Valuation Techniques Help Please

[SharperDingaan]

For simplicity, assume that future fines negate all earnings over the next year, & there are no capital raises.

 

BIS requires all banks to hold a minimum 10.5% of RWA as regulatory capital, effective Q1 2014. The current official minimum (in Canada) is 8.5% of RWA. To get that extra regulatory capital, you would have to rank your various LOB by RAROC, & reduce business in the lowest ranking LOB until you get to the 10.5% RWA. All you need know is average asset quality by LOB, which LOB are capital heavy, how much of that LOB the bank does, & what the new regulatory capital requirement is. All published quarterly.

 

The more asset quality improves (& the better the bank is run) the less need for capital raises &/or exits from higher risk LOB. The lack box becomes far easier to assess. Wells beats Goldman Sacs because outcomes are less uncertain.

 

SD 

 

 

 

 

[augustabound]

How do dividends factor in your stock valuations?

 

I notice that most people don't mention them at all.  I realize a company yielding 1% is negligible in the grande scheme but what about 3 or 4%?

[Guest longinvestor]

Does anyone believe that Buffett (arguably the greatest investor of all time) does more than back-of-the-envelope calculations when making investment decisions?

 

He barely knows how to use Excel and rarely touches a computer, so, think long and hard about that.

 

The complexity of the calculations he uses when making investments are limited.

 

Either he veers away from overly complicated businesses that he cannot value with his relatively simple methods or he figures out what kind of back-of-the-envelope calculation makes plenty of sense for the business he's considering.

 

If it takes a Masters or PhD caliber of person / knowledgee to arrive at your valuation, the market will definitely never look at it like you do. Most market participants can't think on those levels and will never be comfortable with your thought process, therefore.

 

I believe Buffett's purchase of Bank of America, despite the company's complexity, was based significantly on a back-of-the-envelope calculation that made a lot of sense...a la Bruce Berkowitz.

 

And, I believe Buffett is a heavy user of multiples (derived based on his experience)...Alice Schroeder has said that all Buffett wants to do is make a 10% pretax return on his investment with little risk, for example. In his younger days (when he had less capital to manage), it was probably 15-20% instead of 10%.

 

Well said! Munger uses an "Adding machine" and his "dog-eared book of discount tables". Surely these two tools are put to use only on a few select ideas after voracious reading of everything under the sun.

[JBird]

Here's an example of valuing businesses: http://webreprints.djreprints.com/3026020366910.pdf

 

Understanding the business is key. I'm not sure how to choose a discount rate. I only feel comfortable estimating intrinsic value when there are comps to look at. Usually if something is trading at low multiples, I don't think about a target price.

 

When I read about EBITDA I can't help but think of Charlie Munger calling it bullshit earnings, yet so many people seem to use it. 

Most of Geoff Gannon's articles cite EBITDA. But I like his thought process in researching the actual company.

 

If I understood the article, this guy uses an industry comp as a basis for EBITDA and cash flow.

 

Different strokes for different folks I guess. 

It's times like this that I see why people use Buffett's owner earnings number.

 

That Munger quote is one of my favorites. Here's one from Buffett, ""We’ll (Berkshire Hathaway) never buy a company when the managers talk about EBITDA. There are more frauds talking about EBITDA. That term has never appeared in the annual reports of companies like Wal-Mart, General Electric, or Microsoft. The fraudsters are trying to con you or they’re trying to con themselves. Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money. We have found that many of the crooks look like crooks. They are usually people that tell you things that are too good to be true. They have a smell about them."

 

Augustabound, your username got me thinking. For the golf-minded reader, EBITDA is akin to what may be called SYB-WELR; Shot Yardage Before Wind, Elevation, Lie, and Rough. A player may happily boast his distance before WELR on the range, but ignoring WELR on the actual golf course makes him look like a total horse's ass.

[JBird]

And, I believe Buffett is a heavy user of multiples (derived based on his experience)...

 

I don't know if you are right or wrong about this statement. But is there evidence to back this up? Quotes?

[LC]

And, I believe Buffett is a heavy user of multiples (derived based on his experience)...

 

I don't know if you are right or wrong about this statement. But is there evidence to back this up? Quotes?

 

I don't think Buffett would do anything more complicated, like using a spreadsheet, to estimate intrinsic value. He probably takes owners earnings (normalized) and uses a multiple that he finds appropriate. He might compare a business to a 10-year treasury and work from there. Businesses he invests in usually have durable economic advantages and steady cash flow generation, which makes intrinsic value estimation a bit easier.

 

I also read something about a 15% hurdle rate. He might be looking at owners earnings [normalized]/EV.

I don't think he is contemplating between a 12 vs 15x multiple. I think he reads everything he can get his hands on about an investment and then makes an intelligent and fair estimate at what it is worth. Discount it for a margin of safety and he has his offer price.

[WarrenWatsa]

And, I believe Buffett is a heavy user of multiples (derived based on his experience)...

 

I don't know if you are right or wrong about this statement. But is there evidence to back this up? Quotes?

 

He has spoken in terms of multiples if you follow his writings / quotes.

 

eg. "I love newspapers and, if their economics make sense, will buy them even when they fall far short of the size threshold we would require for the purchase of, say, a widget company. …At appropriate prices – and that means at a very low multiple of current earnings – we will purchase more papers of the type we like."

 

At the 2012 shareholder meeting, one analyst asked Buffett how he would value the non-insurance operations. Buffett responded that he would look to buy similar businesses for 9-10 times pre-tax earnings.

[blainehodder]

And, I believe Buffett is a heavy user of multiples (derived based on his experience)...

 

I don't know if you are right or wrong about this statement. But is there evidence to back this up? Quotes?

 

I don't think Buffett would do anything more complicated, like using a spreadsheet, to estimate intrinsic value. He probably takes owners earnings (normalized) and uses a multiple that he finds appropriate. He might compare a business to a 10-year treasury and work from there. Businesses he invests in usually have durable economic advantages and steady cash flow generation, which makes intrinsic value estimation a bit easier.

 

I also read something about a 15% hurdle rate. He might be looking at owners earnings [normalized]/EV.

 

Maybe I’m crazy, or maybe this should be taught in MBA programs… I’m not really sure... but this is how I think about owner earnings:

 

Owner Earnings is an equity number as opposed to an enterprise number.  Owner earnings is bascially normalized operating cash flow less maintenance capex right?  It basically answers the question, "What could I pull out of the company and stuff in my jeans if I were a private owner?"  If you are looking at an owner earnings yield you should compare it apples to apples with the market cap.  This can be very useful for napkin math.

 

Using rough numbers here, say "Company A" has a relatively normalized Cash flow from ops of 10M, with maintenance capex of 4M and a market cap of 50M.  Ower Earnings are going to be roughly 6M in this scenario. 

 

Theoretically,the owner earnings yield would equal your dividend yield if "Company A" chose to pay out the whole sum of owner earnings as dividends (which is net of enough capex to maintain the business at roughly the rate of inflation).  In this scenario it would be 6/50 = 12%.  If your assumptions are correct the company could theoretically isssue dividends at 12% of your purchase price, scaled to inflation forever, assuming the company has at least inflation protective pricing power (like See's or Coke).  That would be nice.

 

Where this analysis becomes complicated is when the company chooses not to just pay it all out.

 

Maybe the company chooses to do other things with the owner earnings.  Maybe it reinvests in the business to grow faster than simple maintenance, or it could pay down debt, or  buyback stock etc...

 

This is where analysis of capital allocation comes into play.  Lets say the company dividends out half of your owner earnings, and reinvests half of your owner earnings at precisely a 20% return.... now you are going to do better than the simple "payout everything" baseline of 12% right?  You are now going to make more like 13%+ because of the (3M dividends + 3M*1.2 internal reivestment) / vs market cap) , ignoring tax implications.

 

Now, if you dont make at least your "owner earnings yield", it basically means management is destroying value... and it typically happens when companies take owner earnings and pursue low return projects instead of paying out the cash.

 

That is basically how I use owner earnings. I use it as a baseline, to answer the question, "How much would I earn here if the company paid out everything it could to simply maintain unit volume and grow at the rate of inflation."  Then I ask if management will do better or worse than this baseline "pay it all" model.  Will they invest in low return projects which would make me do worse, or will they reinvest in high return projects (because it is a good business) and that will boost my baseline return? Will they buyback stock if the net of those assumptions increases my owner earnings yield...etc.  The most important question then becomes, do I trust management to allocate the owner earnings well.  If the purchase price is cheap but the business is terrible but stable, you will do well if you pull the cash out (Like the old mills at BRK).  If the the business is great, you want to reinvest as much as possible before the returns dwindle, at which point you want to start pulling the cash and finding higher return investments (like See's - great returns but limited scale).

 

If you start to find many companies with a theoretical owner earnings "pay it all" yield greater than 15%, and they can allocate capital internally at even higher rates, you will do very well over the long term if your owner earnings estimates are correct.  At least that is my assimption. 

 

I think Buffett uses owner earnings for this sort of napkin math. Of course if you flip the yield you get a multiple.  I find that less intuitive personally.  Maybe this simple model is garbage and way off the mark to Buffett's actual thinking...but I find it pretty useful.

[Buckeye]

 

LC - Great tip on not trying to focus so much on the exacts of future cash flows, but concentrate more on past and current exacts and be general about future prospects.

 

 

I'd recommend reading this speech: http://turnkeyanalyst.com/wp-content/uploads/2013/02/Williams-Trying_too_Hard.pdf

 

Some of my key takeaways (and a humorous line):

 

-Confidence in a forecast (or valuation) comes from the amount of information we put into it. However the accuracy of your forecast/valuation stays the same.

 

-Respect the virtues of a simple investment thesis. Successful investments must have a simple thesis, by nature.

 

-Complication is evidence of a poor thesis

 

 

Now for the humorous line:

"An investor without a forecast is like a fish without a bicycle"

 

Hey LC-

 

Nice find.  That talk is great.  I like the story of the 75 year old investment manager who had the best ten year returns and had never heard of Ben Graham!

 

Have you ever read the two books that were mentioned in the talk? The Tao of Physics or Dancing Wu Li Masters?  That seems like some Charlie Munger titles to me:)

 

Thanks for posting.

[LC]

They're on my "zen" to-do list once I finish "Zen and the Art of Motorcycle Maintenance"  ;D

[Palantir]

Am I right in saying that there is no difference between FCFE and "Owner Earnings" apart from the addition of "Net borrowing" to FCFE? I don't see any, and I just want to confirm.

[LC]

Am I right in saying that there is no difference between FCFE and "Owner Earnings" apart from the addition of "Net borrowing" to FCFE? I don't see any, and I just want to confirm.

 

In my view, FCFE is the cut and dry cash in and out of the business. All non-cash expenses are included, including working capital and financing costs.

 

Owner's equity I view as the cash-adjusted Net Income. I will include financing costs if they are necessary to the regular running of the business. That is, it's a real cost to have to pay a $20m financing cost up front. Amortizing it over the life of the debt is not a true cost. I will not include working capital adjustments because the changes in cash there are for the regular running of the business.