Whats up SD, can't google this one?
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Thanks!
It is the value of the cashflow in perpetuity! in other words constant ROE, constant 100% payout and constant cost of capital.Quote:
So what you have calculated here is the 'real return' on top of the cost of capital.
It can also be expressed as:
INCOME/COC
Also known as, the "Earnings Power Value" (Greenwald).
Yes! Its straight line compounding growth discounted at the cost of capital!Quote:
So now you are taking the 'real return' and putting it through the sausage machine that has generated your returns (the company) so that it spits out your subsequent real return on profits earned as a 'return on your return'.
Well it allows you to put a value on compounding growth.Quote:
Not sure you really need to go to the trouble of working out the return on the return. I use an ROE target of 15% minimum for new companies that I invest in. If say the cost of capital was 7%, I might equally say my target was 8% above the cost of capital. But what is the difference between that and a gross ROE target of 15%? I would say nothing.
But you may be right. I doubt Buffett does needs to do too many of these calculations. I suspect he will intuitively be able to assess the value of the growth.
But for us lesser beings, this formula is a quicker, easier and simpler than spending hours developing full blown multi-growth-period cashflow forecasts and deciding on a terminal value and discounting it all back.
To stay on topic (of RBD), Lets pretend we are Warren E. Buffett, and use RBD for a working example and see how the output compares to Gregs more considered and worked DCF model:
We will assume we (Warren) have assessed RBD and it has passed our qualitative checklist.
(sorry ROE figures calculated on year end equity, which is not technically correct, but I am using hopeless ASB info sheet figures as I cant be bothered downloading annual report)
RBD had net ending equity of 50cps in 2010
RBD had earnings per share of 20cps in 2010
Therefore RBD had an ROE of 40% year end 2010
Now because this is a straight line formula, and the ROE determines your rate of growth, it would be foolish to use the very high recent ROE of 40% to determine the long term re-investment returns.
If we average out the last 9 years return on ending equity we get average ROE of 22.72% this seems like a fair long term economic return for a very well run company with competitive advantages, and is historically accurate, so lets run with this.
As we are comparing this valuation method to Gregday's lets use his Cost Of Capital to be consistent.
COC = 7.7%
In 2010 RBD paid out 40% of its profits as dividends. So we have to be careful not to accidentally compound those profits as they will not be reinvested. So the formula becomes:
V = (ROE/COC) * E * D% + (ROE/COC) ^2 x E * (1-D%)
Where D% is the ratio of profits paid out in dividends.
For RBD this is
(22.72% / 7.7) * 0.50 * 0.40 = 0.59cps
+
(22.72% / 7.7) ^ 2 * 0.50 * 0.60 = 2.61cps
= $3.20
= "INTRINSIC" VALUE OF RBD
CURRENT MARKET VALUE = $2.40
MARGIN OF SAFETY = 33%
This is very close to Gregs valuation of $3.58 which is encouraging.
Most importantly, and this is key in my opinion, for this type of valuation to be a "good guess", we MUST be confident that competitive advantages exist that will keep returns higher than the cost of capital for the long term, in which case a straight line formula is totally sufficient. And of course this may not work for all investments or for every investor, or even every market. However, in context with the discussion, it would work for Buffett as he is searching in a huge market for businesses with an unassailable moat.
At least it only takes a few minutes to do!
What do you guys think?
Cheers
P.s. I just realised these figures are of course old now and we are in reporting season, so with new data and more equity on the balance sheet, the value will be higher and margin of safety greater.
Hi Sauce and others,
Thanks for the great thread. I have learnt a lot from this thread and the RYM one also.
What you have written is exactly what Roger Montgomery (formerly of Clime Capital) and their Stockval program uses to calculate intrinsic value, except they use a power of 1.8 rather than 2 probably to be more conservative.
http://www.stockval.com.au/documents...ing_080923.pdf is a good read it details more about Graham Value investing and the Stockval approach and some of pitfalls of DCF.
Agree it is useful to use a long run ROE rather than top of cycle. This is where a lot of companies came unstuck in GFC, although EPS was generally increasing at the same rate as stock prices, earnings were top of cycle, buoyed by extensive credit growth.
Attachment 3208
Like you say the companies must exhibit a strong competitive advantage and moat or barriers to entry to preserve the consistent ROE.
I agree with the comments on discount rates also. I consider it as the return an investor requires as an owner of the business.
The finance community use beta as it is an objective measure that standardises the valuation process. However, whether it is an accurate measure of risk is another story.
Keep up the good thread.
Sauce wrote:
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"For a company without growth that makes a high return on existing equity, but pays it all out to Warren to invest elsewhere, the calculation is this:
VALUE = (ROE/COC) x EQUITY
(ROE = Return On Equity and COC = Cost Of Capital)"
Snoopy commented:
-----------------------
"So what you have calculated here is the 'real return' on top of the cost of capital."
Sauce wrote:
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And for the cashflows of a company that are being retained and re-invested in growth the equation is:
VALUE = ROE/COC x ROE/COC x EQUITY
or
V = (ROE/COC) ^ 2 x E
Snoopy commented
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"So now you are taking the 'real return' and putting it through the sausage machine that has generated your returns (the company) so that it spits out your subsequent real return on profits earned as a 'return on your return'."
I wanted to add something to my comment above. Isn't the equation for the reinvested profits as below?
VALUE = ROE x ROE/COC x EQUITY
I changed it because the reinvested profits are 'all real' and represent money that would otherwise have been pocketed by the investor. I can't see how it makes sense to divide that otherwise pocketed money by the cost of capital again. Once you have divided by the cost of capital the first time, that correctly discounts your initial capital profit against the yardstick of your cost of capital. But when the just generated profit which converts to new capital is reinvested the cost of that new capital (reinvested profits) is nil is it not? Because the reinvested capital concerned did not exist at all before it has cost the investor nothing. Or am I getting confused? Perhaps Sauce or Greg or others can sort me out!
SNOOPY
Snoopy wrote
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Not sure you really need to go to the trouble of working out the return on the return. I use an ROE target of 15% minimum for new companies that I invest in. If say the cost of capital was 7%, I might equally say my target was 8% above the cost of capital. But what is the difference between that and a gross ROE target of 15%? I would say nothing.
Sauce responded
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Well it allows you to put a value on compounding growth.
Snoopy counteresponded
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Using gross figures like my 15% still allows you to do the compounding growth calculation. The only thing you have to remember is that when looking at the result after a few years is that if you use a 'gross return figure', there is an underlying profit in there which you would have got anyway by just investing in government bonds, roughly akin to that cost of capital. But I fail to see how moving the zero return point up to say 7% allows you to put a value on compounding growth. If you didn't do that you can still measure compounding growth equally well.
SNOOPY
Thanks for your reply Snoopy!
My understanding is that the new capital is not exempt from the "time value" of money, i.e. opportunity/aternative use cost.
So when talking about a compounding annuity, all future cashflows become new capital, but still require discounting. Re-investment of profits is still using cash that could be used elsewhere, just like the initial investment. So it needs to be treated in the same way, with the same "cost". Surely that's fundamental to capital management?
Regards,
Sauce
I am pretty sure I understand you....
Correct me if I am misunderstanding something obvious, but I believe the net return after the discount is the present value. So by discounting it to determine the 'present value' it allows you to compare with prevailing prices simply and easily helping you to determine if a margin of safety exists.
So yes you could value the compounding growth without the discount rate. But for purposes described above and since it is not hard, why not build in the required return/discount rate.
Again, I hope I am not displaying my ignorance here, but this seems intuitive to me.
Cheers
Sauce
Is my interpretation correct.
The first part values the current div per share as a perpetuity.
The second part values the retained earnings per share as a perpetuity but compounds this at the return of equity rate, discounted at req rate of return?
What's the explanation for ignoring future growth in dividends from the model?
Cheers
RBD has traded off from the highs pretty easily recently. ACC raising its stake in past 2 days hasn't provided any impetus either.
Am sure Mr P would indicate a confirmed downtrend now in place.
Any thoughts on why?
cheers
Moi.
Yes Moi, the downtrend and the SELL signals began over 2 months ago. Yet again, RBD shows the difference between FA and TA in stark contrast. While the fundamentalists are having earnest discussions on how best to assess the theoretical "worth" of this stock, the technicians are out of RBD and, more importantly, the market is selling it down. RBD has dropped over 30 cents since then.
This could be re-phrased as "Those still holding RBD must be either diehard fundamentalists or insane".
We are all in this for the money. Which approach has proved to be the more profitable?
Given the long-running TA vs FA argument that has raged over RBD, it is easy to weigh up the relative merits of these 2 approaches. It is all documented right here for anyone that bothers to look.
http://i602.photobucket.com/albums/t...sPB/RBD210.gif
SD
On a $1000 1year bond paying 7% how much can I pay today for my bond to earn 15%? Answer $930.43(intrinsic value)
$1000 1year bond @ 7% = $1070.(compound growth calculation)
$1070 discounted at %15 today = $930.43 (discounted cashflow valuation)
The discounted cash that I can take out of my bond during its remaining life is $930.43 if I hope to earn 15%.
Phaedrus, no-one on this forum would doubt your charting acumen. However in the past you have claimed to be using both FA and TA to get a best of both worlds solution. You have demonstrated clearly why you have sold out of RBD on a technical basis. But on what fundamental basis did you sell out? Overblown forecast PE (of 9!)? Increasing company profits (A record this year and looking to get better over the world cup period)? Insiders selling out (No-one has)?
Can you name a single fundamental indicator that marks RBD as a sell? I can't.
The best reason I can come up with is the patchy performance of retail companies in general of late. But unlike what you might purport, all retail shares do not behave equally on a trending basis. RBD is forecasting strongly increasing profits, so it seems unreasonable to tar the company with a badly performing retail brush.
I rest my case that you are in fact a pure chartist. Nothing wrong with that of course if that is how you operate. But what is this line that you combine both FA and TA strategies? It strikes me as an inaccurate assessment of how you actually behave in this market. Anyway, I do congratulate you on sticking to your charting methods and coming out with a good profit at the end of the day. Nice work. I will be thinking of your cash earning 5% in the bank while my capital is earning close to double that as a shareholder of RBD.
SNOOPY
Mathematical simplicity? Allowing increasing dividends woudl simply make the arithmetic too complex. Ignoring increasing dividends (if they occur) doesn't invalidate the use of the model, which is a relatively quick and easy method. But if actual dividends do increase it means the model will give you an extra margin of safety.
SNOOPY
Quite right Sauce. I think I was muddling what I wrote with something I read in the Mary Buffett books. In particular the idea of buying 'a share' as 'a bond' with a market coupon rate. But regarding the dividends received (interest in the bond analogy) as having an incremental coupon rate greater than your bond purchase price because of the internally generated compounding effect of shareholders equity reinvestment.
However you are quite right. All new investment, from whatever source, should be discounted back when calculating 'present value'.
SNOOPY
I did think of asking you where you got the quote from SSD, before I guessed that I might be able to google it myself and find out. Your statement that Buffett doesn't use different discount factors for different companies was 100% correct. But any implication that he does in fact treat all companies exactly equally from an evaluation perspective (a dollar is a dollar) was not. That is why I saw the context as important.
Likewise I would not dispute that Warren is capable of doing his future cashflow projections and valuation fairly accurately. But that isn't the same as claiming that Warren does this on every investment he makes. I suspect Warren , given his experience, can do a near enough calculation in his head.
SNOOPY
No Snoopy, I can't. Technically, though, the story is very different. Unmistakable multiple RBD Sell signals were triggered and these have proved their worth because RBD's shareprice has continued slipping since then. Like you, I consider RBD to be a good, sound stock, so I will be monitoring the current downtrend with a view to re-entering if/when this slide ends. Who knows how far it will run - the further the better as far as I am concerned!
Snoopy, anyone trying to combine two very different approaches will inevitably have to deal with situations when the two methods disagree. When that happens, they must go with one or the other, or possibly try to find some sort of compromise. When that happens to me, I go with TA. Every time. I have found that doing so increases my profits because I am not "fighting the market". I use FA to help me decide what stocks to get into in the first place then time my entries with TA.
What you have overlooked here Snoopy is the crucial fact that in just 3 months RBD's downtrend has wiped out an entire year's dividends more than TWICE OVER! To me it seems quite bizarre to focus solely on dividend gains when these are dwarfed by concomitant capital losses! This is exactly the mistake you and others made with TEL. Seduced by high dividend yields, you chose to totally ignore the unfortunate fact that your capital losses were bigger than your dividend gains.
This strange attitude found its fullest expression in this timeless quote from Major von Tempsky :-
"Frankly I don't personally care what the price is....... as long as it keeps paying its dividends".
word of the day is concomitant ..... learn something new every day .... must use it ...thanks P
Phaedrus I accept that if I claim to be using the same share picking method method then I cannot cherry pick my best NZX investment (RBD) while forgetting about my worst (TEL) and crow just about RBD. The question is even if you see my methods as sub optimal, have my winners more than made up for my losers? As you saw in the Snoopy vs the Index thread the answer over the last 5 years has certainly been yes.
If you look at the last three months and ask the same question then my three month loss on RBD has not been made up by a corresponding profit on Telecom shares. However, since my time horizon is rather greater than three months this fact is of little relevance to my long term strategy. If lessons are to be learned here, the best one is that where you have an industry heavily dependent on technology such as telecommuications, in Buffett terms "something that is difficult to understand", you might be best to stay out of it altogether. Now perhaps you would just interpret this as a hindsight FA perspective (not that reasons are needed when using TA) on why you would have best kept out of TEL. Perhaps you would be right. However, investing is not a 'rear vision mirror' exercise.
The question is should the deregulation of Telecom's market in New Zealand five years ago, dictate your policy on investing in the new Telecom today? I would say the answer to that question is no.
The concommitant capital losses of which you speak, while real, are not realised until the completion of any investment plan. Acting on market signals is always optional, and I would argue that many of these market losses are really market noise. I would argue this with the performance of RBD over the last three months. I would find it harder to argue the same case for TEL when considered over the much longer timefraame of the last five years.
SNOOPY
Hi guys, not to walk into a technique fight, I think Snoopy and I are on the same page. This is probably because I have little understanding of technical analysis. But I do see some value in a timing approach, particularly with respect to my options trading. I tend to trade options on weakness that I think is overdone.
I'm only learning, but have done reasonably well off the GFC, when it was blatantly obvious to even neophytes like me that stocks like RBD were undervalued. My current thesis is the same, the amount of money RBD are producing should justify a higher share price. But, in order that my trades are fairly transparent, I basically do what I forecast. eg: Bought RBD, Sold MHI, Sold XRO etc.
So for RBD, I bought at 2.59, which obviously sent the price downwards (its my special power). But... it hasnt altered my thesis, that RBD is undervalued. I don't care particularly about the daily ups and downs, because they havent altered the thesis. I've learned (to some degree) not to be greedy and chase every last penny. I will simply be happy if the thesis plays out and RBD heads to $3.40+. I havent seen anything that has disturbed that thesis, so will remain invested until I do.
Thats my approach at least.
cheers
Greg