Watch PE when valuing a company

(18-02-2014, 10:22 AM)specuvestor Wrote:

(15-02-2014, 12:11 AM)Clement Wrote:

(14-02-2014, 10:57 PM)ashparagon Wrote:

(30-09-2012, 12:14 AM)FFNow Wrote: Yes. The video is talking about something else though. It pays to watch if you haven't.

That guy in the video said if 2 companies have the same PE at 10, ROE at 20%, share price at $2, in fact everything the same, except that company A pays all the profits in dividends while company B don’t pay any dividend, which company gives you more in 5 years time? The answer is company B. Because company B gives you 20% return of your money while company A only gives you only 10%.

My question is how is that company B gives you 20% return 5 years later?

This example requires the assumption that the business is scalable and that earnings growth is roughly going to be roe x (1-payout ratio). In this case, growth will be 0 for company A and 20% for company B.

Assuming you buy 1000 shares,

The company that does not reinvest it's profits is assumed to have 0 growth and therefore will earn $0.2 per share for perpetuity. Assuming you reinvest all dividends at 10x PE, after 5 years, you will have $3220 (1610 shares at $2 a piece, 10 x PE)

The company that reinvests will earn 0.2(1.2)^t per share, where t is the number of years from now. Now after 5 years, the company is now earning $0.5 per share and applying a 10 x PE, price is now almost $5, effectively compounding your investment at 20%.

Just want to add to this discussion and calculation. Clement is right on a financial 101 basis, but the way value investors and businessman looks at it is a bit different.

In the case of dividend paying, assuming no reinvest, the guy now has $1 in cash and $2 market value in shares.

With no dividend paying the guy owns say $5 in market value

What is the ROIC for the guy at 5th year going forward? With paid dividends, his effective Invested Capital is $2-$1=$1. With just $0.2 dividend his ROIC on 6th year is going to be 20% and 7th year is 0.2/(1-0.2)= 25%

For the no dividend case, his Invested Capital is still $2. Over the long run, it is hard for it to beat the ROIC of a dividend paying company since on the 10th year the Invested Capital is zero ie fully paid back. As in all exponential curve, you will not see the difference in first 5 years and note some difference in 10 years, but big difference thereafter.

And we haven't factor in counterparty risk ie the investor face the full risk of the non dividend paying company throughout the years. Only way to remove the counterparty risk is to sell the stock.

This is one of the most important lessons on Buffett.

In the case of no dividend, at the 5th year, the share price is $5, with invested capital of $2, the return is 250%.

In the case of dividend, at the 5th year, the share price is still $2, with total dividends collected of $1, the return is 50%.

Well, my lesson from Buffett seems pretty different from yours. If the investor (without dividend) wants to de-risk at 5th year, a 2/5 of divestment will able to make the ROIC better than the one with dividend, in subsequent years.

Counterparty risk is real, that the reason for a comprehensive DD before putting in your money, and aim for long term. isn't it?

I hope my math didn't fail me.

(18-02-2014, 10:59 AM)CityFarmer Wrote:

(18-02-2014, 10:22 AM)specuvestor Wrote:

(15-02-2014, 12:11 AM)Clement Wrote:

(14-02-2014, 10:57 PM)ashparagon Wrote:

(30-09-2012, 12:14 AM)FFNow Wrote: Yes. The video is talking about something else though. It pays to watch if you haven't.

That guy in the video said if 2 companies have the same PE at 10, ROE at 20%, share price at $2, in fact everything the same, except that company A pays all the profits in dividends while company B don’t pay any dividend, which company gives you more in 5 years time? The answer is company B. Because company B gives you 20% return of your money while company A only gives you only 10%.

My question is how is that company B gives you 20% return 5 years later?

This example requires the assumption that the business is scalable and that earnings growth is roughly going to be roe x (1-payout ratio). In this case, growth will be 0 for company A and 20% for company B.

Assuming you buy 1000 shares,

The company that does not reinvest it's profits is assumed to have 0 growth and therefore will earn $0.2 per share for perpetuity. Assuming you reinvest all dividends at 10x PE, after 5 years, you will have $3220 (1610 shares at $2 a piece, 10 x PE)

The company that reinvests will earn 0.2(1.2)^t per share, where t is the number of years from now. Now after 5 years, the company is now earning $0.5 per share and applying a 10 x PE, price is now almost $5, effectively compounding your investment at 20%.

Just want to add to this discussion and calculation. Clement is right on a financial 101 basis, but the way value investors and businessman looks at it is a bit different.

In the case of dividend paying, assuming no reinvest, the guy now has $1 in cash and $2 market value in shares.

With no dividend paying the guy owns say $5 in market value

What is the ROIC for the guy at 5th year going forward? With paid dividends, his effective Invested Capital is $2-$1=$1. With just $0.2 dividend his ROIC on 6th year is going to be 20% and 7th year is 0.2/(1-0.2)= 25%

For the no dividend case, his Invested Capital is still $2. Over the long run, it is hard for it to beat the ROIC of a dividend paying company since on the 10th year the Invested Capital is zero ie fully paid back. As in all exponential curve, you will not see the difference in first 5 years and note some difference in 10 years, but big difference thereafter.

And we haven't factor in counterparty risk ie the investor face the full risk of the non dividend paying company throughout the years. Only way to remove the counterparty risk is to sell the stock.

This is one of the most important lessons on Buffett.

In the case of no dividend, at the 5th year, the share price is $5, with invested capital of $2, the return is 250%.

In the case of dividend, at the 5th year, the share price is still $2, with total dividends collected of $1, the return is 50%.

Well, my lesson from Buffett seems pretty different from yours. If the investor (without dividend) wants to de-risk at 5th year, a 2/5 of divestment will able to make the ROIC better than the one with dividend, in subsequent years.

Counterparty risk is real, that the reason for a comprehensive DD before putting in your money, and aim for long term. isn't it?

I hope my math didn't fail me.

That simple maths is crystal clear since I put it in Reading between the lines of theory and reality, the implicit assumption is of course company can continuously grow at 20% clip and share price react correspondingly. Value investing focus on pay back period, cashflows and bird in hand

We are of course also assuming Mr Market always take it from you at $5. Cash in hand in certain days will be worth more than the "intrinsic" $5 value. You are an experienced investor. You know what I'm saying in real life, not some theory or elementary maths.

Why Buffett don't care if market closes for a year or more is because on the focus on cashflow. In fact he is only interested in Mr market when he is extremely greedy or fearful, hardly in between.

Buffett's lesson is well illustrated in his oft quoted example of See's candies.

PS for sure it is not easy convincing people cashflow is more important than the elusive capital gains... but at least I tried

(18-02-2014, 11:09 AM)specuvestor Wrote:

(18-02-2014, 10:59 AM)CityFarmer Wrote:

(18-02-2014, 10:22 AM)specuvestor Wrote: Just want to add to this discussion and calculation. Clement is right on a financial 101 basis, but the way value investors and businessman looks at it is a bit different.

In the case of dividend paying, assuming no reinvest, the guy now has $1 in cash and $2 market value in shares.

With no dividend paying the guy owns say $5 in market value

What is the ROIC for the guy at 5th year going forward? With paid dividends, his effective Invested Capital is $2-$1=$1. With just $0.2 dividend his ROIC on 6th year is going to be 20% and 7th year is 0.2/(1-0.2)= 25%

For the no dividend case, his Invested Capital is still $2. Over the long run, it is hard for it to beat the ROIC of a dividend paying company since on the 10th year the Invested Capital is zero ie fully paid back. As in all exponential curve, you will not see the difference in first 5 years and note some difference in 10 years, but big difference thereafter.

And we haven't factor in counterparty risk ie the investor face the full risk of the non dividend paying company throughout the years. Only way to remove the counterparty risk is to sell the stock.

This is one of the most important lessons on Buffett.

In the case of no dividend, at the 5th year, the share price is $5, with invested capital of $2, the return is 250%.

In the case of dividend, at the 5th year, the share price is still $2, with total dividends collected of $1, the return is 50%.

Well, my lesson from Buffett seems pretty different from yours. If the investor (without dividend) wants to de-risk at 5th year, a 2/5 of divestment will able to make the ROIC better than the one with dividend, in subsequent years.

Counterparty risk is real, that the reason for a comprehensive DD before putting in your money, and aim for long term. isn't it?

I hope my math didn't fail me.

That simple maths is crystal clear since I put it in Reading between the lines of theory and reality, the implicit assumption is of course company can continuously grow at 20% clip and shareprice correspondingly. Value investing focus on pay back period, cashflows and bird in hand

We are of course also assuming Mr Market always take it from you at $5. Cash in hand in certain days will be worth more than the "intrinsic" $5 value. You are an experienced investor. You know what I'm saying in real life, not some theory.

Why Buffett don't care if market closes for a year or more is because on the focus on cashflow. In fact he is only interested in Mr market when he is extrememly greedy or fearful, hardly in between.

Buffett's lesson is well illustrated in his oft quoted example of See's candies.

PS for sure it is not easy convincing people cashflow is more important than the elusive capital gains... but at least I tried

With the same vein, Berkshire Hathaway's (BH's) investors were wrong, since no dividend for more than 40 years.

I agree cash flow is important for value investor, but I might not take dividend(s) as the ONLY cash flow. As an example, cash flow within BH is more meaningful than cash flow as dividend(s), on the other hands, cash flow as dividend is more meaningful for telecom stocks.

If dividend was the only concern on cash flow, I might not invest in water-treatment companies, which have ONLY guaranteed future cash-flow, but minimum or no dividend cash flow.

You might not mean cash flow = dividend, but in the example above, it seems the case.

Berkshire has been an on-going oxymoron since Buffett focused so much on cash flow but yet pays no dividend. He has defended his rationale many times so I won't repeat it here.

Bottomline is how many Berkshire can you find, with consistent returns, credible management and most important of all, integrity. Return Of Money is more important than Return On Money

I have been presenting to this forum that there are at least 3 layers in the security we buy. The asset layer, the business layer and the structural layer and each has different cashflow profiles. As an OPMI... and I stress that unless you are a big time vulture fund etc... we take the residual of the 3rd layer. We will have to calculate our cashflow profile and ROIC based on that.

(18-02-2014, 12:09 PM)specuvestor Wrote: Berkshire has been an on-going oxymoron since Buffett focused so much on cash flow but yet pays no dividend. He has defended his rationale many times so I won't repeat it here.

Bottomline is how many Berkshire can you find, with consistent returns, credible management and most important of all, integrity. Return Of Money is more important than Return On Money

I have been presenting to this forum that there are at least 3 layers in the security we buy. The asset layer, the business layer and the structural layer and each has different cashflow profiles. As an OPMI... and I stress that unless you are a big time vulture fund etc... we take the residual of the 3rd layer. We will have to calculate our cashflow profile and ROIC based on that.

I didn't see the oxymoron with Berkshire and WB's cash flow statements, base on interpretation of cash flow doesn't always mean dividend. Positive FCF is also a meaningful cash flow.

I respect your interpretation of "cash flow" within the context of this thread. I am afraid I have slightly different interpretation, which I am pretty sure consistent with WB's

I admire your theory of the 3 layers, which doesn't seem contradicting with my view.

Put in another way: With dvd paying assets, in 10 years you can buy another one. In another 10 years you would have 4 of such assets.

Curiously Buffett likes to clip 10% coupon from pref shares

One similarity between Buffett and China govt is that they aim to just double in 10 years. Simple steady formula but requires loads of patience and discipline.

(19-02-2014, 11:52 AM)specuvestor Wrote: Put in another way: With dvd paying assets, in 10 years you can buy another one. In another 10 years you would have 4 of such assets.

Put in another way from my perspective: Without the dvd paying, in less than 5 years, you have already got another one, albeit double the same one.

(19-02-2014, 11:52 AM)specuvestor Wrote: Curiously Buffett likes to clip 10% coupon from pref shares

Yes, Mr. Buffett likes 10% coupon, as much as he likes the warrant attached with the deal. Interesting, the return from warrant seems better than the coupons, at the end of the day.

(19-02-2014, 11:52 AM)specuvestor Wrote: One similarity between Buffett and China govt is that they aim to just double in 10 years. Simple steady formula but requires loads of patience and discipline.

I agree.

It seems the discussion will continue to stay on opinion level. I respect your view, and may be a good point to end the discussion here.

Bow out with respect.

(19-02-2014, 01:22 PM)CityFarmer Wrote:

(19-02-2014, 11:52 AM)specuvestor Wrote: Curiously Buffett likes to clip 10% coupon from pref shares

Yes, Mr. Buffett likes 10% coupon, as much as he likes the warrant attached with the deal. Interesting, the return from warrant seems better than the coupons, at the end of the day.

Actually, it is not exactly the 10% coupon that Buffett likes ceteris paribus. You have to take into context of the all the securities bundled together. In the case of Goldman for example, there are 3 things to note:

1st) The most important, the capital structure at which preferreds are standing is higher than the common. That is, Buffett bought some security for himself in terms of higher claims on assets if things worsen. Of course you may argue the value on its derivatives book may be nothing more than waste since I guess no one really understands the linkages.

2nd) His hurdle rate is 13%. A just only slightly lower coupon rate of 10% gives much more room to catch up with his warrants. More than that, Goldman had to repurchase the preferreds at the 10% premium.

3rd) Lastly, of course is the warrants that give him the upside to exercise at $115/share. Basically a long on the stock.

So you have to really put these together to see that the odds are good at it is going to work out higher than 10%. It is just that his manner of structure goes akin go sacrificing some upside (by means of higher exercise price), for more downside protection. Something like convertible preferreds.

Please correct me if I am wrong.

IMHO pref share structure is not primarily for the credit perspective, but for a FIXED 10% coupon with no tenor. That's his cashflow. If you read how he analyse the S&P puts that he sold, it is also on a financing cashflow perspective rather than on a option pricing basis.

If upside is all he cares about he should have bought shares with warrants. In a nut shell it all buoys down to why one needs to have a split between bonds and equities in a portfolio.

If you can answer that in a practical non academic way, you will know the angle. For sure limited downside with good MOS is important to him. In fact it is risk-adjusted returns that counts.

PS how do you arrive at the 13% required return for Buffett?

Speculator Bro,

Buffett did mention publicly a while back that he wouldn't have done the GFC pref share deal (i.e. either Goldman or GE, or both) without the equity options. Also, the BAC pref shares + option deal done in 2011 was at much lower than 10% (6%+ IIRC).

At the risk of appearing silly in front of a financial expert , I believe what Buffett look for (in this sequence) is, (1) he must like the stock and importantly at the exercise price (and hence the options); (2) downside protection via pref shares exposure rather than equity; and lastly (3) sweetener in the form of high pref share dividends.
My view if it doesn't pass screen (1), he probably won't proceed.