Present Value of Future Cash Flows
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Very nice. I like the CAPE (EP in your case) and I like comparing it to credit even better.
Hey guys,
Return on invested capital (ROIC) and / or Return on Capital Employed (ROCE).
I am currently playing around with this. It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation? I would like to explore issues surrounding goodwill / other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible. For instance, it is possible that a company has overpaid for an acquisition in the past (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.
Return on invested capital (ROIC) and / or Return on Capital Employed (ROCE).
I am currently playing around with this. It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation? I would like to explore issues surrounding goodwill / other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible. For instance, it is possible that a company has overpaid for an acquisition in the past (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.
Hey guys,
Return on invested capital (ROIC) and / or Return on Capital Employed (ROCE).
I am currently playing around with this. It's fairly easy to calculate it on a basic level, although obviously there are many different subtleties.
Does anyone have (or would like to personally discuss) a link to an in-depth discussion around the Funds Employed equation? I would like to explore issues surrounding goodwill / other indeterminable life intangibles, working capital in more detail, and other adjustments that could be made to get to the bottom of the true economic reality of a balance sheet, if at all possible. For instance, it is possible that a company has overpaid for an acquisition in the past (ie Wesfarmers and Coles) and the true return on this asset is technically being understated by the goodwill on the balance sheet.
Feel free to let me know if no such discussion exists and I will gladly keep beating away at it in my own head.
V your post makes me smile, you are getting to the pointy end now.
I haven’t really seen much written on the points you raise.
The penny dropped for me form one of the BH letters (can’t remember which one) but the discussion was around ownership change accounting.
Returns that include indefinite life intangibles have no bearing on incremental returns on new capital and shouldn't in turn be used to calculate "implied" growth rates (retained x ROE) because that will misrepresent future growth rates available. Reasonable future growth estimates and incremental return is what you need to make reasonable estimation of value and you can't obtain them from the historical when change of ownership transactions cloud the balance sheet.
For example, and using a smaller and easier to understand example then WES:
Look at PMV – look at the segment information for Just Group and work out what that business is worth as if it was still standing alone and then ask how much capital can be deployed organically at this rate. If you analyse PMV as a whole it hides the return on capital employed, that its major business segment generates.
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Thanks for that post, craft. This is something I've been thinking about while I was on holiday. So much attention is paid to the possibility of a write-down of goodwill but I'm not sure why such a write down is important, unless of course there are debt/equity loan convenants etc. Capital budgeting 101 tells you that sunken costs are not important in future decision making and yet for some reason so much attention is paid to what a company paid for an asset x years ago rather than what is on the horizon. As you say, it's the return that the next $1 can be invested into the business that's important. I guess in the same vein, it's the ability of the business to generate cash on its tangible assets that really counts. Goodwill is just an accounting construct, to me it seems neither here nor there, except in limited circumstances (esp a growth by acquisition strategy).
I think the BH letter you are referring to is one of the early ones...around 1980, I could be wrong though.
I think the BH letter you are referring to is one of the early ones...around 1980, I could be wrong though.
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I guess what I'm trying to say, in a terribly round-about way, is that RoE is such a dirty number, with so many historic accounting adjustments in it that its use is pretty limited.
Actually this is the exact business that made something "click" in my head for some reason. I had thought about a lot of the principles, but for some reason they never came together, or they didn't feel like they needed to be pursued in a holistic fashion.
The words "incremental capital", "cash flow generation" etc are starting to strike me as much more important to investment decisions that something as basic (but obscured with accounting treatments) as return on equity. Profit is a short-term accounting function, just look at the recent JP Morgan results for an example of what is possible!! But cash is king, it is much harder to hide that without being completely fraudulant in the long run. I think my main purpose as an investor is to find how the business generates cash flow and to find as best as possible how it "sticks" to it in the long-term.
To use a basic example a business like Myer listed upon absolute premium multiples (at least to those who coffed up the money to the private equity cohort), but it never made sense to me to view the profitability of this business going forward based on what equity holders previous coughed up. In this case, I would argue that you can never know the true economics of the business by looking at its ROE.
I will have a flick through, I honestly still need to read these properly. Now might be a good time since I have a better idea of what questions I want them to answer.
This could be what you guys were referring to:
http://gregspeicher.com/?p=1708
Possibly the 2003 letter? I will have a read of the actual letter after work, I don't have the time at the moment unfortunately.
http://gregspeicher.com/?p=1708
Possibly the 2003 letter? I will have a read of the actual letter after work, I don't have the time at the moment unfortunately.
This makes sense - but you were dead right when you once said you have to know what questions to ask before getting any answers out of the great man's letters.
There's a few other pearls of widsom in that very letter too. Just small tidbits that hopefully start to add up for me. The bit about being patient and waiting for your turn to bat again is a good reminder.
The major lesson seems to be: a premium can be paid for a business with good economics, but in the long run, if you can put large amounts of incremental capital into it and earn large returns on this the purchase price often becomes unimportant.
?????
I wholeheartedly agree with this Buffet quote – but only because conventional valuation wisdom generally mis-judges/mis-values cash flow from wonderful as opposed to fair businesses.
However interpreting the principal as wonderful business at any price is a mistake. The purchase price ALWAYS matters. Pay more than the present value of the future cash flows – no matter how wonderful the business and your only possible mechanism for making your required return is selling to a greater fool.
The possibility of future high(er) market price- to-value should be utilised for excess return not made a requirement to make your hurdle rate.
I meant the purchase price of an entry as defined by the accounting entries. This can create artificially low return on equity in the beginning.
But over time, the cash flows that the asset generates more than make up for this. The purchase price, loses context over time, in this respect, that's what I meant by unimportant, not that you would pay well over-the-odds for an asset of any sort.
When I say premium I refer to "goodwill" and the associated purchase entries that are added to the balance sheet.
But over time, the cash flows that the asset generates more than make up for this. The purchase price, loses context over time, in this respect, that's what I meant by unimportant, not that you would pay well over-the-odds for an asset of any sort.
When I say premium I refer to "goodwill" and the associated purchase entries that are added to the balance sheet.
Some back of the envelope numbers for PMV to illustrate how intangibles on the balance sheet distort the economic reality and usefulness of ROE.
Market Cap: $770M
BRG Investment: $175M
Cash: $300M
Market Cap less Cash and BRG = $295M + $135M debt gives EV of $430M
Forecast guidance for Just Group = EBIT of 80M.
EV/EBIT of 5.4 times on subdued retail market profit. Average profitability suggests 95M EBIT in more normal conditions.
As I see it PMV is cheapest retail asset comparatively, but by no means the worst. Just generates a normalised EBIT margin on funds employed of 43%. Has 5 proprietary clothing brands with big online presence that will do O.K over time plus Peter Alexander and Smiggle which have bright prospects. PMV has a cashed up balance sheet and about 230M in franking credits to boot.
Mis-understood and out of fashion – produces buying opportunities. Mind you it’s not as cheap now as in the GFC where you could buy it for less than its cash holdings.
Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.
Market Cap: $770M
BRG Investment: $175M
Cash: $300M
Market Cap less Cash and BRG = $295M + $135M debt gives EV of $430M
Forecast guidance for Just Group = EBIT of 80M.
EV/EBIT of 5.4 times on subdued retail market profit. Average profitability suggests 95M EBIT in more normal conditions.
As I see it PMV is cheapest retail asset comparatively, but by no means the worst. Just generates a normalised EBIT margin on funds employed of 43%. Has 5 proprietary clothing brands with big online presence that will do O.K over time plus Peter Alexander and Smiggle which have bright prospects. PMV has a cashed up balance sheet and about 230M in franking credits to boot.
Mis-understood and out of fashion – produces buying opportunities. Mind you it’s not as cheap now as in the GFC where you could buy it for less than its cash holdings.
Of course I could be wrong because valuing PMV using some other popular methods which would feed in a ROE of around 5%, means it’s a dog stock – but that doesn’t make sense to me, so they sell – I buy.
Im personally very keen to be able to find and identify any business that is trading at a value less then its cash holding. Does anyone have any quick method of scanning to identify possible culprits that can then be weedled down properly ?
Craft,
This is what I meant.
Let us say an entity is purchased and after all the accounting adjustments the cost on the balance sheet is $10.
The entity earns $0.70 of profit on this asset. The return on equity would read 7%. But they can retain 50% of these earnings and re-invest them at a return of 25%.
year equity earnings roe dividend retained
1 10 0.7 7% 0.35 0.35
2 10.35 0.7875 8% 0.39 0.39
3 10.74 0.89 8% 0.44 0.44
4 11.18 0.99 9% 0.49 0.49
5 11.69 1.12 10% 0.56 0.56
6 12.25 1.26 10% 0.63 0.63
7 12.88 1.42 11% 0.71 0.71
8 13.59 1.60 12% 0.80 0.80
9 14.38 1.80 12% 0.90 0.90
10 15.28 2.02 13% 1.01 1.01
11 16.29 2.27 14% 1.14 1.13
After only 10 years the reported return on equity has doubled!! There are limitations to this example (my rounding being one of them). It does not take into account any discount rate or inflation, it just shows you what the return on equity figure will be like over time in such a business...
Spot on.
Accounting ROE will always be dragged towards incremental return on new investments.
my original ????? were just because I read your line
to literally. I agree with your clarifications.
I think the PMV example I put up spells out what you are saying in real life – A fair chunk of their incremental investments will not be earning 5% as per their accounting ROE but ~40% as per their subsidiary’s return on funds employed.
Big question is how wisely will they deal with the cash and franking credits on hand.
I feel like I've found the tip of a really big iceberg in this last week or two. There's a lot to go over, and the issue of incremental capital is not always straight forward (ie. service companies that require very, very little capital to expand). DTL is possibly the first to come to mind in this respect. It would appear on first glance that their "capital", since they have very little in the way of physical assets, revolves around expanding their skilled workforce as their market share expands, or indeed improving revenue per employee if possible. It seems hard to imagine return on invested capital in this situation. The report will be released tomorrow. Perhaps it will help me if I give it a thorough read.
