Present Value of Future Cash Flows

[McLovin]

Incidentally, I would say that almost everybody I know in Wall Street has had as many good ideas as I have, they just had a lot of [bad] ideas too.

I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.

 

[Klogg]

I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.

Agreed. In my limited experience, when I manage my poor choices well and simply accept I made the wrong decision, the rest manages itself.

 

[Ves]

I reckon this is one the best bits of advice you can give anyone. You don't need to hit it out of the ballpark, just limit your downside when you are wrong and let compounding do the rest. Most people have a sort of auto-denial of these things and spend too much time looking at their winners and how they can repeat them, than looking at their losers and how they can avoid them.

I agree - this sort of thing was fairly natural to me. However, the more experience I get the more situations I can come up with that I do not want to be put in.

In a sense risk mitigation (and investing in general) has a lot to do with pattern recognition, and Buffett seems to have that in truckloads, in both positive (positions he exposes himself to) and negative (those he avoids) elements.

 

[craft]

Buffett's speech from Monte Carlo if anyone is interested or has not read it:

http://www.tilsonfunds.com/BuffettNotreDame.pdf

Thanks V

Probably only those who appreciate Buffett will wade through 39 pages – but well worth it.

Thanks for posting.

 

[Ves]

Thanks V

Probably only those who appreciate Buffett will wade through 39 pages – but well worth it.

Thanks for posting.

No worries!

I actually found it pretty light reading - he has an entertaining way of explaining things. An hour tops - unless you really want to get into it and take notes.

Can you have a look at my reply to your post about PMV please? It got left behind on the previous page last week.

 

[systematic]

I've read the second quote before, thanks for posting it...the part that you bolded is the crux for me. For me that means the temperament, discipline etc to avoid style drift and stick to proven methods in good times and bad.

 

[craft]

I noticed something inadvertently when doing my own analysis of PMV since we have discussed it.

I think for the last 10 years I had an average ROIC of about 41%.

I am curious if you treated the PP&E on the balance sheet the same as me. I PP&E in the denominator "net assets employed figure" at cost rather than written down value. If I did not do this the ROIC would obviously be much higher. I thought it made sense because it would be closer to the replacement cost of those assets. However, you could get technical and adjust them for inflation over the years, but that seems like pointless complexity at this stage.

I also included about $30-45 million operating cash in my calculations for each year after PMV took over JST.

I am also using EBIT as my numerator (I know some people use EBIT * (1- tax rate)). EBIT / (Total assets - excess cash - intangible assets - non-interest bearing liabilities ) = ROIC

The reason I ask is because I am interested if we get a similar end result using different methods.

Sorry for not replying

Generally written down value is used for calculating ROIC by the data providers. I understand the argument for using cost price or even more ideally replacement cost; however I don’t feel the need to go to that level of detail. The standard measure paints a rough enough picture of capital intensity which is what I want to know from ROIC.

Your figure look reasonable if you are using ‘cost’. However as I don’t use ROIC implicitly for valuation I have not recorded it over a historical range.

For valuation purposes;

The parts of the business that have no enduring competitive advantage I use replacement value of its assets.

For the franchise parts of the business I use expected returns on new Investments. (This figure is where a historical ROIC number could inform your thinking) [My assumption for this figure is deliberately absent from this post]

I feel I probably haven’t answered what you are looking for which is why I guess I didn’t respond initially.

 

[Ves]

Sorry for not replying

Generally written down value is used for calculating ROIC by the data providers. I understand the argument for using cost price or even more ideally replacement cost; however I don’t feel the need to go to that level of detail. The standard measure paints a rough enough picture of capital intensity which is what I want to know from ROIC.

Your figure look reasonable if you are using ‘cost’. However as I don’t use ROIC implicitly for valuation I have not recorded it over a historical range.

My view is that if it is possible to calculate all of them over a reasonable period of time and compare them. It should be easy to see if the capital intensity of the business as a whole. Generally anything above 20% (especially if it is over a period of 10 years is more) is pretty solid and worthy of further investigation in my view).

For valuation purposes;

The parts of the business that have no enduring competitive advantage I use replacement value of its assets.

For the franchise parts of the business I use expected returns on new Investments. (This figure is where a historical ROIC number could inform your thinking) [My assumption for this figure is deliberately absent from this post]

I feel I probably haven’t answered what you are looking for which is why I guess I didn’t respond initially.

As per my bolds - both of these things are obviously mystical and arcane to a beginner like me. They make sense when written in a book, but beyond that...

For instance, I have read about practical solutions to assess replacement value in authors like Greenwald, but it seems to me that they require a high level of industry knowledge, and in a lot of cases the balance sheet does not go into enough detail to be able to base much of an opinion on these things. It might click for me one day, and I will keep bashing away at it like I am now, but I will admit the concept, although theoretically easy to understand on face value, still boggles me in practice.

Expected returns on new capital deployed is also tough. I try to find businesses that have a long, predictable history if possible. Forecasting is not my forte, at the moment, my best application of this in practice is reviewing the past, playing with a range of variables in the future and trying to determine which is most probable on the limited information that I have. This probably seems hocus pocus to most people reading, and it might turn out that my figures are ridiculous in ten years time. Conservatism seems to be my best weapon whilst learning, but it also opens up errors of omission if you are not brave enough.

I'm still not really confident in the valuations that I am producing (but saying that I would rather do them than rely on a magic-bullet formula). However, if I do not do them, I will become lazy and never get better - so I am trying to be as persistant as possible and come up with some conclusions that seem reasonable enough to act on in the mean time.

I think the best thing I can possibly do at the moment is try to find as many businesses as possible that I can understand.

edit: I never thought of this before, but it is possible that the replacement value concept gives me grief because of the fact that I am a trained accountant who sat through many discussions in university, and whilst studying for my CPA, on the pitfuls of asset values on the balance sheet. Perhaps I am bogged down by academic discourse and I am struggling to see it in a practical light like someone such as yourself who was probably never exposed to such things?

 

[craft]

My view is that if it is possible to calculate all of them over a reasonable period of time and compare them. It should be easy to see if the capital intensity of the business as a whole. Generally anything above 20% (especially if it is over a period of 10 years is more) is pretty solid and worthy of further investigation in my view).

Seems reasonable.

As per my bolds - both of these things are obviously mystical and arcane to a beginner like me. They make sense when written in a book, but beyond that...

Until you are comfortable with the concepts then perhaps the bold should be on 'This figure is where a historical ROIC number could inform your thinking' which is what you are doing - and is where I started.

For instance, I have read about practical solutions to assess replacement value in authors like Greenwald, but it seems to me that they require a high level of industry knowledge, and in a lot of cases the balance sheet does not go into enough detail to be able to base much of an opinion on these things. It might click for me one day, and I will keep bashing away at it like I am now, but I will admit the concept, although theoretically easy to understand on face value, still boggles me in practice.


Expected returns on new capital deployed is also tough. I try to find businesses that have a long, predictable history if possible. Forecasting is not my forte, at the moment, my best application of this in practice is reviewing the past, playing with a range of variables in the future and trying to determine which is most probable on the limited information that I have. This probably seems hocus pocus to most people reading, and it might turn out that my figures are ridiculous in ten years time. Conservatism seems to be my best weapon whilst learning, but it also opens up errors of omission if you are not brave enough.

I'm still not really confident in the valuations that I am producing (but saying that I would rather do them than rely on a magic-bullet formula). However, if I do not do them, I will become lazy and never get better - so I am trying to be as persistant as possible and come up with some conclusions that seem reasonable enough to act on in the mean time.

Seems you undersatnd better then you may think. The Investors job is not one of absolutes but of judjement and skill, for which you get paid well if you get it right and slapped if you get it wrong.

I think the best thing I can possibly do at the moment is try to find as many businesses as possible that I can understand.

The world’s best documented investor sticks tightly to his circle of competence - coincidence - I think not.

edit: I never thought of this before, but it is possible that the replacement value concept gives me grief because of the fact that I am a trained accountant who sat through many discussions in university, and whilst studying for my CPA, on the pitfuls of asset values on the balance sheet. Perhaps I am bogged down by academic discourse and I am struggling to see it in a practical light like someone such as yourself who was probably never exposed to such things?

Being a simplton is my advantage.

 

[Ves]

Thanks, dont get me wrong, I do have ideas on this sort of thing, but they require further refinememt before they can be used! I am still certain that this would be easier to implement in practice if it were my full time focus. A long way to go yet until I am able to finance the capital and income to do this.

 

[craft]

Thanks, dont get me wrong, I do have ideas on this sort of thing, but they require further refinememt before they can be used! I am still certain that this would be easier to implement in practice if it were my full time focus. A long way to go yet until I am able to finance the capital and income to do this.

It’s not that complex or time consuming. (Says he who soaks up far too much time on it – but I’m happily addicted)

It’s more that you are at the stage equivalent of ‘proof’ in mathematics. You don’t need to be able to prove a formula to use it – but in an investment perspective with randomness effecting individual outcomes you do need to go through a very complex proving stage to identify, trust and stick to some simple approaches.

Every time I have mastered some piece of complexity down to simple - I find Buffett has already simply stated my ‘aha’ concept. That’s why he is my touch stone.

 

[Huskar]

Buffett's speech from Monte Carlo if anyone is interested or has not read it:

http://www.tilsonfunds.com/BuffettNotreDame.pdf

I love this sort of stuff. Thanks Ves!

I also find it interesting to note the sometime inconsistencies between what Uncle Warren says and what he does.

For example, his oft-cited confession that he was born with a brain for asset allocation. My opinion is that his expertise came all from hard work. The biography Snowball relates how he knew the important accounting attributes for nearly every listed stock on the American exchange: this gives a pretty damn good base to be able to say this or that company is over/underpriced.

And on the last page of the speech he talks about never using leverage. But this also is illusory. He has never borrowed heavily in a conventional sense (bank debt), but his whole fortune has been built on leveraging off of other people's money, whether in his partnership days or in Berkshire days.

A very interesting recent Buttonwood article in the Economist to which a link was posted somewhere else on this forum (sorry I forget where) relates how Buffet's outperformance came from the use of leverage by way of the large insurance float he had access to. That Buttonwood article cites "Buffet's Alpha" which concludes that Buffet has consistently had 1.6-to-1 leverage.

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

Some food for thought...

 

[craft]

I love this sort of stuff. Thanks Ves!

I also find it interesting to note the sometime inconsistencies between what Uncle Warren says and what he does.

For example, his oft-cited confession that he was born with a brain for asset allocation. My opinion is that his expertise came all from hard work. The biography Snowball relates how he knew the important accounting attributes for nearly every listed stock on the American exchange: this gives a pretty damn good base to be able to say this or that company is over/underpriced.

And on the last page of the speech he talks about never using leverage. But this also is illusory. He has never borrowed heavily in a conventional sense (bank debt), but his whole fortune has been built on leveraging off of other people's money, whether in his partnership days or in Berkshire days.

A very interesting recent Buttonwood article in the Economist to which a link was posted somewhere else on this forum (sorry I forget where) relates how Buffet's outperformance came from the use of leverage by way of the large insurance float he had access to. That Buttonwood article cites "Buffet's Alpha" which concludes that Buffet has consistently had 1.6-to-1 leverage.

http://www.econ.yale.edu/~af227/pdf/Buffett's Alpha - Frazzini, Kabiller and Pedersen.pdf

Some food for thought...

Free/cheap money, that and pricing power are the economics of a wonderful business – It is Buffett 101 and he has deliberately built internal funding via insurance float, deferred Capital Gains Tax and derivative premiums into Berkshire Hathaway.

Taking DTL as an example of the concept:

In 2012 they had

Return on Assets of 8.1% (Ebit/Total Assets)

An Internally financed leverage of 647% which juices the return on funds employed up to 52% (Ebit/equity+debt). This is the line at which Buffett utilises leverage.

Financial Leverage for DTL is just 107% producing Ebit on Equity of 56.3%. (It is at this line that Buffett warns against and steers clear of leverage).

Although some see a contradiction in his use of leverage – I see that he has sung the same tune for a very long time. Free(cheap) , variable with revenue, leverage that doesn’t risk control is wonderful – the other stuff can be toxic even in small doses under the wrong conditions.

Not sure why people are suddenly surprised about the academic paper results, but perhaps they might start to cotton onto the importance of a business’s structural economics – maybe not.

 

[Ves]

It’s not that complex or time consuming. (Says he who soaks up far too much time on it – but I’m happily addicted)

You are right - I don't think it is so much the time factor, it has something to do with focus / energy / distraction / inconvenience. Working full-time can drain focus and concentration levels. You can of course mix both, but by the time I get home at 6pm, have some dinner and sit down to task it is a tough slog to get much done before I realise I probably should be winding myself down before bed. I have often had 'aha' moments and not been able to sleep! It would be nice not having the additional commitment of work in these cases.

It’s more that you are at the stage equivalent of ‘proof’ in mathematics. You don’t need to be able to prove a formula to use it – but in an investment perspective with randomness effecting individual outcomes you do need to go through a very complex proving stage to identify, trust and stick to some simple approaches.

Every time I have mastered some piece of complexity down to simple - I find Buffett has already simply stated my ‘aha’ concept. That’s why he is my touch stone.

I really like how you put this and I can see what you mean (at least more so than I would have 12 months ago).

I often find asking questions on forums (as dumb as they may seem to others) helps clarify my own thought process too. I'll ask a question and for some reason answers that were not previously coming often start to form. I know Buffett (and many other successful people from all fields) say that writing something down or typing it out has this effect.

 

[Ves]

Free/cheap money, that and pricing power are the economics of a wonderful business – It is Buffett 101 and he has deliberately built internal funding via insurance float, deferred Capital Gains Tax and derivative premiums into Berkshire Hathaway.

Taking DTL as an example of the concept:

In 2012 they had

Return on Assets of 8.1% (Ebit/Total Assets)

An Internally financed leverage of 647% which juices the return on funds employed up to 52% (Ebit/equity+debt). This is the line at which Buffett utilises leverage.

Financial Leverage for DTL is just 107% producing Ebit on Equity of 56.3%. (It is at this line that Buffett warns against and steers clear of leverage).

Although some see a contradiction in his use of leverage – I see that he has sung the same tune for a very long time. Free(cheap) , variable with revenue, leverage that doesn’t risk control is wonderful – the other stuff can be toxic even in small doses under the wrong conditions.

Not sure why people are suddenly surprised about the academic paper results, but perhaps they might start to cotton onto the importance of a business’s structural economics – maybe not.

Great post.

Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA? In this case 52% / 8.1% = 641%?

 

[McLovin]

Great post.

Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA? In this case 52% / 8.1% = 641%?

(Equity + debt)/total assets?

craft, thanks for this thread, it's one of the most interesting reads.

 

[McLovin]

(Equity + debt)/total assets?

Flip that around...

 

[Ves]

Flip that around...

Now I am at home I have actually been able to have a proper look.

As follows:

165602 Current liabilities
-135883 Current Assets
1899 Current Tax liability
1433 Current Provisions
20701 Other Current Provisions
1344 Non-current Provisions
671 Other non-Current Provisions
-2222 Other Assets
165602 Current liabilities
-135883 Curren Assets
1899 Current Tax liability
1433 Current Provisions
20701 Other Current Provisions
1344 Non-current Provisions
671 Other non-Current Provisions
-2222 Other Assets
53545 Net internal financing


8278 Contributed Equity

646.8%

Craft can correct me if I am wrong of course, but I assume it is no mere coincidence that I came up with the same figures. I find it weird that there is no literature coming up via a google search in terms of "how to guides" for this. Working it out blind was fun though!

 

[Ves]

165602 Current liabilities
-135883 Current Assets
1899 Current Tax liability
1433 Current Provisions
20701 Other Current Provisions
1344 Non-current Provisions
671 Other non-Current Provisions
-2222 Other Assets
53545 Net internal financing

Not sure what happened, but for some reason when I editted my original post for a spelling error the calculations in this part duplicated on my screen. I have had this issue on the forum before, it is possibly a glitch with Mozilla firefox or the forum software. any how, should look like this for those curious.

 

[craft]

Is there another way of calculating the internal financing leverage of an entity other than ROIC / ROA? In this case 52% / 8.1% = 641%?

As McLovin posted, Total Assets/Funds Employed(debt+equity)

Now I am at home I have actually been able to have a proper look.

As follows:

165602 Current liabilities
-135883 Current Assets
1899 Current Tax liability
1433 Current Provisions
20701 Other Current Provisions
1344 Non-current Provisions
671 Other non-Current Provisions
-2222 Other Assets

53545 Net internal financing


8278 Contributed Equity

646.8%

Craft can correct me if I am wrong of course, but I assume it is no mere coincidence that I came up with the same figures. I find it weird that there is no literature coming up via a google search in terms of "how to guides" for this. Working it out blind was fun though!

You have (nearly) provided the long hand proof here – the ratio is much quicker.