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:
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"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