The numbers

[collegeinvestor]

Hey I am a new investor and I don't know if anyone else is new here. I thought it would be cool if we had a forum thread on this website where we can figure out the numbers to help others out. I feel like you could read millions of articles and still not be able to invest. I feel like if you dont know how to calculate the numbers sitting on the internet reading the wsj is a waste of time! Its so hard for a nubie to actually understand the numbers!

 

I am going to try to calculate owners earnings and let me know if I am right or wrong:

 

For JNJ in the year 2008 you would take the net income (12 billion 266 million) + depreciation (2 billion 744 million) and subtract (CAPEX)  2 billion 365 million to get owners earnings of 12,645,000,000. As a result if you divide the market cap of of roughly 178 billion/12,645,000 you get an owners earnings yield of 14.83 percent and if things were to stay that way thats how much cash you would generate from that investment.

 

In addition Enterprise value is 178 billion + net debt which is pretty much zero so the enterprise value is roughly the market cap? Am I wrong? thanks for the help. I feel like this could be a good place for nubies to figure out the numbers. Let me know if you want me to delete this topic or if i am totally wrong!

[Nnejad]

Well one thing that sticks out:  If you take market cap and divide it by owner earnings, you get the P/E ratio, not the earnings yield.  Owner Earnings / market cap gives you the yield.

[collegeinvestor]

haha first mistake. I knew something was messed up when I saw that so if you take that you get a cash yield of 6.74%. I am guessing there are bonds that yield this figure that are way safer?

[collegeinvestor]

Oh and also I have another question sorry about so many questions. I am looking at casinos stocks because they got smashed and are still down. If you look Las Vegas Sands Corp their depreciation has gone through the roof roughly 5x. Is this directly as a result from their increase in PPE? For instance, Las Vegas sands corp has the following stats:

 

2006                                          2009:

depreciation  110 million                          depreciation 586 million

total ppe          6 billion                                      total ppe 16 billion

[Parsad]

Don't worry about the questions.  It's how we all learned.  In regards to the increase in depreciation...yes it is directly correlated to the increase in PPE.  Cheers!

[collegeinvestor]

Parsad I have been reading your posts for a while. This is a really cool website for me to learn. I went to the annual shareholder meeting in 2008 and it changed my life (BRK). Munger was hilarious. In addition, one of my favorite quotes was when he was saying how if you can learn how to compound 15% for 15 years you will be very rich. He also talked about how he would rather just own 1 stock that could do that--while Warren was a little apprehensive about giving that advice. Thanks for this resource.

 

So in essence if you purchase property with debt you can essentially increase cash flow and fool your investors if the debt expense for the year are less than depreciation. Pretty interesting.

[Parsad]

There are alot of strange things under GAAP accounting.  Over time, the more financial statements you read, the more amazed you'll be by all the stupid things you see and the stuff people get away with.  Enjoy the board!  Cheers!

[Rabbitisrich]

You wouldn't necessarily be fooling investors by funding PPE with debt. Keep in mind that even Buffett made adjustments to owner's earnings if there were special circumstances with working capital and growth vs. maintenance capex. The numbers are an aid to understanding the economics of a company. If the rate of return on an asset is greater than the debt used to fund it, then you may have a good purchase so long as the additional debt doesn't significantly impair the balance sheet.

[twacowfca]

haha first mistake. I knew something was messed up when I saw that so if you take that you get a cash yield of 6.74%. I am guessing there are bonds that yield this figure that are way safer?

 

Maybe. But bonds with reinvested interest may not compound at the same rate as JNJ with reinvested dividends ( especially considering the different tax rates on interest payments and dividends).  JNJ has a much higher return on capital over many years than the return on capital that would occur with reinvestment in the bond.  Therefore, if JNJ's ROC continues to be high and there are substantial opportunities for reinvestment,

JNJ's intrinsic value will grow at a much higher rate than the bond's.  :)

 

Also realize that JNJ's main reinvestment isn't capex, but R&D that is generally expensed rather than capitalized.  If this incremental expense works like a good investment, JNJ's earnings will grow magically in the years ahead, with allowance for the ups and downs of their patent development and expiration cycle.  If their earnings don't grow after making allowance for their cycle, they may be experiencing regression to the mean in their returns along with the entire pharmaceutical industry, although their non pharmaceutical products may insulate them from this trend,

[hyten1]

i tend to be on the conservative side

 

i would usually not include depreciation/amortization as part of earnings, nor would i include stock options etc

 

obviously the depr/amort really depends on the company

 

but i try to be conservative

[SharperDingaan]

 

Always keep in mind that even if the P/E multiple (assume 12x) for both a casino operator, and a big integrated oil, are the same; it does not mean that they are priced equally (despite what the textbook says). It really means that if you bought today it will take 12 years to get your original investment back, without regard for inflation (2), and only if the future earnings are the same as todays (1).

 

(1) Earnings volatility. The business cycle produces higher earnings at the peak vs trough; some industry cycles are shorter & more extreme than others, and some industry earnings are more predictably reliable. Your purchase locked you in to a certain point on the business cycle for the next 12 years;tears if you locked in at peak earnings. You also locked in an annual $ amount of earnings, & an early shortfall will hurt; volatility is not your friend. The integrated oil is the better choice.

 

(2) Inflation. Assume average inflation over the 12 yr period of 2%/yr, & GDP growth of 2%/yr. The future value, adjusted for inflation, of today’s $12 investment is $15.22 [12*(1.02)^12]. Earnings should increase by at least the inflation + GDP growth rate, or 4%/yr. The future value, adjusted for inflation, of today’s $1 of annual earnings investment is $1.60 [1*(1.04)^12].  All other things equal the P/E multiple at the end of year 12 should be 9.51x [15.22/1.60]. Points? (A) if you expect positive GDP growth, the higher the P/E the more of a margin of safety you have [ WEB’s Burlington Rail] (B) If you expect deflation (& economic intervention) you want the lowest P/E possible as the future P/E multiple will be less than what you paid; ie: FI becomes the better bet [Hoisington].

 

The lesson here is recognizing that there are 2 applications;

95% of the population will do nothing more than calculate the industry multiple, develop a company specific earnings estimate, & multiply. Buy if the shares are underpriced, sell if they are overpriced. But maybe 5% of the population goes that extra mile to actually understand the ratio. Nothing magical. Guess where WEB is.

 

SD 

 

[kapilm]

In EV calc, you need to subtract the cash as well.

[savant]

 

Points? (A) if you expect positive GDP growth, the higher the P/E the more of a margin of safety you have [ WEB’s Burlington Rail] (B) If you expect deflation (& economic intervention) you want the lowest P/E possible as the future P/E multiple will be less than what you paid; ie: FI becomes the better bet [Hoisington].

 

 

SD 

   

 

Hi - I'm not quite sure I understand. Are you saying that every thing else being equal it makes more sense to pay 12x instead of 6x for earnings if one expects positive GDP growth? Please could you elaborate as it flies in the face of conventional wisdom that the lower the multiple the more the marign of safety.

 

Thanks in advance for your reply

[SharperDingaan]

 

"Please could you elaborate as it flies in the face of conventional wisdom that the lower the multiple the more the marign of safety"

 

Assume inflation is 2% & GDP is 2%. If you simply bought & held for the entire payback period the P/E you paid today, recalculated at the end of year 12, would fall to 9.51x from the 12.00x that you actually paid. If nothing changed, & you held for the full term, the 2% GDP growth alone would give you a 21% margin of safety [1-(9.51/12)]*100.

 

Recalculate using the same 2 & 2 assumption, & a multiple of 25. Then recalculate using a multiple of 12; & a -2 & 2 assumption. Very different effects. 

 

You're looking at what GDP does, deflation does, & the length of the holding period does. Then look at WEBs actual practices ('buy & hold forever' & Burlington Rail). The old guy aint bad.

 

SD

[Packer16]

Another important adjustment is adding back any acquisition related amortization (as this is a non-cash charge) and changes in working capital (in this case it is not significant but in some industries it is).

 

Packer

[collegeinvestor]

Why would you add back changes in working assets (current liabilities or assets) is this b/c you  use cash to either buy the assets or you use cash to pay off the current liabilities? How would this work if you added current liabilties b/c you are not changing cash. Thanks again for all the help.

[Packer16]

I mistyped there.  You need to subtract changes in net working capital to account for the additional cash required to support current assets less current liabilities with a required amount of cash.

 

Packer

[savant]

 

Assume inflation is 2% & GDP is 2%. If you simply bought & held for the entire payback period the P/E you paid today, recalculated at the end of year 12, would fall to 9.51x from the 12.00x that you actually paid. If nothing changed, & you held for the full term, the 2% GDP growth alone would give you a 21% margin of safety [1-(9.51/12)]*100.

 

Recalculate using the same 2 & 2 assumption, & a multiple of 25. Then recalculate using a multiple of 12; & a -2 & 2 assumption. Very different effects.   

 

 

Thanks for the reply SD

 

Recalculating using a 25x multiple I did the following calc:

 

In year 1, Price is $25 and EPS is $1.00 for a multiple of 25x. Assuming 2% inflation and 2% GDP growth, in 12 years price goes to $31.7 and EPS to $1.60 for a multiple of 19.8x which is still a margin of 21% (19.8/25 -1). I think I may be missing something here. Help would be appreciated. Apologies for being so slow on the pick up.

[SharperDingaan]

 

There were 3 things to note:

(1) Doubling or halving the multiple effectively produces the same MOS (barring a very small mathematical delta). ie: The MOS is almost entirely a function of expected GDP. (2) Both inflation, AND deflation, reduce the day-1 multiple the longer you hold; & they do it by about the same amount (slightly more for deflation). ie: The MOS is almost entirely due to the length of the holding period. (3) If todays GDP growth is negative - the multiple is actually much higher than it looks.

 

Here endeth the lesson.

 

SD 

 

 

[savant]

 

There were 3 things to note:

(1) Doubling or halving the multiple effectively produces the same MOS (barring a very small mathematical delta). ie: The MOS is almost entirely a function of expected GDP. (2) Both inflation, AND deflation, reduce the day-1 multiple the longer you hold; & they do it by about the same amount (slightly more for deflation). ie: The MOS is almost entirely due to the length of the holding period. (3) If todays GDP growth is negative - the multiple is actually much higher than it looks.

 

Here endeth the lesson.

 

SD 

 

 

 

Thanks. I agree with your points above. But I still don't quite understand your initial statement (which I have pasted below) but lets put the topic to rest as you mentioned. Thanks for taking the time.

 

"if you expect positive GDP growth, the higher the P/E the more of a margin of safety you have [ WEB’s Burlington Rail]

[collegeinvestor]

I dont understand how inflation leads to higher earnings. If you increase the price of goods then the costs (VC and fixed costs) will still increase as well. In addition, I understand that if you grow earnings then the forward P/e ratio would get smaller but then wouldn't you techincally be a speculation on the growth ? Also, how would an increase in GDP create a margin of safety? I see how if you have an increase in gdp the future value of the earnings will go up in time but arent you guessing that the gpd will go up which involves speculation?

[SharperDingaan]

 

"if you expect positive GDP growth, the higher the P/E the more of a margin of safety you have".

Sorry this was a miss-keying; it should be if you expect positive GDP growth, the higher the GDP growth, the more of a margin of safety you have.

 

The future dated P/E formula is P(1+i)^N/E(1+i+g)^N. P=Price paid today, i=inflation, g=GDP growth, E=current one-year earnings estimate, N=holding period in years. As i is in both the numerator & denominator the formula simplifies to P/E(1+g)^N.

 

I sell a good for $10 that has has a $6 VC; CM is $4. Assume I have 10% inflation & can pass it on to my customer. I now sell at $11.00 with a cost of $6.60; CM is now $4.40. If most of the fixed cost is depreciation or amortization (doesn't change with inflation), & labour cost raises are 'sticky' (usually the case), most of extra $0.40 in CM will flow to the bottom line. Earnings go up.

 

To buy any business is to speculate that its future growth will be at least the GDP growth rate. Buying NT at 120x earnings is to speculate that NT's future earnings are going to 10x what they today (if a 12x P/E is reasonable), & in pretty short order. Ridiculous of course, but par for the course when looking at start-ups!

 

Cheers

 

SD

 

 

 

[collegeinvestor]

Thanks for all the help. So in essence, over time if the government prints money they help business owners make money while squishing the lower classes.

[SharperDingaan]

 

No - a government action that produces GDP growth (free trade, hi-tech research, labour force productativity, etc), helps BOTH business owners (make more $ by making increasing the pie), & workers (higher standard of living). Printing money (inflation or deflation) just increases nominal earnings, & often to negative effect (Zimbabwe, Weimar Germany, etc). Make an extra $10 to buy things that now cost $10 more, makes you no better off.

 

Burlington is esp attractive as it is a high FC business with revenues that are largely not commodity driven, & a large chunk of FC (amortization) that doesn't vary much. A small government action (ie: small tax on gasoline to raise revenue) increases volume (truck traffic switches to rail) AND rate, and then magnifies g by the operating leverage in the coy.

 

Lesson: Offer conservative financial leverage, aggessive operating leverage, & the reasonable prospect of positive GDP growth ... and you'll get a high multiple for it. ..... And isn't this pretty close to the value investors definition of a 'good' business?

 

SD

[twacowfca]

 

No - a government action that produces GDP growth (free trade, hi-tech research, labour force productativity, etc), helps BOTH business owners (make more $ by making increasing the pie), & workers (higher standard of living). Printing money (inflation or deflation) just increases nominal earnings, & often to negative effect (Zimbabwe, Weimar Germany, etc). Make an extra $10 to buy things that now cost $10 more, makes you no better off.

 

Burlington is esp attractive as it is a high FC business with revenues that are largely not commodity driven, & a large chunk of FC (amortization) that doesn't vary much. A small government action (ie: small tax on gasoline to raise revenue) increases volume (truck traffic switches to rail) AND rate, and then magnifies g by the operating leverage in the coy.

 

Lesson: Offer conservative financial leverage, aggessive operating leverage, & the reasonable prospect of positive GDP growth ... and you'll get a high multiple for it. ..... And isn't this pretty close to the value investors definition of a 'good' business?

 

SD

 

Hear!  Hear!  Very well said, Sharper D.