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

[New Stratos]

humbug

humbug

humbug - all valuation models (incl. RM) do the same thing - discount an earnings stream - the judgement is only in an approriate cap. rate - which by defninition requires your judgement on risk in sustainable earnings and on earnings growth.

humbug

humbug ... you won't have a chance to buy (or you'll stay in too long with a false positive sense of security) if your IV calc. is grossly excessive.

humbug ... notwithstanding that you've read the other 84%, if you decide to follow his model, it is the IV calc. which will mainly dictate your investment decision.

Well, thanks for your thoughtful consideration of my points.
And your last point is wrong - the other 84% primarily determine what to buy; the 16% represented by the IV chapter mostly tells you when to buy it.

 

[New Stratos]

New Stratos, sorry the example I posted did not format right - but if you can follow you will see my point. If you have selected a conservative 15% (assume based on a dilligent risk premium assessment), how do you feel when that is stripped from you (by RM model without your knowledge) and a much lower cap rate substituted because of div. policy or ROE - both of which may have little or nothing to do with sustainable earnings or earning growth?

Your algebraic manipulations are correct, but your interpretation of what things mean is wrong, in my view. You are equating the RR in the equation to the inverse of a PE ratio, but that's not it's purpose, and ROE/RR is not about 'adjusting the capitalization rate'; it's about recognising that when ROE is higher than your Required Return it's better left in the company than returned to shareholders as dividends. Both Graham and Walter had plenty to say about this. if your read them (though Graham was a bit skeptical about 'daddy knows best' boards).

I also think you should go back and read what Warren B has said in his letters to Berkshire Hathaway share holders about the merits of high ROE and low Capital Intensity. (You can find the same remarks in RM's book, but since you don't care for that, you may prefer reading WB)

 

[waimate01]

waimate01, sorry to persist re. this but good to get off the chest so to speak, so I'll run through an example of where I'm coming from.

Nice worked example, and I appreciate the time you put into it.

But to recap, your statement was: "as used by Roger, ROE has nothing to do with using book values", but your example calculates ROE as exactly based on book value ("ROE (a) / (b)", a=earnings, b= equity (book value)).

Perhaps what you meant to say was "Roger's IV has nothing to do with book values", which is clearly correct simply by doing the algebra of "IV= ROE / RR * BV", and substituting for "ROE=EPS/BV", wherein the two BV's cancel out and you're left with "IV=EPS/RR".

In any event, I totally agree with your broader point about Roger's IV methodology -- it produces whacky results.

 

[New Stratos]

Perhaps what you meant to say was "Roger's IV has nothing to do with book values", which is clearly correct simply by doing the algebra of "IV= ROE / RR * BV", and substituting for "ROE=EPS/BV", wherein the two BV's cancel out and you're left with "IV=EPS/RR".

In any event, I totally agree with your broader point about Roger's IV methodology -- it produces whacky results.

Three, perhaps minor, points:

1. that's only the formula for the 'all earnings paid out as dividends' part of the valuation;
2. it's not Roger's IV methodology - he's using well established valuation methods;
3. all valuation methods produce wacky results in some circumstances - hence Roger regularly mentions caveats and even has them incorporated into those tables in his book...

 

[Intrinsic Value]

Three, perhaps minor, points:

1. that's only the formula for the 'all earnings paid out as dividends' part of the valuation;
2. it's not Roger's IV methodology - he's using well established valuation methods;
3. all valuation methods produce wacky results in some circumstances - hence Roger regularly mentions caveats and even has them incorporated into those tables in his book...

I think the IVs are a good starting point in that they filter out a lot of the rubbish and indeed i think this is what RM is getting at anyway.

Once you have what you consider an attractive IV with a large MOS of safety then you have to start doing the real digging. Looking at moat, track record, management, industry, etc And i am pretty sure this is what RM does anyway.

 

[Mike23]

And your last point is wrong - the other 84% primarily determine what to buy; the 16% represented by the IV chapter mostly tells you when to buy it.

So you agree you can't buy until your decision is supported by a bogus formula?

 

[Mike23]

Your algebraic manipulations are correct, but your interpretation of what things mean is wrong, in my view.

I have not interpreted anything - only given you the mechanics.

You are equating the RR in the equation to the inverse of a PE ratio, but that's not it's purpose, and ROE/RR is not about 'adjusting the capitalization rate'

The result of the mechanics is the result - regardless of any purpose. If the purpose is to est. risk premium for sustainable earnings and earnings growth then I agree with the purpose - just not the result.

it's about recognising that when ROE is higher than your Required Return it's better left in the company than returned to shareholders as dividends.

What about a mature product business with low growth prospects but high ROE?
Therer are many examples of why you can't categorise sustainable earnings and growth based on their ROE. This is bogus!

Both Graham and Walter had plenty to say about this. if your read them (though Graham was a bit skeptical about 'daddy knows best' boards).

I have read The Intelligent Investor a couple of times.

I also think you should go back and read what Warren B has said in his letters to Berkshire Hathaway share holders about the merits of high ROE and low Capital Intensity. (You can find the same remarks in RM's book, but since you don't care for that, you may prefer reading WB)

I beg you to find anything written by WB or Graham which contradicts my view expressed. I'd guess WB would be horrified by RM's formula for Mum's and Dad's investors.

 

[Mike23]

But to recap, your statement was: "as used by Roger, ROE has nothing to do with using book values", but your example calculates ROE as exactly based on book value ("ROE (a) / (b)", a=earnings, b= equity (book value)).

Perhaps what you meant to say was "Roger's IV has nothing to do with book values", which is clearly correct simply by doing the algebra of "IV= ROE / RR * BV", and substituting for "ROE=EPS/BV", wherein the two BV's cancel out and you're left with "IV=EPS/RR".

What I was trying to say was that ROE is promoted by RM as being very important to valuations, yet it has nothing to do with his IV calc. except to adjust his cap. rate for EPS, which I further say is bogus as it takes out of your hands the important decision making for a suitable risk premioum for sustainability of earnings and earnings growth.

 

[Tysonboss1]

So you agree you can't buy until your decision is supported by a bogus formula?

I think Roger is just trying to instill into investors an ability to measure and quantify what it is they are buying, I think that is a good thing.

Offcourse rogers book is not the be all and end all of all things value investing, But it is a good introduction into the subject.

Remember alot of new investors have never been exposed to the concept, and it can't hurt to get them thinking about the idea.

Most people who have lost money in the market, especcially "mum and dad" types have not lost money because they bought bad companies, But because they got excited at the wrong time and over paid for good ones, and then became disheartened and sold out of a good company right when it was actually becoming good value.

 

[Macros]

Whilst I disagree with some of RM's approach (had a futile attempt at explaining my view some pages back on this thread), particularly with regards to poor concepts in economics and the macro view/trends, which ultimately drive future earnings and therefore valuations, the valuations in themselves aren't necessarily a bad thing.

I think that the concept of RR or RoR is based on the markets expectation and not that of the individual investor. We can only control the decision of what to invest in and when to buy or sell. Our expectations are not necessarily that of the market.

Here is a graph of Cochlear - I think the valuations are fairly representative of the market expectations.



I think the problem is not in the valuation process, but rather in understanding that value is based on earnings expectations and the economic factors that drive those expectations. To be honest, I don't think that every single person can be an expert in understanding these factors, wherein the dangers of this process arise.

 

[New Stratos]

I think the IVs are a good starting point in that they filter out a lot of the rubbish and indeed i think this is what RM is getting at anyway.

Once you have what you consider an attractive IV with a large MOS of safety then you have to start doing the real digging. Looking at moat, track record, management, industry, etc And i am pretty sure this is what RM does anyway.

It's a bit "chicken and eggy" but I start with looking at whether the company is worth investing in for other reasons, then move to the price I think is reasonable (but it is iterative and you should keep looking deeper companies).

 

[New Stratos]

I beg you to find anything written by WB or Graham which contradicts my view expressed.

OK, two examples - you don't seem to think a high ROE is important; you think there should be an individual equity risk premium (beta?) included in the 'capitalization rate' used for each different IV calculation.

"The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc) and not the achievement of consistent gains in earnings per share." (annual report, 1983:11)

"To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, options pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. ... Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now." (annual report, 1996:12)

"What counts, however, is Intrinsic Value -- the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business -- in and out -- and discounting them at prevailing interest rates." (RJ Connors, Warren Buffett on Business, Appendix F)

 

[Mike23]

OK, ... you don't seem to think a high ROE is important

It was a rhetorical question. My views on ROE (which I have not actually shared) are consistent with the quotes you have posted. The last though needs to be in context. Discounting at prevailing interest rates was (i) with qualification "with perfect foresight" meaning no risk to cash flows; (ii) with WB as owner (hence theretical seller not buyer); and (iii) his quote if you read next sentence was merely using this as an example of equivalence or relative values.

FYI I think ROE is very important which I use as a filter, not in my IV calc.
What I had previously said about ROE is that "as used by RM" it is improperly used. i.e. used in IV calc by ROE/RoR^1.8 to adjust your cap rate. I have said this is bogus and will give false positives. It effectively substitutes your RoR (assuming properly considered) with a cap rate which may be not be justified by the business and market fundamentals. For high ROE companies it may give you a false sense of security of a company's IV and keep you in a stock when you should be selling; or support your buy decision when it is already over-valued. On other hand for a low ROE capital intensive company but with good EPS and good prospects, the RM method will undervalue these companies - and doubly so if it is a good dividend payer. I understand the apparent rationale given by RM - I just totally disagree with it.

... you think there should be an individual equity risk premium (beta?) included in the 'capitalization rate' used for each different IV calculation.

Absolutely - and so do you if you use RM's formula - by adjustment to your RR cap rate behind the scene. As to this "not being the purpose", the formula does not share its purpose - but you should know what it does. You have already agreed with the algebra - hence you should now know what it does.

re. beta, this is not a factor for long term > 5 year investors, but of course volatility risk, for market itself + stock relative to market (beta), is a factor for short term investors. (i.e. some people may need a short horizon due to possible short term need for funds - deposit for a house etc.. etc.. - not saying that these people should be in the market in first place but if they are...)

 

[The Trooper]

Attached is a spreadsheet i put together based on Chapter 11 of Value.Able. including an example for CCP. It requires some basic inputting but should be fairly easy to understand to anyone with a baclground in the RM IV method. Please feel free to critique as would love to improve on this.

IV is a tool in share valuing but obviously to be used in conjunction with understanding the business, cashflows, prospects and management.

My question is what weighting to apply to intangible assetts? In a pure ROE assessment they are included in the equity calculation but the level of goodwill and the "risk" of that goodwill is not easily ascertainable. In calculating IV would you include intangibles or reduce them by a risk factor to provide cover in event of a writedown of goodwill?View attachment Intrinsic Value Calculation Template.xlsx

 

[McLovin]

My question is what weighting to apply to intangible assetts? In a pure ROE assessment they are included in the equity calculation but the level of goodwill and the "risk" of that goodwill is not easily ascertainable. In calculating IV would you include intangibles or reduce them by a risk factor to provide cover in event of a writedown of goodwill?View attachment 44361

How long is a piece of string?

Seriously, it's pretty hard to give a one size fits all answer. I guess as a first stop if a company has a lot of goodwill and their RoE is low then you could make the assumption that their goodwill is overvalued.

 

[Intrinsic Value]

RM is initiating his A1 service Skaffold with preliminary invites already being sent out with a sneak preview.

No mention of cost.

I wonder what sort of uptake it will get considering the MCE debacle!

 

[Noddy]

RM is initiating his A1 service Skaffold with preliminary invites already being sent out with a sneak preview.

No mention of cost.

I wonder what sort of uptake it will get considering the MCE debacle!

Sent back a response to RM's Skaffold invitation.
Very interested in what he has to offer.
Seems to be somewhat similar to Lincoln Indicators system to me, which retails a little under $2,000 or so for 12 months registration.

 

[The Trooper]

How long is a piece of string?

Seriously, it's pretty hard to give a one size fits all answer. I guess as a first stop if a company has a lot of goodwill and their RoE is low then you could make the assumption that their goodwill is overvalued.

True...I suppose i have come to distrust intangible assets after now being privy to the detail behind a few companies balance sheets. If one removes all intangible assets however this would decrease the company's equity per share while at the same time increasing its ROE. The net effect might be grossly undervaluing a business. My comment broadly i suppose is that i see goodwil as overpaying for an asset and is something that should be written to the profit and loss account as an expense rather than the balance sheet as an asset.

 

[So_Cynical]

Is Roger a sell out?

After 12 months + of selling his book, he seems to have switched to selling a promise/illusion of A1 wealth.
~

 

[Tysonboss1]

Is Roger a sell out?

After 12 months + of selling his book, he seems to have switched to selling a promise/illusion of A1 wealth.
~

He was a fund manager long before he was an auther,