Buy and Hold Valuation Question/Discussion

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#1
Hi all,

I was thinking if one was assessing potential investment candidates for buy and hold capital appreciation, how would one go about doing the valuation since the returns are to come mainly from the future?

Standard finance textbook preaches the discounted projected free cash flow model for valuing companies intrinsic value.

In Mohnish Pabrai "Dhandho Investor", he uses a variation where instead of the standard terminal value computation, he assumes a trading multiple on future projected cashflow for terminal value.

Problem is with DCF projection models, a large part of the intrinsic value comes from terminal value... but given that most business models grow obsolete overtime e.g. Kodak, Video Rentals even so called standard terminal value assumptions like "assume terminal growth rates at GDP/Rate of Inflation" can prove to be too optimistic. Other problems include high sensitivities to assumed growth rates and discount rate.

How do we overcome this problem? (Without some form of terminal value computation, the DCF model cannot work...)

Mohnish method was to buy at a 50% margin of safety on the calculated intrinsic value which appear to me to be quite self contradicting since it means his projected DCF model accuracy and reliability is very low... (might as just set a very low CF/PE mulitple as price target)

Some of my newbie thought on the above as below:

i) There is no need to come up with precise intrinsic value figures... think valuation instead in more probabilistic terms of whether it is possible to achieve desired IRR in light of current available facts .

ii) First come up with a desired rate of return say 15% per annum and an investment horizon say 5 years. In this case, to double one $ in 5 years time.

iii) Look at the current stock price today. Say company sells at $10 per share with 3-5 years average free cash flow per share of $1 (can use some other more relevant proxy metric like EPS, book value, important thing is metric need to be representative and adjusted for cyclicality and one off factors)

iv) Also look at the representative dividend payout ratio. Say company has been paying 20% of FCF for some years.

v) Since goal is to receive $2 for every $1 invested. It means selling at an approximate price of $19 in 5 years times assuming 20 cents in dividend per year.

vi) Since company need to sell at $19 in 5 years time... we can reverse engineer the business fundamental needed to justify the price and can cross check whether such fundamentals are achievable realistically in light of the industry environment and company track record.

vii) In this case, the company will need to generate FCF in the range of S$1.70 to S$2.00 depending on one guess of the future multiple (can look at historical trading range for reference) at which it would trade. More important would be thinking about the associated business fundamentals such as the revenue base, margins, amount of invested assets etc needed to produce that range of FCF.

viii) Think and assess business wise what management has to do in order to attain those revenue base, margins, level of invested assets in light of its current business environment.

ix) In this hypothetical case, the company has to either double the revenue or the margins or some function of both. It also probably has to double its invested operating assets unless margins i.e. ROA can be expanded/increased. Operations wise, this mean management taking actions to increase market share, raising prices, introducing new products, increased productivity on infrastructure/capital equipment etc.

x) Application wise, the method inclined towards a negative selection process. For example, the candidate company existing fundamental profile may be one of a niche provider with little growth space and already high margins/ROA, thus one can reject the company as an investment since it is not probable the fundamentals can improve to such an extent within 5 years (unless the share price of the company now falls like 40% to 50%). One can also use this method to reject things like companies with already very high market share unless new products will be introduced (say 45% of existing products market share) or are demonstrated price takers or stretched balance sheets (unable to get financing to invest the necessary amount of assets) etc. One can also reject if management plans for the future seem to not reconcile with what need to be done.

xi) Positive selection would seem to occur only when the current share price is very low in relation to existing fundamentals and it seem highly probable from one assessment that the improvements to fundamentals needed to reach/justify the desired exit price are not too aggressive and is within reality.

xii) In the end, my method is still banking on future fundamental performance which is uncertain and unknown. Different from DCF modelling only in that I do not attempt to come up with specific year to year forecasts nor compute a specific intrinsic value, nor seek some specific % MOS from computed intrinsic value. The go and no go is almost entirely determined by probabilistic assessment of business factors driving the chosen valuation metric.

Not sure if I being naive or illogical here or is over simplifying the valuation process... what am i missing here? Appreciate and be grateful for any comments fellow buddies may have. Thanks and sorry for the long post.
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#2
hmwes Wrote:Problem is with DCF projection models, a large part of the intrinsic value comes from terminal value... but given that most business models grow obsolete overtime e.g. Kodak, Video Rentals even so called standard terminal value assumptions like "assume terminal growth rates at GDP/Rate of Inflation" can prove to be too optimistic. Other problems include high sensitivities to assumed growth rates and discount rate.

How do we overcome this problem? (Without some form of terminal value computation, the DCF model cannot work...)

You are essentially asking:

"I am trying to drink soup. But the fork does not work well. How can I use the fork better?"

The obvious answer is:

"Do not use a fork. Use a spoon."

In other words, recognize that DCF is NOT always the best tool. As Charlie Munger has pointed out, to a man with a hammer, every problem looks like a nail.

Sometimes you are dealing with a screw. Wouldn't it be much effective to use a screwdriver? And other times you need pliers, scissors, wire cutters etc. Keep multiple tools in your toolbox. A so-so screwdriver is still far better than the best hammer at dealing with a screw.

I personally use 3 models:

1. DCF

This is only if the future cash flows are extremely predictable. Very very few companies fall into this category. Usually I use it for companies with a known terminal value e.g. K-Green Trust which has a terminal value of zero when its concessions expire. The biggest variable here is the discount rate.

If the company is a commodity producer e.g. plantations, mines etc then you have another variable - the commodity price. If you use DCF for commodities it becomes clear that EVERYTHING depends on the commodity price - so if you have no concrete idea why future prices will be X, you are flying blind.

2. RNAV

This is essentially a calculation of liquidation value. Best used for companies that can be sold off in pieces without disrupting business e.g. real estate, shipping. Most manufacturing companies do not fall into this category.

3. Earning Power

This assumes the company in question has a perpetual life. During the period you own it, it makes money, some of which it pays to you as a dividend, and some of which it reinvests to grow the business. The historical track record gives you some idea as to how stable/cyclical the business is, and whether the current level of earnings, debt etc is low/high relative to history. You have to decide how much you are willing to pay for such a business.

====
Category 3 is probably the hardest as it contains many subjective elements. Unfortunately, most companies fall into this category, so either learn to analyze it, or accept that your investment universe will be very restricted (which may not be a bad thing, as doing one thing well can be better than doing many things poorly).
---
I do not give stock tips. So please do not ask, because you shall not receive.
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#3
And suddenly, the gangster realised he had brought a knife to a gun fight...
Just google singapore man of leisure
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#4
(19-08-2012, 04:43 PM)Jared Seah Wrote: And suddenly, the gangster realised he had brought a knife to a gun fight...

RELAX!
Just For Laugh!

Hey! It's me
"小李 飛 刀".
Na.. Ah..
Never believe in guns when i can kill Bear & Bull with my flying knives.
Ha! Ha!
WB:-

1) Rule # 1, do not lose money.
2) Rule # 2, refer to # 1.
3) Not until you can manage your emotions, you can manage your money.

Truism of Investments.
A) Buying a security is buying RISK not Return
B) You can control RISK (to a certain level, hopefully only.) But definitely not the outcome of the Return.

NB:-
My signature is meant for psychoing myself. No offence to anyone. i am trying not to lose money unnecessary anymore.
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#5
(19-08-2012, 02:39 PM)d.o.g. Wrote: 3. Earning Power

This assumes the company in question has a perpetual life. During the period you own it, it makes money, some of which it pays to you as a dividend, and some of which it reinvests to grow the business. The historical track record gives you some idea as to how stable/cyclical the business is, and whether the current level of earnings, debt etc is low/high relative to history. You have to decide how much you are willing to pay for such a business.

====
Category 3 is probably the hardest as it contains many subjective elements. Unfortunately, most companies fall into this category, so either learn to analyze it, or accept that your investment universe will be very restricted (which may not be a bad thing, as doing one thing well can be better than doing many things poorly).


Sorry to hijack the thread, but just a point for discussion. The commonly cited method of calculating Earnings Power Value is to use After-Tax EBITDA - Maintenance Capital Expenditures. Should free cash flow be used instead? (i.e. should changes in working capital be taken into account as well?).

To me, it would seem more prudent to use free cash flow, so I'm kinda perplexed by most sources that explain Earnings Power Value without accounting for changes in working capital.

Any thoughts from the old birds here? :S
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#6
(19-08-2012, 07:41 PM)mysterion Wrote: Sorry to hijack the thread, but just a point for discussion. The commonly cited method of calculating Earnings Power Value is to use After-Tax EBITDA - Maintenance Capital Expenditures. Should free cash flow be used instead? (i.e. should changes in working capital be taken into account as well?)

At steady state working capital should be constant. That's why the emphasis is also on "Maintenance Capex" and not on "Total Capex" which would include money spent on expansion.
---
I do not give stock tips. So please do not ask, because you shall not receive.
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#7
(19-08-2012, 07:44 PM)d.o.g. Wrote:
(19-08-2012, 07:41 PM)mysterion Wrote: Sorry to hijack the thread, but just a point for discussion. The commonly cited method of calculating Earnings Power Value is to use After-Tax EBITDA - Maintenance Capital Expenditures. Should free cash flow be used instead? (i.e. should changes in working capital be taken into account as well?)

At steady state working capital should be constant. That's why the emphasis is also on "Maintenance Capex" and not on "Total Capex" which would include money spent on expansion.

So what you are saying is that an increase in working capital due the growing business should not be taken into account because EPV does not take into account any future expansion. E.g. a consistent inventory build-up in a growing consumer product business should not be taken into account in calculating EPV?
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#8
(19-08-2012, 08:30 PM)mysterion Wrote: So what you are saying is that an increase in working capital due the growing business should not be taken into account because EPV does not take into account any future expansion. E.g. a consistent inventory build-up in a growing consumer product business should not be taken into account in calculating EPV?

Working capital requirements should scale with the business. That includes receivables, inventory and payables.

If you are looking at current earning power, then you are assuming steady state operations which means no change in working capital.

If you assume the company grows forever, then cash flow will always be reduced by the additional investments into capex and working capital. You should adjust your calculations accordingly.
---
I do not give stock tips. So please do not ask, because you shall not receive.
Reply
#9
d.o.g. Wrote:
3. Earning Power

This assumes the company in question has a perpetual life. During the period you own it, it makes money, some of which it pays to you as a dividend, and some of which it reinvests to grow the business. The historical track record gives you some idea as to how stable/cyclical the business is, and whether the current level of earnings, debt etc is low/high relative to history. You have to decide how much you are willing to pay for such a business.

====
Category 3 is probably the hardest as it contains many subjective elements. Unfortunately, most companies fall into this category, so either learn to analyze it, or accept that your investment universe will be very restricted (which may not be a bad thing, as doing one thing well can be better than doing many things poorly).


Unquote:-
Me think for layman who knows very little mathematics, category 3 is much more easier to understand.
At least the company's has a lot of historical data for you to compare until the latest report.
And most of these companies in local aspects have been around for many, many years who are looked after with "GLC"= Gentle Loving Care (Er.... Gov. Linked Companies.

Layman who has very little knowledge of mathematics has no much choice.
DCF?
RNAV?
EPV - Maybe

Of course even some of these "GLCs" have gone into oblivion.
There is no such thing as a "free lunch"

Example:-
Who can know SMRT used to be a small "CASH COW" for so many years that seems nothing can go wrong, now looks like a "bottomless pit".
Don't know when or even whether SMRT can be a "CASH COW" again. Maybe it will never be again.
i have benefited from "SMRT"
i never imagine this "National Asset" of ours can deteriorate due to "overlooked-mismanagement".
SAD.
WB:-

1) Rule # 1, do not lose money.
2) Rule # 2, refer to # 1.
3) Not until you can manage your emotions, you can manage your money.

Truism of Investments.
A) Buying a security is buying RISK not Return
B) You can control RISK (to a certain level, hopefully only.) But definitely not the outcome of the Return.

NB:-
My signature is meant for psychoing myself. No offence to anyone. i am trying not to lose money unnecessary anymore.
Reply
#10
Britain in the pre-tatcher days had many "GLC" that were financially worsening through the bleeding of losses. Though it was a conflux of mis-management and strong union power.

Hence nvr just think cos its a GLC, its stable. Its still like any other business prone to cyclical environment etc.

Oh also, for DCF, you can create a spreadsheet out of it

I did DCF on PepsiCo before as project. Hope this could help those who seek to use DCF as calculations, though D.O.G will disapprove of DCF valuation methodology being used. Just input your company's financial info on the DCF tab

Feel free to edit any of the formulas. But no copying as your project lol


Attached Files
.xlsx   Finance Spreadsheet FINAL (valuebuddies).xlsx (Size: 479.21 KB / Downloads: 29)
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