RBD - Restaurant Brands

[gregrday]

Hi Sauce, thanks for that link, very interesting. I have looked at buffet methodologies in the past, and found them pretty valuable, particularly just the simple concepts of having a defendable moat, catastrophic failure (Xero, I'm talking to you!) and not overpaying. My DCFs are generally (very!) conservative, and I use them to try and get more or less a worst case scenario.

I agree, the WACC is ... suspect, and potentially meaningless. My gut feeling is don't make it too low! I'm reasonably happy with the 7.7% because of RBDs low interest bank loans, and also because the rest of the valuation is very conservative in terms of growth.

I guess where I come from is: I'm not very good at this, so I need a big margin-of-safety before investing. Although RBD has had a big run-up, I still think it is pretty undervalued on a very conservative basis. Time (probably the next earnings release) will tell...

cheers
Greg

[h2so4]

Hey Sauce thanks for that.

[Snoopy]

I think snoopy is challenging the method that one arrives at an appropriate discount rate, rather than saying one is unnecessary.

Snoopy, please correct me if I am wrong, but in more general terms I think you are saying this: Rather than bother with esoteric WACC formulas, why not just make your best judgement as to what is an appropriate rate of return that a rational investor would expect from the business based upon its quality and the risk of being in business, and use that as your discount rate?

The way you have expressed it may make be sound a bit pratty and arrogant, but I think you have summed me up correctly Sauce. Actually I probably am a bit pratty and arrogant on this issue!

SNOOPY

[Snoopy]

Why? Their cashflows are exactly the same. If you have a lower discount for Coke and a higher discount for Grandma then you wont be able to compare the two.

It seems to me that you are changing the discount rate to fit the valuation.

I will leave you with a quote from Buffett.

"Don't use different discount rates for different businesses...it doesn't really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows."

SSD, I think you are making the point that at the end of the day a dollar from Granny's Trotters is as good as a dollar from Coca Cola. Myself, I have yet to hold a dollar coin that cared where it came from either! I was also interested in your quote from Buffett, so I took the trouble to look it up to find out the full context.

It seems to be from a Meeting with Warren Buffett on 28 Jan 2005, as part of some synthesised notes. The full note text on "Discount rates used for valuation" is as follows:

------------
Discount rates used for valuation:
- Use a long term normalized interest rate for Treasuries…e.g. 6%
- Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.
- Only want one variable to compare in order to assess the viability of an investment – price versus value. If we allowed discount rates to change it would lead to more than one variable.
- WB’s assessment of the risk of a company is baked into the probabilities for future cash flow scenarios of the company
- “I don’t know what the true cost of capital is for a business unless we own it”
-----------

I would be interested if anyone has a different opinion. But my own take from these five bullet points is that Warren is very concerned with the quality of future cashflows from companies he holds. He assesses this future cashflow quality by looking at a series of scenarios and forming a probabilistic view of what will happen. He doesn't favour any variation in discount rates, because that makes his analysis more complicated than it needs to be.

Another way of looking at this same problem is to get a feel for the risk depending on what industry the company you are analyzing is in, and base some variable discount factor on that. Over one or two years this method is IMO not very reliable. But over a business cycle I think it has merit, and it is probably easier to quantify than the various probabilistic scenarios that Warren goes to the trouble of working out. Thus my own variable discount factor is really a substitute for the variable probability scenarios that Warren is using. I am more focussed on a single long term likely scenario than Warren, and I use a variable industry discount factor to rate the likely accuracy of my prediction. If I were to use probabilistic alternative scenarios and a variable industry discount factor this would be too much information and lead to a confusing picture.

The important thing is to have a factor of safety in some form. If you do a full variation of scenario analysis as Warren does, that becomes your factor of safety. If you don't then having a variable discount factor is a legitimate, albeit not quite as sophisticated alternative.

SNOOPY

[h2so4]

SD, Warren's instruction is very clear.

I didn't read too much into it and took his instruction verbatum.

Then I came to understand the reason. It puts every business you analyse, irrespective of industry, on the same level playing field.

KIS

[Sauce]

I would be interested if anyone has a different opinion. But my own take from these five bullet points is that Warren is very concerned with the quality of future cashflows from companies he holds. He assesses this future cashflow quality by looking at a series of scenarios and forming a probabilistic view of what will happen. He doesn't favour any variation in discount rates, because that makes his analysis more complicated than it needs to be.

The important thing is to have a factor of safety in some form. If you do a full variation of scenario analysis as Warren does, that becomes your factor of safety. If you don't then having a variable discount factor is a legitimate, albeit not quite as sophisticated alternative.

SNOOPY

I think you are spot on Snoopy. But being concerned with the quality of future cashflows is not the same as trying forecast what they will be in the future with the sort of precision required for DCF valuation.

Snoopy Here is my (probably totally off the mark) own view on Buffetts methods ( in very general, simple terms )

Also you have to imagine you are Warren for this example, as it sounds easy, and probably is fairly easy now for Warren, but without his lifetime of experience and intelligence I think its very difficult:

Qualitative:

1. Does the business have a durable competitive advantage
2. Is it extremely improbable that something external (new technology etc) could derail the business
3. Are management extremely talented and honest

Quantitative:

4. Has the business been able to invest its retained earnings at returns well above the cost of capital ?
5. How much do I have to pay for equity in the business at prevailing prices?
6. Does a margin of safety exist?

(obviously actual work of assessing margins, debt levels, adjusting asset values to get true equity etc - who knows there could be all sorts of work that MIGHT go in, but this is my view on the points critical for valuation, if we were to put ourselves in Warren E. Buffetts shoes)

Now if you are Warren E. Buffett and you have answered yes to questions 1 - 3, then the balance of probability says that great business economics, if they exist, are highly likely to continue into the future. Therefore questions 4 - 6 require only basic maths, rather than a complex forecasting model.

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)

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

This assumes the ROE is sustainable, but Warren is only looking for businesses with a durable competitive advantage anyway. And because sustainably return on equity, above the cost of capital, is the inevitable product of a durable competitive advantage, it is implicit that he is confident the underlying economics are sustainable. (Not so easy in smaller markets like NZ I would guess... )

Now if you were Warren Buffett and you had spent your whole life analyzing companies, it would not be long before you could simply look at the return on equity and the price offered in relation to the equity on the balance sheet and you would know very quickly if it was a good deal or not.

Of course he is very concerned about the quality and probability of future cashflows. But this is my best shot at a guess at to how he operates and how he makes value decisions without forecasting precise future cashflows, terminal values etc.

Love to hear your thoughts on this Snoopy or anyone else.. I might be talking meaningless rubbish that is totally inaccurate but I would enjoy the banter.

With regards,

Sauce

[h2so4]

Of course he is very concerned about the quality and probability of future cashflows. But this is my best shot at a guess at to how he operates and how he makes value decisions without forecasting precise future cashflows, terminal values etc.

Love to hear your thoughts on this Snoopy or anyone else.. I might be talking meaningless rubbish that is totally inaccurate but I would enjoy the banter.

With regards,

Sauce

Oh I'm pretty sure he does his future cashflow projections and valuation fairly accurately. Take a look at this quote.

"The investment shown by the discounted cash flow calculation to be the cheapest is the one that the investor should purchase irrespective of whether the business grows or does not, displays volatility or smoothness in it's earnings, or carries a high price or a low price in relation to its current earnings."

[Snoopy]

SD, Warren's instruction is very clear.
I didn't read too much into it and took his instruction verbatum.

KIS

SSD, Warren's 'instructons' it seems have been reconstituted from the notepad of some journalist (albeit it appears quite a good one) who had a few hours of immersion with the great man. Any such pearls of wisdom that spilt from the journalistic notepad are always within a context. Yet if you think you can reproduce the work of Warren by self selecting a few bullet points you will probably do better than most.

I actually agree with your 'Keep things as simple as required' philosophy, but I would amend it as follows:

'Keep things as simple as required, but not simpler'

SNOOPY

[Snoopy]

Snoopy Here is my (probably totally off the mark) own view on Buffetts methods ( in very general, simple terms )

Also you have to imagine you are Warren for this example, as it sounds easy, and probably is fairly easy now for Warren, but without his lifetime of experience and intelligence I think its very difficult:

Qualitative:

1. Does the business have a durable competitive advantage
2. Is it extremely improbable that something external (new technology etc) could derail the business
3. Are management extremely talented and honest

Quantitative:

4. Has the business been able to invest its retained earnings at returns well above the cost of capital ?
5. How much do I have to pay for equity in the business at prevailing prices?
6. Does a margin of safety exist?

(obviously actual work of assessing margins, debt levels, adjusting asset values to get true equity etc - who knows there could be all sorts of work that MIGHT go in, but this is my view on the points critical for valuation, if we were to put ourselves in Warren E. Buffetts shoes)

Now if you are Warren E. Buffett and you have answered yes to questions 1 - 3, then the balance of probability says that great business economics, if they exist, are highly likely to continue into the future. Therefore questions 4 - 6 require only basic maths, rather than a complex forecasting model.

With my reading of how Buffett's mind works, I think that is a good summary Sauce.

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)

So what you have calculated here is the 'real return' on top of the cost of capital.

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

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'.

This assumes the ROE is sustainable, but Warren is only looking for businesses with a durable competitive advantage anyway. And because sustainably return on equity, above the cost of capital, is the inevitable product of a durable competitive advantage, it is implicit that he is confident the underlying economics are sustainable.

Yes :-)

(Not so easy in smaller markets like NZ I would guess... )

Yes :-(

Love to hear your thoughts on this Snoopy or anyone else.. I might be talking meaningless rubbish that is totally inaccurate but I would enjoy the banter.

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.

SNOOPY

[Snoopy]

Oh I'm pretty sure he does his future cashflow projections and valuation fairly accurately. Take a look at this quote.

"The investment shown by the discounted cash flow calculation to be the cheapest is the one that the investor should purchase irrespective of whether the business grows or does not, displays volatility or smoothness in it's earnings, or carries a high price or a low price in relation to its current earnings."

Context?

SNOOPY