Present Value of Future Cash Flows

McLovin said:

My approach is generally to look for companies that have recurring business models. From my experience estimating future cash flows is a lot easier when a high % of them are recurring in nature. By way of example an insurance company has about 80-85% of its customers renew year after year, so at the beginning of each year you can get a rough estimate of what premium income will be for the year (of course there are a myriad of variables that may change this). In these sort of recurring business models the cost of customer acquisition is also low (80% of your customers are coming back without any cost) which means the business can grow using less cash. At the other end of the spectrum would be contracting businesses that I generally class as speculative, only because without being able to sit down with management it is very difficult to know how the business is tracking.

To determine whether a company is undervalued, I use a mix of DCF and an absolute P/E model. The P/E model can be good for getting a ball park number and the DCF allows me to get in a bit deeper and understand what drives cash flow. I come up with a price range, then look for a margin of safety in case things go wrong. In the spirit of Greenwald, I don't like paying for growth because I really don't know whether it will eventuate. I think one of the biggest mistakes many investors make is paying for blue sky, IMO that should be a bonus.

It's quite a simple strategy, but it gets the job done. For some reason I also find a pen and paper gives me a better understanding of a company than a computer does. Weird.

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Hi McLovin

Great post – well at least it certainly resonates with me.

Not sure why everybody thinks DCF is so tricky – it’s not like you have to do the calcs longhand any more. And if you put valuation at the end of the research process where it needs to be so that you have the best chance of making realistic assumptions, you probably won’t be doing that many valuations anyway.

In relation to paying for growth – I will include short term growth on a risk weighted basis accoring to it's certainty but I don't generally put growth into any terminal part of the calc, unless it is something like WOW where I would use a conservative estimate of GDP. Greenwald should be mandatory reading for Investors.

I agree that once you know a bit about what you are doing the back of an envelope with a few shortcuts can give you a pretty good pre-emption of what the full works analysis will come out at

craft said:

Hi McLovin

Great post – well at least it certainly resonates with me.

Not sure why everybody thinks DCF is so tricky – it’s not like you have to do the calcs longhand any more. And if you put valuation at the end of the research process where it needs to be so that you have the best chance of making realistic assumptions, you probably won’t be doing that many valuations anyway.

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Thanks craft.

I think wrt to DCF there are two big issues most people have:

1) They don't really understand the business. You can't build a DCF valuation by looking at a few numbers on Commsec.

2) Not all businesses are suitable to that type of valuation. Take MCE, if I attempted a DCF on that it would be no better than spinning a roulette wheel and coming up with a number. There are far too many variables to make it reliable.

The closer the business is to an annuity the more accurate a DCF valuation will be, hence I tend to gravitate toward recurring revenue type companies.

craft said:

In relation to paying for growth – I will include short term growth on a risk weighted basis accoring to it's certainty but I don't generally put growth into any terminal part of the calc, unless it is something like WOW where I would use a conservative estimate of GDP. Greenwald should be mandatory reading for Investors.

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I agree. I think WOW is a classic example of overpaying for growth. It has the highest margins of almost any grocery chain in the world and, as I think I've mentioned before, margins are notorious for being mean reverting.

Greenwald is excellent and a bit overlooked. He mixes quantitative and qualitative better than most and forces you to really think about how one effects the other, IMO.

Which books from Bruce Greenwald do you guys recommend?

McLovin said:

Thanks craft.

I think wrt to DCF there are two big issues most people have:

1) They don't really understand the business. You can't build a DCF valuation by looking at a few numbers on Commsec.

2) Not all businesses are suitable to that type of valuation. Take MCE, if I attempted a DCF on that it would be no better than spinning a roulette wheel and coming up with a number. There are far too many variables to make it reliable.

The closer the business is to an annuity the more accurate a DCF valuation will be, hence I tend to gravitate toward recurring revenue type companies.

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DCF in isolation is useful but I think a lot of value rests in doing sensitivity analysis on the inputs.

So you know what variables drive returns for a business. Is it high or low fix costs? How much profit is lost for every 1c improvement in $A? What input costs are underthreat? What will rising commodity price do to a project? What is the impact of a loss of 5pts market share?...

While equally you can't accurately predict what the $A, input costs, commodity price or market share will behave in the future, it allows you to test your logic for congruency, and it allows you to react quickly when things do change.

Ves said:

Which books from Bruce Greenwald do you guys recommend?

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'Value Investing: From Graham to Buffett and beyond' and 'Competition Demystified'


Plus there is a fair bit of Greenwald stuff floating around the internet.

This is a good paper (All Strategy is Local) that will give you a feel for Greenwald.
http://www.capatcolumbia.com/Articles/FoStrategy/All Strategy is Local.pdf


If you prefer Videos, this is an appetiser. Lots of others videos on youtube etc.
http://fora.tv/2009/02/07/Bruce_Greenwald_on_Value_Investing_Buy_Cheap_Obscure_and_Out_of_Fashion


These two videos are a bit more obscure to find. They run to three hours and are pretty poor quality but if you are interested in Greenwald then they are gold.

Part 1
http://www.gurufocus.com/news/97636/value-investing-seminar-by-bruce-greenwald-

Part 2
http://www.dailymarkets.com/stock/2010/06/18/value-investing-seminar-by-bruce-greenwald-part-2/

Lecture Notes
http://www.scribd.com/doc/15987706/Greenwald-Earnings-Power-Value-EPV-lecture-slides

skc said:

DCF in isolation is useful but I think a lot of value rests in doing sensitivity analysis on the inputs.

So you know what variables drive returns for a business. Is it high or low fix costs? How much profit is lost for every 1c improvement in $A? What input costs are underthreat? What will rising commodity price do to a project? What is the impact of a loss of 5pts market share?...

While equally you can't accurately predict what the $A, input costs, commodity price or market share will behave in the future, it allows you to test your logic for congruency, and it allows you to react quickly when things do change.

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Hi SKC

I have a slightly different take on sensitivity analysis for valuing Businesses, and it probably has to do with timeframes. What you have put is the sort of DFC I would expect business management to be making on their short/medium term Capex, but I take a longer/larger perspective for the valuation of the business.

I take into consideration the types of variables you are referring to when looking at the business’s competitive advantage and economics. There will always be fluctuations/increases in costs (known and still unknown), what I’m interested in is whether the business can neutralise these through its pricing power and how margins will cycle because of any lags in increasing price. The same goes for demand, is there consistent demand or are will profits cycle because of variable demand. I’m not interested in businesses that experience large volatility in margin or demand.

I’m looking to make the best ‘full cycle’ assumption I can and feed these into the valuation models. I use multiple models but I don’t do sensitivity analysis with each model – To do so, sort of negate my attempts to make my best assumption about the inputs. If I don't feel I can make good full cycle assumptions - that is where it ends - I don't attempt to value them. Buying cheaper than my valuation is how I attempt to protect myself from making poor assumptions.

In Collin Nicholson latest free newsletter he has published Michael Kemp’s ‘Intrinsic Valuation’ Presentation given at the 2011 AIA Conference. In my opinion it’s very well articulated piece from an Australian Author. Very worthwhile reading if you are interested.

http://docs.google.com/viewer?url=http://www.bwts.com.au/_n.cfm?127&key=56504047

Thanks for all the links and recommendations, Craft. i will definitely add these to my reading list.

Craft, in what sense and in which context are the concepts of portfolio allocation (or weighting) and diversification important to the successful implemetation of your approach?

edit: Personally, I am leaning towards around 10-15 stocks to stop a "dividend cut" from derailing my portfolio in one foul swoop.

Ves said:

Craft, in what sense and in which context are the concepts of portfolio allocation (or weighting) and diversification important to the successful implemetation of your approach?

edit: Personally, I am leaning towards around 10-15 stocks to stop a "dividend cut" from derailing my portfolio in one foul swoop.

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Hi V

I have set myself some rules for diversification. Within my SMSF I hold a minimum of 7 and a maximum of 10 Companies when fully invested. Outside Super the respective numbers are 5 and 8.

The minimum number of holdings is there as a protection against unknowns and because I am a minority holder with no control over management. The maximum number of holdings is to force focus.

These Min and Max have implications for capital allocation. Ie the most I can allocate to one company in my SMSF is 14.2% and the minimum if fully invested is 10%. I work all my calculations on purchase price and don’t adjust for market movements which skew things over time, for example the top 3 stocks currently account for 65.2%

I have no formal rules for diversification between sectors etc, but I do think about how each piece fits as part of the whole.

I’m not sure if any of this is ‘technically’ right but it is what works for me, though I am continually evaluating it. At the moment the merits of rebalancing, is exercising my mind as it has been for the last year or so – I’m a slow thinker, actually the problem is that Logically I don’t want to cut my winners short but psychologically I am uncomfortable with where the market has taken the diversification.

craft said:

I’m not sure if any of this is ‘technically’ right but it is what works for me, though I am continually evaluating it. At the moment the merits of rebalancing, is exercising my mind as it has been for the last year or so – I’m a slow thinker, actually the problem is that Logically I don’t want to cut my winners short but psychologically I am uncomfortable with where the market has taken the diversification.

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Craft, you seem to be taking a thoughtful approach.
Personally, I think diversification is over-rated. If you have some ongoing winners, why would you want to limit your profits just for the sake of diversification?

Julia said:

Craft, you seem to be taking a thoughtful approach.
Personally, I think diversification is over-rated. If you have some ongoing winners, why would you want to limit your profits just for the sake of diversification?

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My head agrees with you – my emotions see me continually re-evaluating the question. The volatility that the concentration causes seems to raise no ends of prompts to re-evaluate. Normally when I have adopted a strategy based on research and logic the emotions fall into alignment, but not with this issue. So far the head is winning the battle.

craft said:

These Min and Max have implications for capital allocation. Ie the most I can allocate to one company in my SMSF is 14.2% and the minimum if fully invested is 10%. I work all my calculations on purchase price and don’t adjust for market movements which skew things over time, for example the top 3 stocks currently account for 65.2%

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Food for thought.

I can definitely see why you would allocate on cost since you are paying for an income stream in the first instance, not market movements.

My instincts tell me that I should be able to devise some sort of quality rating system or critera to help define allocation. This would be centered around income earning potential / yield on cost growth, rather than the traditional capital growth alternative.

The sentiment of limiting the number of stocks that you invest in is a great idea. You describe it as a way of keeping focus; and it rings true in my limited experience. Keeping a track of more than 12-15 companies at any one time is a nightmare.

http://www.thediv-net.com/

Here's a network of US & Canadian investors that aim to build long-term passive income via growth dividend streams.

It's a shame there isn't anything similar for the ASX, but there is some good company analysis theory that could be applicable for those interested.

Some quotes that indicate that Buffett uses present Value of Future Cash Flows to estimate value.

How do you think about value?
The formula for value was handed down from 600 BC by a guy named Aesop. A bird in the hand is worth two in the bush. Investing is about laying out a bird now to get two or more out of the bush. The keys are to only look at the bushes you like and identify how long it will take to get them out. When interest rates are 20%, you need to get it out right now. When rates are 1%, you have 10 years. Think about what the asset will produce. Look at the asset, not the beta. I don’t really care about volatility. Stock price is not that important to me, it just gives you the opportunity to buy at a great price.

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Q&A with 6 Business Schools 2009

Intrinsic value is terribly important but very fuzzy. We try to work with businesses where we have fairly high probability of knowing what the future will hold. If you own a gas pipeline, not much is going to go wrong. Maybe a competitor enters forcing you to cut prices, but intrinsic value hasn't gone down if you already factored this in

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If you calculate intrinsic value properly, you factor in things like declining prices.

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BRK Annual Meeting 2003

If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years ... Businesses have coupons too, the only problem is that they're not printed on the instrument and it's up to the investor to try to estimate what those coupons are going to be over time

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If you attempt to assess intrinsic value, it all relates to cash flow. The only reason to put cash into any kind of investment now is that you expect to take cash out--not by selling it to somebody else, that's just a game of who beats who--but by the asset itself ... If you're an investor, you're looking on what the asset is going to do, if you're a speculator, you're commonly focusing on what the price of the object is going to do, and that's not our game. We feel that if we're right about the business, we're going to make a lot of money, and if we're wrong about the business, we don't have any hopes of making money.

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BRK Annual Meeting 1997

To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics.

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BRK Annual Meeting 2002

Some quotes relating to the discount rate.

We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.

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BRK Annual Meeting 2003

which is a little contradictory to this one

We don’t formally have discount rates

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but in the same AGM Munger said

Everything is a function of opportunity cost.

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&

The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about the returns from each.

The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly

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BRK Annual Meeting 2007

Putting it all together I take it that they don't have a set hurdle rate - but they use a single floating rate for comparison purposes that continually varies to reflect the return of their best current opportunity.

I have also read but can’t find a quote that Buffets uses a minimum rate if the ‘best alternative opportunity rate’ falls too low. The minimum is based on Government bonds + a liquidity premium. The liquidity premium represents how much current return he is prepared to forego to wait in cash for a better opportunity.

craft said:

Some quotes that indicate that Buffett uses present Value of Future Cash Flows to estimate value.

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Yes: and Robert Hagstrom in The Warren Buffet Way also discusses Warren's use of DCF analysis so no doubt it is another tool in Warren's arsenal (just as - according to Snowball and all technical analysts might note - when Warren was young he read everything he could on stock market trends and technical charts). But I think on closer analysis the quotes you give still are consistent with Greenwald's warning that DCF analysis is to be used with caution. Greenwald agrees that short to medium term cash flows can be predicted with quite good accuracy. The problem comes when you try and predict the longer term. And as he says, good information + bad information = bad information...

WB relates the discount of cash flows specifically to bond coupons - and relates this to stocks only with the warning that it is up to the investor to discern what the coupons of a stock held for a 100 years might be.

Huskar said:

Yes: and Robert Hagstrom in The Warren Buffet Way also discusses Warren's use of DCF analysis so no doubt it is another tool in Warren's arsenal (just as - according to Snowball and all technical analysts might note - when Warren was young he read everything he could on stock market trends and technical charts). But I think on closer analysis the quotes you give still are consistent with Greenwald's warning that DCF analysis is to be used with caution. Greenwald agrees that short to medium term cash flows can be predicted with quite good accuracy. The problem comes when you try and predict the longer term. And as he says, good information + bad information = bad information...

WB relates the discount of cash flows specifically to bond coupons - and relates this to stocks only with the warning that it is up to the investor to discern what the coupons of a stock held for a 100 years might be.

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Estimating the future cash flows is where all the skill is required. There is no valuation model that will substitute for a failure in getting the future cash flows reasonably accurate.

Greenwald’s advice is very astute. Best to err on the conservative side in calculating cash flows especially the further you go out eventually paying nothing for the potential long dated cash flows. Better to be pleasantly surprised down the track then remorseful.

Cheers and thanks.

craft said:

Estimating the future cash flows is where all the skill is required. There is no valuation model that will substitute for a failure in getting the future cash flows reasonably accurate.

Greenwald’s advice is very astute. Best to err on the conservative side in calculating cash flows especially the further you go out eventually paying nothing for the potential long dated cash flows. Better to be pleasantly surprised down the track then remorseful.

Cheers and thanks.

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Hi Craft,

Would you be willing to post an example of a DCF? I posted my simple method of DCF on another thread. See below:-

“Have you ever used the valuation tools on www.moneychimp.com? They have a tool which converts a 2 stage DCF into an benjamin graham style intrinsic value formula. Using the credit suisse global investment returns yearbook 2011 as a reference the nominal return from equities on the ASX is 12.4%, this is sufficent as a discount rate and assuming that a company will continue to grow after the first 5 years at a rate of 2% you end up with a simple conservative IV formula of P/E ratio = 8.5 + 0.5 x G where G is the growth rate. I like the simplicity of the formula and believe it is sufficient to see if there is any of margin of safety particularly with established companies”

For an established company the remainder of my valuation is to somehow quantify my confidence that the company is still going to making cash in a few years time. The confidence comes from the profitability, operating history of the company, management and my view of the world. I am looking for a business where I am at least 80% confident it is going to be making cash in a few years time. 80% confidence and a discount of 30-40% to my conservative IV is a fair investment, note the use of the word fair, not great just fair. 5 minutes to do the DCF and a couple of hours to quantify my confidence.

Cheers

Oddson

odds-on said:

Hi Craft,

Would you be willing to post an example of a DCF? I posted my simple method of DCF on another thread. See below:-

“Have you ever used the valuation tools on www.moneychimp.com? They have a tool which converts a 2 stage DCF into an benjamin graham style intrinsic value formula. Using the credit suisse global investment returns yearbook 2011 as a reference the nominal return from equities on the ASX is 12.4%, this is sufficent as a discount rate and assuming that a company will continue to grow after the first 5 years at a rate of 2% you end up with a simple conservative IV formula of P/E ratio = 8.5 + 0.5 x G where G is the growth rate. I like the simplicity of the formula and believe it is sufficient to see if there is any of margin of safety particularly with established companies”

For an established company the remainder of my valuation is to somehow quantify my confidence that the company is still going to making cash in a few years time. The confidence comes from the profitability, operating history of the company, management and my view of the world. I am looking for a business where I am at least 80% confident it is going to be making cash in a few years time. 80% confidence and a discount of 30-40% to my conservative IV is a fair investment, note the use of the word fair, not great just fair. 5 minutes to do the DCF and a couple of hours to quantify my confidence.

Cheers

Oddson

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Hi Oddson

Money chimp looks good to me. There are quite a few free valuation models on the internet and most of them are pretty good.

What you are doing seems logical enough to me. I like the fact that you have found credit Suisse year book and are using some long dated history to ground your thinking.

When I think about risk – and I predominantly think my job as an investor is risk management. – I split risk into three categories.

• Default risk
• Valuation Risk
• Earnings risk.

When I look at default risk – I am looking to see if the company is likely to experience an event that could cause its bankruptcy. There is no use in a company having great prospects in 5-10 years time if it is dead in 4. The company default analysis require one assumption that is NOT true, and that is that I can predict the future cash flows and company structure correctly.

The same with the Valuation Models – they require the incorrect assumption that I can predict the future cash flows correctly. As I can’t, all a valuation model really does is stop you over paying for the cash flow you have projected.

Given the first two models are dependent on getting the cash flows accurate, 99% of my time and thinking goes into earnings risk.

The companies I hold or are really interested in, I model their financial reports and project them forward based on my assumptions. Those assumptions and how well I can make them is where earnings risk comes into play. My valuation is simply to run an IRR on the bottom line to determine the projected yield. The yield is determined without the sale of the asset, but a terminal valuation is included at the end of the cash flow projections, that terminal value is normally the replacement value of the physical assets unless I am absolutely convinced the company has a sustainable competitive advantage, in which case It will be some sort of multiple of replacement asset value.

I have a minimum yield below which I stay in cash (Online saver interest rate + liquidity option value) otherwise I concentrate my buying on the highest yielding opportunities.

My rudimentary valuation when scouting for potential research opportunities has now become internalised – I don’t do any explicit valuation, but am looking at a whole raft of things EV/EBIT, ROIC/NTA, FCF blah blah blah. I find valuation at this stage a bit like beauty – you know it when you see it but it’s hard to define. I have nothing against using something more explicit at this stage but I found everything potentially gives false positives and negatives. You miss some opportunities you should investigate further and pick up some dogs that can potentially bite. Any rudimentary valuations which ignore earnings risk should never be the sole basis for investment decisions IMO.

Cheers