Present Value of Future Cash Flows

[Ves]

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.

Thanks

Perhaps I am reading your message wrong, but I think I know what you mean, because it sounds exactly what I am trying to achieve... however, I'm yet to find a way to represent my thinking on competitive advantage and earnings cycles in a mathematical fashion that seems to make complete sense.

Part of me thinks that there must be a better way to represent earnings power than is represented in the text books as standard DCF practice* . Am I correct in saying that your method diverged from this over the course of your journey this far? Picking a forecast cash flow for year 1, 2, 3, 4 and so on however far you want to go into the future seems a bit counter-intuitive to me. Your posts read to me that you do something different to this (although it's hard to discern how far different).

*Standard text book is similar to the 25 years spread sheet you posted.

 

[Ves]

Greenwald said this in 2008 about American Express in this article

http://money.usnews.com/money/perso.../07/bruce-greenwald-on-value-investing?page=2

American Express: If you ask yourself what the average yearly earnings should be even in a fairly distressed economic environment, it's probably about $3.50 a share. Typically, they commit to pay out at least half of those earnings to you in cash, so you're getting a 7 percent cash return either in buybacks or the dividend. Then they reinvest 7 percent of your money. In the short run, where that money is going is cash to protect themselves financially against any catastrophic drop in credit card repayments, but in the long run it's going to credit card loans, and the economics of those are fairly transparent: They lend at 15 percent, borrow at 4 or 5 percent, have a 10 percent margin, and the default rate is around 5 percent. So they make 5 percent on every dollar of loans, and they leverage up because you can because it's fairly safe. Even if they do 7 to 1, which is a fairly conservative ratio, you're making 5 percent times seven on your unemployed equity capital which is 35 percent, or 20-percent-plus post-tax. And billings by American Express just grow over time. It's probably faster than GDP because they have high-income customers, and spending is skewed towards services, which are growing faster than (spending) on goods. You probably get another 5 percent even making conservative growth (projections). You're looking at returns, without any improvement in the multiple, of well over 20 percent. That's the sort of investment (Buffett) sees. It gives you an enormous margin of safety for long-lived bad economic conditions.

The short-hand formula for something like this is:

Expected Return (IRR) = Div Yield % + Buyback Yield % + Future Growth in cash Returns % + Organic Growth % (ie return to trend cyclical earnings) less a margin of safety based on probability of company losing its competitive position

Obviously any growth priced in has to be profitable growth within a franchise & there is the caveat that any numbers are based on the company maintaining its competitive position....


Which reminds me I need to get around to reading Leibowitz' Franchise Value now that I have got more questions to ask...

 

[craft]

Which reminds me I need to get around to reading Leibowitz' Franchise Value now that I have got more questions to ask...

I hope you like formula's - but if any book is going to get you near a mathematical solution to what you are searching for it will be that one.

Grab your wife and try to have a simple game of noughts and crosses using only your mind to record the moves. What's easy visually is not easy from memory.

What am I trying to say? - you can't easily reduce judgement to a system or formula.

I suspect you already know enough of what is important ( I would swap your research/analysis skills for mine) - how you accept/act on it without being able to proof it seems to be an issue though, maybe that's where you need to concentrate for a while. but I don't have any advice on that as I was just born arrogant enough to back the beliefs I believed I had logically reached.

 

[Ves]

I hope you like formula's - but if any book is going to get you near a mathematical solution to what you are searching for it will be that one.

Grab your wife and try to have a simple game of noughts and crosses using only your mind to record the moves. What's easy visually is not easy from memory.

What am I trying to say? - you can't easily reduce judgement to a system or formula.

I suspect you already know enough of what is important ( I would swap your research/analysis skills for mine) - how you accept/act on it without being able to proof it seems to be an issue though, maybe that's where you need to concentrate for a while. but I don't have any advice on that as I was just born arrogant enough to back the beliefs I believed I had logically reached.

Good idea with the noughts and crosses.... I play a lot of chess, and she won't play because I'm *too good*, maybe blindfolded chess would even the stakes. I do a lot of chess puzzles where you cannot move the pieces and need to think a few moves ahead (http://www.chesstempo.com - it's free) and yes, visual memory and thinking visually does not come easy for me (my visualisation skills are also pretty weak with art, remember faces, picking up minor details on movies / real life scenarios etc). I'm much better at words and numbers.

I'm also much better with big picture vs small picture, and that's probably why I get stuck with valuation. For instance, I'm happy to look at Navitas, assess the business model and prospects, and say that it has the potential to be five times bigger and generate $500m+ cash flow in 25 years or something like that (PS: take that with a grain of salt, those numbers are for illustrative purposes only, they may not be my actual projections). Maybe it'll take longer, maybe it'll be a few years shorter. Or it won't happen. It seems to me that the smaller details have a lot of influence in a DCF model because of its reputation to having a sensitivity to variables.

The trouble with valuation is that I need to fill in all the minor details and project how it will get there to come up with a net present value. It's not an exact science - I know that. But I still find it hard to come up with those details in a way that I can place enough conviction in, so that's where I get stuck. And that's probably the "proof" part. Expressing the big picture in the form of mathematical calculations. That's an art. I'm getting better at it - and by that I mean I actually do it and make purchases...

 

[Ves]

Hi craft

I've read the first 30-odd pages of the Leibowitz book (Franchise Value) and it's really interesting - a focus on the future capital investments that can be ploughed into a franchise (strong competitive position) and the excess profitability spread above the cost of capital that the firm can reap. It's not so much a matter of how long, but how much - rather than Dividend Discount Model (DDM) and its reliance on "smooth growth".

I also like the comments about "knowable" and the concept of hyper-franchise (the unknowable cream on top that you can't and don't value - the faith / belief part).

Reading your post again

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.

Safe to say that you really like this book?

Can't wait to see some of the maths later in the book...

 

[VSntchr]

Hoping someone can help me try to understand subscriber acquisition costs a little better.

I understand that they are expenses such as advertising that are 'capitalised' as intangible assets which are then amortised over a specified period.

But how does this actually work from a cash perspective? Are the costs that are identified as subscriber acq. costs excluded from the PnL and sent straight to the balance sheet - to then be recognised in the PnL over the future periods through amortisation?

If my description above is correct then I think it would be safe to say that this should not be added back when normalising earnings as one would do for say - acquired customer bases.

For some reason the whole concept of adding back certain amortised intangibles bends my mind and sends me in loops, so hopefully someone a little more educated can shed some light or point to some relevant reading...

 

[McLovin]

But how does this actually work from a cash perspective? Are the costs that are identified as subscriber acq. costs excluded from the PnL and sent straight to the balance sheet - to then be recognised in the PnL over the future periods through amortisation?

Yes. The expense is capitalised so is removed from the P&L and only the amount to be amortised over that period will be expensed. From a cash perspective, OCF will be higher because the capitalised costs will appear in ICF, in the same way that any other capex would.

If my description above is correct then I think it would be safe to say that this should not be added back when normalising earnings as one would do for say - acquired customer bases.

Hmmm...It kind of depends. Capitalising expenses is a pretty good way to massage earnings (I won't mention that BRG had a $2m jump in capitalised expenses this FY). How confident can you really be that they will earn a return on that "investment" or that it's not just stay in business marketing which is really just an expense. Generally, I think of capitalised expenses as a warning sign that management are fairly aggressive with their accounting and I'd usually add it back to get a proper picture of what's going on. That does mean that earnings will be lower than what they otherwise would be when a company is going through a high growth phase, but better to err on the side of caution.

 

[hiddencow]

I understand that they are expenses such as advertising that are 'capitalised' as intangible assets which are then amortised over a specified period.

..

Advertising is not an expense that usually qualifies for being capitalised.

 

[VSntchr]

Yes. The expense is capitalised so is removed from the P&L and only the amount to be amortised over that period will be expensed. From a cash perspective, OCF will be higher because the capitalised costs will appear in ICF, in the same way that any other capex would.


Hmmm...It kind of depends. Capitalising expenses is a pretty good way to massage earnings (I won't mention that BRG had a $2m jump in capitalised expenses this FY). How confident can you really be that they will earn a return on that "investment" or that it's not just stay in business marketing which is really just an expense. Generally, I think of capitalised expenses as a warning sign that management are fairly aggressive with their accounting and I'd usually add it back to get a proper picture of what's going on. That does mean that earnings will be lower than what they otherwise would be when a company is going through a high growth phase, but better to err on the side of caution.

Thanks McLovin, that helps me wrap my head around it a lot better. As for the adding back, I was referring to the amortisation of the created intangible, rather than the initial capitalisation...
But what you have said seems like prudent conservatism.

Advertising is not an expense that usually qualifies for being capitalised.

Agree HC, but if you look through a few of the telco's reports you will find subscriber acquisition costs. I didn't mean advertising per se, but if you look at the taxation guidelines there are a number of expenses which are possible to be grouped under this category if they fit. See here: http://www.aasb.gov.au/admin/file/content105/c9/INT1042_12-04.pdf

 

[McLovin]

Thanks McLovin, that helps me wrap my head around it a lot better. As for the adding back, I was referring to the amortisation of the created intangible, rather than the initial capitalisation...
But what you have said seems like prudent conservatism.

Yeah, add back the amortisation but subtract the full amount that was capitalised for the period.

 

[Ves]

I still can't think of much else more psychologically intimidating (in my life) than the market (at least from an investor's perspective).

It's full of contradictions and conflicts (arguably self-created).

On one hand... sharp, and often sustained, declines in stock prices (I'm talking individual stocks, not the ASX as a whole) present opportunities to buy future cash flow streams at great prices.... as long as you don't need to commute the asset, it can stay there for years and it's a great benefit, even better if you have the liquidity to keep buying.

On the other hand.... if you are wrong in your initial assessment you're toast. But you often won't know for a long time.

The only "real time" performance data you often have is probably on a different feedback loop.

Sometimes trying to be patient in a world full of instant gratification and constant streams of information that lead to popular opinions that can turn on a dime is pretty tough, especially when the market (and often other participants) are keen to offer you a white flag or an easier way out should you need it...

...other times it's a well timed slap in the face that makes you better at identifying risk and how it applies to your own strategy.

This probably won't help anyone deal with the issue, but often it's a good idea to recognise it.

 

[craft]

I still can't think of much else more psychologically intimidating (in my life) than the market (at least from an investor's perspective).

It's full of contradictions and conflicts (arguably self-created).

On one hand... sharp, and often sustained, declines in stock prices (I'm talking individual stocks, not the ASX as a whole) present opportunities to buy future cash flow streams at great prices.... as long as you don't need to commute the asset, it can stay there for years and it's a great benefit, even better if you have the liquidity to keep buying.

On the other hand.... if you are wrong in your initial assessment you're toast. But you often won't know for a long time.

The only "real time" performance data you often have is probably on a different feedback loop.

Sometimes trying to be patient in a world full of instant gratification and constant streams of information that lead to popular opinions that can turn on a dime is pretty tough, especially when the market (and often other participants) are keen to offer you a white flag or an easier way out should you need it...

...other times it's a well timed slap in the face that makes you better at identifying risk and how it applies to your own strategy.

This probably won't help anyone deal with the issue, but often it's a good idea to recognise it.

For something as simple as buying cash flows for less than they are worth – it isn’t easy.

The more you listen to the market and everybody tell you you’re wrong the harder it is.

Are you wrong? Only you can answer that and you have to answer it unequivocally before you can happily stand in the face of volatility, criticism and uncertainty and come out the other end holding the excess return that doing so offers. If you have any doubts that you can be a strong hand (truly committed) the earlier you choose to fold the better.

Being wrong (being defined as wrong on the business analysis) on some stocks doesn’t mean you’re not suited to an analysis approach – It just means sometimes you’re wrong. Sell, take your punishment and move on. No matter how you tackle the market you have to become a good loser. But the question of magnitude of an individual loss is an important factor – fundamental investing doesn’t lend itself to small loses on individual stocks when the businesses fail to perform how we expect.

If you need near term liquidity or the market to immediately reinforce your opinion/position use a market price reactive approach. My personal opinion is that there is no easily available excess return from such a crowded, transactionally expensive, zero sum approach but it may be better then capitulating as an investor.

None of this post is directed at you VES just a general response to the difficulties you expressed in your insightful post.

 

[Ves]

None of this post is directed at you VES just a general response to the difficulties you expressed in your insightful post.

Thanks craft... and you have added another insightful post yourself. I am still thinking about your comment in another thread re: significant highs as a scan. I'll let it churn around in my head for a while (months) and see what comes of the idea.

 

[galumay]

This probably won't help anyone deal with the issue, but often it's a good idea to recognise it.

It helps a little! I go thru the same thought process not infrequently, it is important to have a clarity of mind and a way to shut the noise out - while listening for clues that may lead to nectar!

Certainly one of the challenges with this style of strategy is the long wait before you know whether you have got it right or not.

 

[tech/a]

For something as simple as buying cash flows for less than they are worth – it isn’t easy.

The more you listen to the market and everybody tell you you’re wrong the harder it is.

Particularly if the trade is also heading south.

Are you wrong? Only you can answer that and you have to answer it unequivocally before you can happily stand in the face of volatility, criticism and uncertainty and come out the other end holding the excess return that doing so offers.

If you see that your valuation is one you wish to take advantage of---wouldn't it be easier if you waited to take the trade when it was heading north?

If you have any doubts that you can be a strong hand (truly committed) the earlier you choose to fold the better.

Agree.
But is true commitment a guarantee of profit?--No
Could be blind faith in your valuation in face of evidence to the contrary.
Surely a confluence of positive price action with valuation be desirable.

Being wrong (being defined as wrong on the business analysis) on some stocks doesn’t mean you’re not suited to an analysis approach – It just means sometimes you’re wrong.

Any approach really

Sell, take your punishment and move on. No matter how you tackle the market you have to become a good loser.

Great point and one Ill add to.
This releases you to be able to take advantage of other opportunity.
I think also it can often be a case of timing---right analysis---wrong time---often my problem.
But easily overcome if evidence continues to confirm your analysis---just keep at it!

But the question of magnitude of an individual loss is an important factor – fundamental investing doesn’t lend itself to small loses on individual stocks when the businesses fail to perform how we expect.

True but it can---again timing.
I for the life of me cant see why you cant hold a long term undervalued view---yet monitor your timing of entry and in many cases re entry based upon price.

If you need near term liquidity or the market to immediately reinforce your opinion/position use a market price reactive approach

.

OR as I have suggested a synergistic approach

My personal opinion is that there is no easily available excess return from such a crowded, transactionally expensive, zero sum approach but it may be better then capitulating as an investor.

A few here including me would disagree.


Why don't we run a test case.

The Fundi experts picks say 5-10 stocks that are undervalued and we trade them longer term and I and the other Techi experts use the same stocks picked by the Fundies but the Techies attempt to out perform the pure Fundi traded portfolio's

If we decide not to trade it give us a few more in the portfolio to have a watch list--say 5 more so say have a stable of 15 and try and get the best performance out of each method.

Run it for a year or 3

I made this suggestion last year when the best fundamental picks for 2014 came out.



Was met with horror at even suggesting it!---don't know why.
Surely we can collaborate!

 

[craft]

I made this suggestion last year when the best fundamental picks for 2014 came out.

View attachment 60803

Was met with horror at even suggesting it!---don't know why.
Surely we can collaborate!

You talking about this thread?

https://www.aussiestockforums.com/forums/showthread.php?t=27748&page=2&highlight=hybrid

My view is still the same as expressed there.

Interesting you recall that exercise as

horror at even suggesting it

I thought it just died then normal Tech/A death of no follow through on a comprehensive exercise.

 

[craft]

If you see that your valuation is one you wish to take advantage of---wouldn't it be easier if you waited to take the trade when it was heading north?

Ah opportunity costs.....

I lifted this from a previous post - hopefully you can understand.

– in the context of my investment philosophy, which is to buy assets that generate a greater ‘real’ cash flows over their life time then the price paid for them.

Once an opportunity is identified, there are two risks in relation to timing, one is buying too early, the other is missing out on the price that gives rise to the opportunity.

Buying too early means I suffer a few % points of opportunity cost over my envisaged time frame but I have at least locked in acceptable actual return. (so long as my assumptions were correct).

The ramifications of ‘could have, would have, should have’ are potentially unlimited opportunity costs and missing the opportunity to lock in an acceptable actual return.

Buying too early is a mistake of commission that sucks. ‘Could have, would have, should have’ is a mistake of omission that whilst probably easier to bear, can ultimately be a lot more detrimental to wealth creation.

Obviously I would like to buy at the absolute low – but I’m not that good, given my fallibility I err on the side of buying too early rather than missing out. But I’m not oblivious to the charts or the short term momentum of the business – they guide how aggressively I accumulate

I have made more mistakes of commission then most, but probably less mistakes of omission then most. That's a hard psychological path to tread - but long term market has rewarded it exceptionally.

 

[craft]

Could be blind faith in your valuation in face of evidence to the contrary.

That is not a valid argument against fundamental investing - Only poor implementation of a strategy ignores evidence to the contrary.

That failure will kill any approach.

Following the business trend and ignore evidence contrary to our opinion about the business, is no different to following the price trend and ignoring contrary evidence about the price. The former doesn't invalidate FA just as the latter doesn't invalidate TA

 

[craft]

I for the life of me cant see why you cant hold a long term undervalued view---yet monitor your timing of entry and in many cases re entry based upon price.

In addition to the previous post points - Scale.

Why don't we run a test case.

Try running your test case with a 25M plus account size.

 

[craft]

A few here including me would disagree.

Excellent - no opportunity for outperformance in the market without disagreement.