performance over past 10 years, its recent declines [still grow its earnings at 15 to 20% p.a. over past 5 years]. But who knows, I was only testing the data and found it too good to wait.

Good luck with the site. I'll check back now and then and will learn.

I find it really educational to write your ideas out. Forces us to confront it and structure our approach properly. That and pick fights with smart people on here

It does help, hopefully the odd person may learn a thing or two. Although I'm not even the slightest bit close to being as seasoned as some.

Hi craft

craft said:

HI ves

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

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I agree - and we a crossing over a number of different purposes here.

My focus seems to be in the same vein as your focus, that is I am an investor and I am interested in the present value of the cash flows that I estimate that I will receive in the future (this also includes any compounding from reinvestment by the company). For comparison, it is easier if these are converted and discounted to NPV in pre-tax terms.

Granted, that a hurdle rate and a discount rate can be different as we discussed, it seems fine to me to use an arbitrary rate of 15% (or something else) in your IRR calculations. If those cash flows actually occur... then that is the return that you will receive. I am not sure how this could be mathematically incorrect.

As you have commented, the PPL levy changes to franking mean that the company FCF is slightly different by 1.5% than it would be in your own hands.

Therefore, the main question is whether you want to change your own hurdle rate to compensate for any return lost due to this change. (I believe that originally this discussion started because myself (maybe RY) confused this with another issue - ie. the effect of pre-tax cash flows on valuation in terms of compounding with pre-tax figures etc).

I'm not really in the business of comparing tax and debt structures across companies, like you I prefer it easier to work on the EBIT level, as it feels more consistent.

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)

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I screwed around with this for another hour before work this morning. It would appear that it is much easier to go from post-tax discount rates to pre-tax discount rates. The second paper in my previous post outlines how this is possible in a DCF valuation - I have not been able to figure out how to go from a pre-tax discount rate to a post-tax discount rate, and to be honest it's not really worth spending any more time working out how until I actually have a reason to complete such a calculation....

My understanding of the issue from a theoretical stand point is that the main caveats in DCF valuation, and as we are looking at cash flows to investors it is probably not an issue, is ensuring that the only difference between pre-tax and post-tax cash flows is the tax component. If there are other non-cash entries that do not include tax amounts then the discount rates used may be inaccurate and not readily comparable.

I hope we are on the same page. If not let me know.

Say a company has two operating segments.

One has a competitive advantage which I believe is well entrenched.

The other segment doesn't operate with a competitive advantage (or disadvantage). It's worth the replacement cost of its assets. (However, as an added aside, this segment does provide cross-selling opportunities into the more profitable segment).

In a valuation I would need to value both segments separately.

I am currently running a DCF on the segment with a competitive advantage. It can pay out most of its earnings, as it does not require much capital to grow. I've factored in the cost of the growth for this segment into the DCF.

However - some of the cash flow generated by this segment is reinvested into the second segment (that roughly earns its cost of capital over the cycle).

Should I exclude this from the "discretionary cash flow" of the first segment entirely as it is not contributing to profitable growth? (ie. it does not add any value to the company)

Ves said:

Say a company has two operating segments.

One has a competitive advantage which I believe is well entrenched.

The other segment doesn't operate with a competitive advantage (or disadvantage). It's worth the replacement cost of its assets. (However, as an added aside, this segment does provide cross-selling opportunities into the more profitable segment).

In a valuation I would need to value both segments separately.

I am currently running a DCF on the segment with a competitive advantage. It can pay out most of its earnings, as it does not require much capital to grow. I've factored in the cost of the growth for this segment into the DCF.

However - some of the cash flow generated by this segment is reinvested into the second segment (that roughly earns its cost of capital over the cycle).

Should I exclude this from the "discretionary cash flow" of the first segment entirely as it is not contributing to profitable growth? (ie. it does not add any value to the company)

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It shouldn't matter if you include the discretionary cash from the first segment going into your hand or into the second segment - so long as the 'cost of capital' is equal to the 'return' you can make from alternative investments.

One thing to note is that the second segment may have a competitive advantage by being associated with the first segment in that the first segment provides the cash flow certainty to leverage up (and at lower borrowing costs) the second and get a financial structure benefit, ie ROA at cost of capital because their is no competitive advantage but ROE is sustainably higher because of the debt servicing ability of the first segment.

MMS is an interesting case study on two segments as you have described with the above 'association' competitive advantages.

craft said:

It shouldn't matter if you include the discretionary cash from the first segment going into your hand or into the second segment - so long as the 'cost of capital' is equal to the 'return' you can make from alternative investments.

One thing to note is that the second segment may have a competitive advantage by being associated with the first segment in that the first segment provides the cash flow certainty to leverage up (and at lower borrowing costs) the second and get a financial structure benefit, ie ROA at cost of capital because their is no competitive advantage but ROE is sustainably higher because of the debt servicing ability of the first segment.

MMS is an interesting case study on two segments as you have described with the above 'association' competitive advantages.

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Hi craft, thanks for that. Handy to know - just have to be satisfied that the second segment does not fall into competitive disadvantage and destroy value in that case.

You have a good eye for detail in more ways than one. MMS is one of the companies where I have been considering this very issue.

Your comments about the competitive advantage by association and the fact that this can mean access to cheaper financing I will consider (TGA *might* fit under this category as well).

I think CAB probably does as well.

Highly relevant to MMS, and would make sense to the context of their recent announcement on the conditions that they are experiencing in the UK and the opportunities that this presents.

I'm a bit reluctant to put much excess value on their asset management segment at this point, more from conservatism, but any upside would definitely be a bonus, and the company does not look super expensive at the current prices (there was beginning to be some buffer under $10 for regulatory risk in the medium to long-term too).

In the latest GMO quartley, I found the third section “In Defense of Risk Aversion” by Ben Inker interesting.

Conclusion
Believing that value matters is not quite the same thing as believing that valuations mean revert. If you believe that value matters but valuations do not necessarily mean revert, you should move your portfolio of risky assets around pretty aggressively as valuations shift among the various risky assets. But you should keep a fairly constant allocation to risky assets over time except in the rare instances where valuations are so extreme that risky assets are actually priced to lose out to lower-risk assets. That strategy will outperform a naïve strategy over time, but if valuations do mean revert, it is substantially sub-optimal. If valuations mean revert, you can improve the risk/reward trade-offs of your portfolio substantially by adjusting how much risk you take through time, taking more risk when the return to risk is high, and less when it is low.

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https://www.gmo.com/Asia-Pacific/CMSAttachmentDownload.aspx?target=JUBRxi51IIBfJXb8ASd8%2bVowJLvycx5qwpkOml5KFkvpvW%2bFH01T2tgNC6TBXFMfdUu3Sib0A6H1wXqswGANpVNDG7ycvtoaXx9pPFbuICtgm2NB7on9jjJqObH0znrt

Is that a fancy way of saying that they rebalance based on implied risk premiums?

I'll ask this here, because it's more related to my personal curiosity than it is to SBB

craft said:

The point is that any 'conclusion' you reach with imperfect information could just as easily be explained by another plausible explanation. Facts you don't have to question, but opinions, which is what we form when evaluating imperfect or insufficient information need inverting.

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How long did it take you to internalise this process and make it more of a "reflex action"? Or do you still find yourself falling into bad habits and not 'inverting' as much as you would like at times? Do you have a prompt to remind you?

Ves said:

I'll ask this here, because it's more related to my personal curiosity than it is to SBB



How long did it take you to internalise this process and make it more of a "reflex action"? Or do you still find yourself falling into bad habits and not 'inverting' as much as you would like at times? Do you have a prompt to remind you?

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I still don't do it enough but I'm getting better with experience (experience = learning the hard way)

The prompt is reality. The future keeps turning out different enough then I expect - especially at the detail level. That's enough for me to realise I really know squat and enough for me to keep challenging my own opinions and an open mind to other possibilities.

Sometimes I can catch myself being complacent and will be more diligent in inverting to try and identify the risks/opportunities I haven't comprehended yet but mostly its a different reality emerging that kicks my butt into gear.

Reviewing a diary (or even a forum post) of what you thought would unfold compared to what eventually evolves is really beneficial for learning that you don't know what you think you know.

craft said:

In the latest GMO quartley, I found the third section “In Defense of Risk Aversion” by Ben Inker interesting.



https://www.gmo.com/Asia-Pacific/CMSAttachmentDownload.aspx?target=JUBRxi51IIBfJXb8ASd8%2bVowJLvycx5qwpkOml5KFkvpvW%2bFH01T2tgNC6TBXFMfdUu3Sib0A6H1wXqswGANpVNDG7ycvtoaXx9pPFbuICtgm2NB7on9jjJqObH0znrt

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In relation to stock selection, GMO believes the most mean-reverting variable is EBITDA margin.

In relation to the article, GMO have been very prescient on market return predictions over something like 7-10 year periods. However, one lament which Jeremy Grantham makes is that those who start on the journey (in GMO multi-asset portfolios which use the concepts embedded in Inker's note) don't tend to be the same as those at the end. There are many ways someone can read that statement.

craft said:

I still don't do it enough but I'm getting better with experience (experience = learning the hard way)

The prompt is reality. The future keeps turning out different enough then I expect - especially at the detail level. That's enough for me to realise I really know squat and enough for me to keep challenging my own opinions and an open mind to other possibilities.

Sometimes I can catch myself being complacent and will be more diligent in inverting to try and identify the risks/opportunities I haven't comprehended yet but mostly its a different reality emerging that kicks my butt into gear.

Reviewing a diary (or even a forum post) of what you thought would unfold compared to what eventually evolves is really beneficial for learning that you don't know what you think you know.

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Thanks, that's helpful. The reality that you talk about is exactly what I have been facing in the past few months, there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning. It's a real eye opener, and it makes me feel a bit sloppy (maybe lazy). The more I think I know, the less I really know. Whilst my results are still OK, I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then. Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects). It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful... But I disgress, thanks for the input.

Ves said:

Thanks, that's helpful. The reality that you talk about is exactly what I have been facing in the past few months, there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning. It's a real eye opener, and it makes me feel a bit sloppy (maybe lazy). The more I think I know, the less I really know. Whilst my results are still OK, I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then. Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects). It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful... But I disgress, thanks for the input.

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Ves – probably the most insightful post I have seen.

Here’s some things I know about you.

You can analyse earnings risk and understand competitive advantage.

You can analyse financial risk of a corporate structure and comprehend any economic advantages or disadvantages embedded. (ie capital intensity etc)

You can avoid valuation mistakes because you can form your own view on valuation using a raft of valuation tools.

That all means you can find quality businesses at a price that makes sense.

You convert your current excess capital to well priced quality assets on a regular and consistent basis.

The long term score card is the cash you receive back from your assets but you won’t get your investor report card on that basis for a long time. If you are looking for the market to score your approach on an interim basis then expect its evaluation of your method to vary with its bull/flat/bear phases.

Taking on risk when it’s appropriately priced is the determinant of successful investing. Appropriate pricing requires a true and honest appreciation of what you don’t know about the future.

Reaching the stage where I lost all my false sense of certainty was a critical step for me – I had by that stage however, still enough faith in my judgement of identifying mispriced risk to be a strong hand in sizing and holding certain exposures and continuing on made all the difference.

All your work comes down to making good judgements. (the catch 22 is you can’t make good judgements without the background work) Continuing beyond random outcomes with bad judgement will ultimately results in failure, continuing on with good judgement results in success.

Ves said:

Thanks, that's helpful. The reality that you talk about is exactly what I have been facing in the past few months, there have been things that I either didn't understand properly or didn't think of at all with a few companies that I own and some that I never got around to owning. It's a real eye opener, and it makes me feel a bit sloppy (maybe lazy). The more I think I know, the less I really know. Whilst my results are still OK, I often get that sinking feeling that it's not so much the work that I've put in, but more about the bull market I bought into circa 2011-2013. I haven't really had any outstanding purchases since then. Some of this is probably due to impatience and the very thing that makes value investors quit or be unsuccessful (they fight the market when they should be focusing on long-term business prospects). It's the second-guessing of your own ability that is the real killer in most things (especially investing) - remember strong hand / weak hand? In times like this hard work (which creates confidence), distinguishing worry from productive thinking, and remembering core values to my investing style / strategy are helpful... But I disgress, thanks for the input.

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Hi Ves,

This has really resonated with me, a great observation, I often feel the same.

I try to think of it as swimming with the current. My efforts may speed up or slow down the progress, but a large/most of the progress with determined by overall market movement.

Continuing to invest using the same strategy, while my portfolio was falling, has been more difficult than I thought it would be.

In Giverny capital letters, they talk about Rule of 3, which I find comforting to remeber:
- One year out of three, the stock market will go down at least 10%.
- One stock out of three that we buy will be a disappointment.
- One year out of three, we will underperform the index.

DeepState said:

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

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Turning out to be quite a nice portfolio, up about 11% (I've excluded funds).

craft said:

Ves – probably the most insightful post I have seen.

Here’s some things I know about you.

You can analyse earnings risk and understand competitive advantage.

You can analyse financial risk of a corporate structure and comprehend any economic advantages or disadvantages embedded. (ie capital intensity etc)

You can avoid valuation mistakes because you can form your own view on valuation using a raft of valuation tools.

That all means you can find quality businesses at a price that makes sense.

You convert your current excess capital to well priced quality assets on a regular and consistent basis.

The long term score card is the cash you receive back from your assets but you won’t get your investor report card on that basis for a long time. If you are looking for the market to score your approach on an interim basis then expect its evaluation of your method to vary with its bull/flat/bear phases.

Taking on risk when it’s appropriately priced is the determinant of successful investing. Appropriate pricing requires a true and honest appreciation of what you don’t know about the future.

Reaching the stage where I lost all my false sense of certainty was a critical step for me – I had by that stage however, still enough faith in my judgement of identifying mispriced risk to be a strong hand in sizing and holding certain exposures and continuing on made all the difference.

All your work comes down to making good judgements. (the catch 22 is you can’t make good judgements without the background work) Continuing beyond random outcomes with bad judgement will ultimately results in failure, continuing on with good judgement results in success.

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Hi craft

Thank you for the encouragement - I think I've got a long way to go yet with some of those concepts that you mentioned, but you are right in saying that I do know what they all are and I at least know where to start looking (ie. competitive advantage, financial structure, earnings risk) and experience will provide some cream on top of what I already do know. I try to not get too far ahead of myself, to use a metaphor I feel like the initial part of my journey was finding the right road for me, and now that I have found that road I need to learn how to walk it.

I believe that when Buffett mentioned that 90% of investing revolved around temperament he assumed that the investor already had enough background knowledge (without being a rocket scientist) to be able to start applying it to real life scenarios.

The other statements in your post that resonate with me are "Risk adjusted returns" and "mispriced risk" (beating the market over the long-term is one thing, but doing so with less (calculated) risk is ideal).

I also like the focus on cash flow (both received from the company & which the company can re-invest at higher returns than me as an investor).

I like Socrates approach "I know nothing" (which fits into losing that false sense of certainty that you mentioned). If you believe that you know nothing it forces you to keep asking questions.

The hardest part (at least for me) is keeping these concepts close to the front of my thinking when the noise gets louder. A good example of where I would like to go as an investor was your recent post in the NVT thread and a post in this thread about DTL's earnings cycle vs current market pricing. It is occurrences such as NVT & MMS, and the UGL re-structure that I have found difficult to interpret because I hadn't seen them in real-life scenarios, in real-time, with real money on the line. It would be interesting to see how my response to each would differ if I walked away for a week or two and did not respond immediately.

The removal of the instant gratification of getting immediate or regular feedback on your investments is a pretty hard concept to get my head around. Definitely something that I need to work on, but something I know that I can do if I put my mind to it.

KnowThePast said:

Hi Ves,

This has really resonated with me, a great observation, I often feel the same.

I try to think of it as swimming with the current. My efforts may speed up or slow down the progress, but a large/most of the progress with determined by overall market movement.

Continuing to invest using the same strategy, while my portfolio was falling, has been more difficult than I thought it would be.

In Giverny capital letters, they talk about Rule of 3, which I find comforting to remeber:
- One year out of three, the stock market will go down at least 10%.
- One stock out of three that we buy will be a disappointment.
- One year out of three, we will underperform the index.

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Hi KTP

I remember reading one of the Giverny letters that mentioned those three things (I probably even linked it on here somewhere?). The rule of 3 is a good mental model, it probably also works if you invert it (ie. 1 stock out of 3 will be a really good buy).

I'm probably a bit different to you in that my goal is to find stocks that I can hold forever and as craft once put it buy the cow for its milk with no intention of reselling it. Please note that when my intention and reality diverge, I may need to sell because the cow stops producing quality milk, but not for the reason of cashing it in to vindicate my initial decision to buy. That potentially means that I can ignore the tide?

Ves said:

That potentially means that I can ignore the tide?

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Or perhaps it means that on low tide you will be busy buying those hard-to-buy-always-expensive hold forever businesses...and on high tide, you'll be off surfing :bowser:

Oh and BTW, some great discussion here VES.

Hi craft

I noticed in your previous posts further up the page in this thread the Excel valuation examples that you linked were 25 years in length for the "cash flow" period.

Given that you aim to invest in companies which you believe have enduring / robust competitive advantages this would make sense it allows you to forecast up to two or three economic cycles ahead (I assume that you do indeed do this for companies in which you have a strong conviction on their quality). Logically, the longer a company can plough excess capital into a strong economic position (edit: at rates in excess of your required return), the more that company should be worth. The difference is fairly obvious if you compare a valuation with 10 years of cash flow projections versus a valuation with 25 years of cash flow projections.

I will admit that I have not been comfortable going beyond 10 years of projections at this point, but I have found that with companies such as Navitas (NVT) it does not provide enough scope to factor in the long-term expansion into key overseas markets that in my opinion could potentially bear fruit for a very long time yet.

Would it be fair to say that Buffett would never have bought Coca Cola at the price he did if he was only looking at the next 10 years + Terminal value?

Of course it is a company by company judgment. It definitely forces you to focus higher up the quality chain.

I have been pondering this for many months and keep coming back to this conclusion...

VSntchr said:

Or perhaps it means that on low tide you will be busy buying those hard-to-buy-always-expensive hold forever businesses...and on high tide, you'll be off surfing :bowser:

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VS, that sounds like a fantastic plan to me!

Ves said:

The more I think I know, the less I really know.

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Great post Ves!

"The first and wisest of them all confessed to know this only: that he nothing knew"...

Ves said:

Hi craft

I noticed in your previous posts further up the page in this thread the Excel valuation examples that you linked were 25 years in length for the "cash flow" period.

Given that you aim to invest in companies which you believe have enduring / robust competitive advantages this would make sense it allows you to forecast up to two or three economic cycles ahead (I assume that you do indeed do this for companies in which you have a strong conviction on their quality). Logically, the longer a company can plough excess capital into a strong economic position (edit: at rates in excess of your required return), the more that company should be worth. The difference is fairly obvious if you compare a valuation with 10 years of cash flow projections versus a valuation with 25 years of cash flow projections.

I will admit that I have not been comfortable going beyond 10 years of projections at this point, but I have found that with companies such as Navitas (NVT) it does not provide enough scope to factor in the long-term expansion into key overseas markets that in my opinion could potentially bear fruit for a very long time yet.

Would it be fair to say that Buffett would never have bought Coca Cola at the price he did if he was only looking at the next 10 years + Terminal value?

Of course it is a company by company judgment. It definitely forces you to focus higher up the quality chain.

I have been pondering this for many months and keep coming back to this conclusion...

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The 25 years you refer in that example was only to see the magnification over time that small changes to the imputation system made.

I don't forecast 25 years in advance for valuation. I do consider if the business is cyclical into the future so as to not be potentially misled by current numbers - but that's really about the extent of the forecasting. The rest is competitive advantage, how sustainable that is and how much can the business be expanded within that advantage.

I assume Buffets reasoning for coughing up for Coke was the durability of its competitive advantage and its world scale for expansion.