Students of Roger Montgomery's (Buffett's) intrinsic valuation method

[New Stratos]

Yes, I had a go at using the Free Cash Flow for companies where they had negative NPATs, but I felt that you really need to use it for all years so that you don't end up comparing apples and oranges, so to speak.

There were a couple of problems with doing this, firstly it is considerably more time-consuming to enter the data (and one of the advantages of the RM formula is it supposed to be quick); Secondly, I still ended up with IV figures that were all over the place.

(What was a significant improvement in reducing the number of spurious PORs of 100% was accounting for the Dividend payments in the year they were earned, not paid. So if you have a big profit and total dividend one year, the dividend doesn't swamp a smaller profit the following year.)

So, yes, the FCFF may be 'better' in some regards, but I'm really interested in working out how best to handle this particular issue (NPAT losses) in Roger's Model; he obviously does handle them but is loath to say how

 

[Tysonboss1]

Yes, I had a go at using the Free Cash Flow for companies where they had negative NPATs, but I felt that you really need to use it for all years so that you don't end up comparing apples and oranges, so to speak.

Yes, Just remember cashflows are real. NPAT is not always real, hence why some companies end up with negative npat.

For example if you were tracking Westfields NPAT over 20 years it would be a real story of boom and bust, with big valuations increases followed by valuation decreases.

However if instead you tracked the free cash flow produced, it would be a much truer picture of earnings growth and at the end of the day it is the free cashflow that is paid in dividends and reinvested so I would say that is more important.

 

[McLovin]

So, yes, the FCFF may be 'better' in some regards, but I'm really interested in working out how best to handle this particular issue (NPAT losses) in Roger's Model; he obviously does handle them but is loath to say how

How do you know he uses that model when a company is making a loss?

 

[Tysonboss1]

How do you know he uses that model when a company is making a loss?

switch that to reporting a loss, there is a slight difference.

 

[New Stratos]

How do you know he uses that model when a company is making a loss?

I don't know for sure which model he uses when a company reports a loss - I'd like to know, but he won't tell

However, it would be seriously dodgy to switch models (or inputs to models) to suit the results - it would mean inter-year comparisons were invalid or at least less valid.

Despite the fact that the published tables don't let you use the model in the book for negative NPAT situations (or RR outside 8-14%, ROE outside 5-60%), he has said he does use it, and that the tables are just to make things simpler ... If you use the formulae he generates the tables from you can generate values for any value of RR and ROE and from there calculate IV for negative NPAT.

The issue is how do you treat the Pay Out Ratio:

* cap the POR at 100% on the basis that you paid out more dividends than you made profit and Roger has said to cap POR at 100% => positive value for the dividend portion, large negative figure for the equity portion = - IV (which is nonsensical)
* simply divide Dividends by the Negative Number, result = -POR =>positive value for the Dividend part of the formula and a larger positive figure for the equity part (because 1--POR = POR of 1.something) = exaggerated? IV
* set POR = 0 => dividend portion = 0 (silly if dividends have been paid as they have a value) equity value is positive = a positive value for IV

See the attachment for examples in the order shown above

View attachment POR demo.xlsx

 

[New Stratos]

Yes, Just remember cashflows are real. NPAT is not always real, hence why some companies end up with negative npat.

For example if you were tracking Westfields NPAT over 20 years it would be a real story of boom and bust, with big valuations increases followed by valuation decreases.

However if instead you tracked the free cash flow produced, it would be a much truer picture of earnings growth and at the end of the day it is the free cashflow that is paid in dividends and reinvested so I would say that is more important.

I'm not entirely convinced that the cashflows are any more real than the NPAT They are still subject to all sorts of accounting chicanery. Yes, it is that free cashflow that pays the dividends, but did it come from productive activity or financial activity? eg borrowing money, demergers which then 'pay' money back to the mother company (eg Westfield's various antics in this arena )

 

[McLovin]

I'm not entirely convinced that the cashflows are any more real than the NPAT They are still subject to all sorts of accounting chicanery. Yes, it is that free cashflow that pays the dividends, but did it come from productive activity or financial activity? eg borrowing money, demergers which then 'pay' money back to the mother company (eg Westfield's various antics in this arena )

If you glance at the cashflow statement it's pretty easy to tell where the money funding dividends came from.

 

[ROE]

Look, Roger's book is pretty good, but in the end he is in it to make money. The evidence of that is the fact that he is now trying to monetise his black box system (A1-C5). He has used a simple formula to allow people with not much time on their hands to "value" companies. The real value is in knowing how to grade a company, but he doesn't share that information. I don't believe he uses one single formula in isolation to make investment decisions. I think he probably uses a variety of valuation techniques, depending on the situation. He does also stress that a company making zero is worth zero. I'm not trying to be critical of him, but his formula is not a silver bullet that will work in every scenario. Your spreadsheet is locked btw.

I agree, Nothing Roger do is special it been around for a decades
he is just really good at re-selling old ideas...

look at the explosion of how to be frugal sites and pay down debt
pop up in the US since the GFC, again these ideas been around
since man kind walk the earth

There is no magic formular or any sort of formular that make you
money, you have to have a reasonable understanding of the business
its balance sheet and factors in some risk associated with investing
in the stock market and away you go...

I dont think there is anything wrong taking on some good advices
people like Roger, Warren, Charlie do give out good advices, just dont
get too hang up on a specific calculation...

 

[McLovin]

I agree, Nothing Roger do is special it been around for a decades
he is just really good at re-selling old ideas...

look at the explosion of how to be frugal sites and pay down debt
pop up in the US since the GFC, again these ideas been around
since man kind walk the earth

There is no magic formular or any sort of formular that make you
money, you have to have a reasonable understanding of the business
its balance sheet and factors in some risk associated with investing
in the stock market and away you go...

I dont think there is anything wrong taking on some good advices
people like Roger, Warren, Charlie do give out good advices, just dont
get too hang up on a specific calculation...

Exactly. So many people get hung up on coming up with a number. The key to value investing is, as you say, analysing and understanding the company and its business. If it really were so simple that you could take 3 variables plug them into a formula and get the intrinsic value of a company everyone would be doing it.

 

[Intrinsic Value]

Exactly. So many people get hung up on coming up with a number. The key to value investing is, as you say, analysing and understanding the company and its business. If it really were so simple that you could take 3 variables plug them into a formula and get the intrinsic value of a company everyone would be doing it.

The good thing about RM is that he has made a lot of people aware of value investing.

His media profile has been good at bringing value investing techniques to the attention of the general public.

It makes a nice counter balance to the mumbo jumbo that seems to sprout out from lots of techincal analysts.

IVs is never going to be an exact science but at the very least you can identify potential investments and filter out all the rubbish.

 

[Julia]

It makes a nice counter balance to the mumbo jumbo that seems to sprout out from lots of techincal analysts.

I'm not sure why you couldn't record your praise about your 'value investing' without feeling obliged to make pejorative comments about a different style which fairly obviously you don't understand.

 

[New Stratos]

Look, Roger's book is pretty good, but in the end he is in it to make money. The evidence of that is the fact that he is now trying to monetise his black box system (A1-C5). He has used a simple formula to allow people with not much time on their hands to "value" companies. The real value is in knowing how to grade a company, but he doesn't share that information. I don't believe he uses one single formula in isolation to make investment decisions. I think he probably uses a variety of valuation techniques, depending on the situation.

I'd agree with most of that My question is though; using his published method (but with non published figures for the multipliers) how do you deal with POR to get a somewhat realistic figure?

He does also stress that a company making zero is worth zero.

Where has he said that? If so then that's pretty dumb, which Roger doesn't strike me as being. If Westfield, for example, closed all it's Shopping Centres tomorrow ie no rental income, it would still have value.

I'm not trying to be critical of him, but his formula is not a silver bullet that will work in every scenario. Your spreadsheet is locked btw.

Let's try again
View attachment POR demo.xlsx

If you glance at the cashflow statement it's pretty easy to tell where the money funding dividends came from.

Sure, but my point was about trying to replace one single figure with another, when either can be dodgy.

 

[McLovin]

I'd agree with most of that My question is though; using his published method (but with non published figures for the multipliers) how do you deal with POR to get a somewhat realistic figure?

No idea. I guess you could just assume the company comes back into profit the following year get an IV for that year then discount it back.

Where has he said that? If so then that's pretty dumb, which Roger doesn't strike me as being. If Westfield, for example, closed all it's Shopping Centres tomorrow ie no rental income, it would still have value.

He's said it on numerous occassions, on his blog and on the various Sky Business shows. Usually it is when someone asks about ABC Exploration Ltd. Of course Westfield's assets would still have value.

Sure, but my point was about trying to replace one single figure with another, when either can be dodgy.

Unless you have the world's dumbest auditor and/or a bank willing to forge bank statements, then it is 1,000x harder for a company to get creative with a cash flow statement. It's really not even comparable.

 

[waimate01]

Look, Roger's book is pretty good, but in the end he is in it to make money. The evidence of that is the fact that he is now trying to monetise his black box system (A1-C5).

Right on. Roger's book talks about how you can easily value a company, but yet he disguises the actual equations in his two tables, saying it's to "avoid confusion and the possibility of mistakes", whereas I think really it's to create an air of mystique.

Further, if you take the IV method he sells in Value.able and compare it to the IVs he sells in MyClime, you end up with two completely different IV's. They *have* to be different so people will *both* buy the book and subscribe to the service.

Roger's ostensibly selling the notion of making rational valuation decisions based on immutable facts, but when you get down to the core of it, he applies his own 'secret sauce' which is derived by taking a whole bunch of stuff into consideration and reaching into the far recesses of his mind.

When you take some accurate numbers and apply a precisely defined process to create a deterministic result ... and then multiply that deterministic result by a somewhat arbitrary number you've pulled out of your ear, well the quality becomes equal to that of the least deterministic component.

When you base a calculation on estimated sustainable ROE (a guess of what the future looks like), and RR (a guess of what the risk premium should be), the end result is just a guess.

Roger's talent lies in packaging that up and marketing it.

I'm not saying there's no value to what he's offering, just that it should be seen for what it is.

 

[Intrinsic Value]

I'm not sure why you couldn't record your praise about your 'value investing' without feeling obliged to make pejorative comments about a different style which fairly obviously you don't understand.

Well I have listened to a lot of technical analysts and they seem to blow a lot of hot wind.

So many ifs and buts and maybes and using jargon that seems to have been created by martians to further confuse the layman.

That is why i counterbalance with RMs method because his method seems to make sense and theirs certainly doesn't.

 

[Silhouetteau]

Craft or anyone that can help,

Could suggest any other books/things that are worth reading?

I've read most of the prominent value investing books (Intelligent Investor, Common Stocks & Uncommon Profits, Margin of Safety, Roger's book, Berkshire Letters and Competitive advantages books)

I'd be specifically interested in anything relating to earnings risk and default risk?

 

[craft]

Craft or anyone that can help,

Could suggest any other books/things that are worth reading?

I've read most of the prominent value investing books (Intelligent Investor, Common Stocks & Uncommon Profits, Margin of Safety, Roger's book, Berkshire Letters and Competitive advantages books)

I'd be specifically interested in anything relating to earnings risk and default risk?

Silloeuetteau

The three risks are intertwined and the authors I like best normally have a holistic approach. I guess if you just want information on say default risk you could Google it but that would probably bring up the ratings agencies and you would miss the big picture. O.k approach if you are at the stage where you are trying to answer specific question for yourself.

The best reading by far is the Berkshire Letters (free on the Internet), but you need to know the questions you are trying to answer before you will get the answers from here. Anything Charlie Munger is also normally good. I have read these letters many times and still get something new each time.

Some others I like are:
Bruce Greewald
James Montier
Michael Mauboussin
Martin Leibowitz
Pat Dorsey

The best contemporary information is often in the Value Fund Managers newsletters and web sites (Legg Mason, GMO, tweedy Browne etc). Also the Business schools have some good free info; Paul Johnson & Bruce Greenwald at Columbia, Robert Shiller (Yale) and Answath Damodaran (Stern) for valuation stuff.

And don’t forget to read broadly – Good exponents of the other trading disciplines can offer much if you keep an open mind. For example some of the expectancy stuff in the front of Nick Radge’s Adaptive Analysis is as applicable and just as vitally important to Fundamental Investing as Technical Trading – I have never seen expectancy written about from a fundamental perspective.

 

[Tysonboss1]

. I think his method is better suited to the Bruce Greenwald approach of rarely paying for growth and thus valuing the company as though it's current earnings are what it will earn in perpetuity.

Yeah, Ben Graham warns against over paying for expected earnings growth, He suggests that maximum value for a "growth" company is 25 times the average earnings of the past 7 years, and offcourse a margin of safty would be applied.

 

[New Stratos]

I agree with you, although I also think everyone does make mistakes. From what I have seen, when it comes to assessing the earnings potential of a company his method comes back to sort of airy-fairy concepts "pick wonderful companies" etc and a few Mae West quotes. It's very easy to write that, it is, afterall, commonsense, who is buying bad companies? But for the novice investor, which his book is aimed at it really gives scant detail on how exactly to identify how safe a company's earning stream is.

I think that is a little harsh. There's plenty of advice in the book, and in other commonly available Value Investing books, on what constitutes a good company eg low debt-equity, steadily growing earnings, high ROE, Intrinsic Value increasing (and he gives one way to estimate the IV)

NOT share-price going up quickly.

And plenty of people buy bad companies, especially if they think share-price = value; share price is increasing therefore value is increasing.

There is a heavy reliance on RoE to be able to predict the future earnings potential of companies, I don't disagree that a high RoE can indicate a competitive advantage, but it doesn't always. I think his method is better suited to the Bruce Greenwald approach of rarely paying for growth and thus valuing the company as though it's current earnings are what it will earn in perpetuity.

Sounds quite sensible in a cautious way to me. I am willing to take some risk for some growth, but not everyone should.

 

[McLovin]

I think that is a little harsh. There's plenty of advice in the book, and in other commonly available Value Investing books, on what constitutes a good company eg low debt-equity, steadily growing earnings, high ROE, Intrinsic Value increasing (and he gives one way to estimate the IV)

I was referring to assessing how safe a company's earnings are. Identifying a good/strong company at a point in time is not that hard.