Present Value of Future Cash Flows

[McLovin]

When I look at default risk – I am looking to see if the company is likely to experience an event that could cause its bankruptcy. There is no use in a company having great prospects in 5-10 years time if it is dead in 4. The company default analysis require one assumption that is NOT true, and that is that I can predict the future cash flows and company structure correctly.

Hi craft

It's interesting that you attempt to measure default risk. I've always considered that as an equity investor quantifying default risk is of little value; by the time it gets to that stage equity will be severely impaired. Of course I get your point about a company needing to be a going concern, but wouldn't that just present itself while analysing earnings risk? I guess what I'm saying is my investment threshold is a bit higher than "will this company be around in 4 years". I assumed your own risk profile would also steer you away?

Agree on the rest of your post, especially on the earnings risk. My biggest investments are always in companies with high recurring revenue streams, so the 99% of time going into assessing the sustainability and direction of earnings is something that definately resonates with me.

[craft]

Hi craft

It's interesting that you attempt to measure default risk. I've always considered that as an equity investor quantifying default risk is of little value; by the time it gets to that stage equity will be severely impaired. Of course I get your point about a company needing to be a going concern, but wouldn't that just present itself while analysing earnings risk? I guess what I'm saying is my investment threshold is a bit higher than "will this company be around in 4 years". I assumed your own risk profile would also steer you away?

Agree on the rest of your post, especially on the earnings risk. My biggest investments are always in companies with high recurring revenue streams, so the 99% of time going into assessing the sustainability and direction of earnings is something that definately resonates with me.

I don’t so much measure default risk and apply it as you would for valuing debt instruments, but I certainly consider it and think about it as its own distinctive risk. I generally analyse it by stress testing my best guess earning assumptions to see how far out I can before things get terminal. Default risk is present as soon as a company takes on a fixed expense, predominantly debt or lease. It is a major consideration when looking at financial stocks and many other stocks carry enough debt to make it a serious consideration under stressful trading conditions.

As for my risk profile - I may be more aggressive then you imagine. Prices just aren’t that attractive when everything looks rosy to all. It's darkest just before the dawn and that's where you get the best prices.

[McLovin]

I don’t so much measure default risk and apply it as you would for valuing debt instruments, but I certainly consider it and think about it as its own distinctive risk. I generally analyse it by stress testing my best guess earning assumptions to see how far out I can before things get terminal. Default risk is present as soon as a company takes on a fixed expense, predominantly debt or lease. It is a major consideration when looking at financial stocks and many other stocks carry enough debt to make it a serious consideration under stressful trading conditions.

I understand, so you take it as a worst case scenario and work back from there.

As for my risk profile - I may be more aggressive then you imagine. Prices just aren’t that attractive when everything looks rosy to all. It's darkest just before the dawn and that's where you get the best prices.

No, I think I understand your risk profile, just needed clarification on how you used default risk.

We're probably more a like than different. One of the first shares I ever bought (at 17) was Crown back in late '98 when it was seriously under the pump, just before Packer bought it.

[craft]

Sorry to continue this off topic stuff but I was just wondering Tyson, what % of disposable income did you have to put aside and what % return did you have earn to achieve this?

I apologize if I am intruding, but would appreciate if you could give a rough indication of the answer to this question for yourself too.

Hi V, I hope you find this response here - save cluttering up the housing thread

The time needed to accumulate the funds to be financially self sufficient depends on amount saved and return achieved.

To get some idea of a realistic answer needs some maths.

If we say the income you earn is 1 (you can multiply this to suit your requirements) and your after tax and inflation return is 5% then you will need to save 25% of your income for 33 years to accumulate 20 times your income. 20 / 5% will gives you 1 which means you are now financially independent at the income level you are used to.

The inflation figure I include is wage inflation and have estimated it runs at about 4.5% p.a long term. To achieve a 5% return after inflation and tax you need to make a nominal return of 1*1.05*1.045-1/(1-tax rate). The tax rate looms large in this calculation so you will want to pay it some attention and a 15% tax rate in a SMSF is a big advantage as is any tax you can delay by not realising capital gains.

The current grossed up dividend yield on the ASX is 7%. Long term, I would expect capital and labour to benefit from productivity gains at the same rate, so capital gains on shares should match wage increases. History also sugest you can can also factor in about a 1% real return from retained earnings for shares. If you figure you can make 8% after inflation and tax you would be building in a requirement to do better than the market as a whole.

With a 8% after inflation and tax return you would need a capital amount of 12.5 times to be financial self sufficient. This could be accumulated in 21 years by saving 25% of your wage.

If you know how to use the excel functions – play around with the PV, FV, PMT and Rate functions. Come up with a plan that suits you.

If you want to speed things up safely, save more; or relatively safely, increase return by buying things for less then they are worth or actively trading with proper risk control; or not so safely look at leverage or higher risk investments.

[Vesupria]

Thanks craft - just for the assumption's sake - is the 25% invested after tax?

[craft]

Thanks craft - just for the assumption's sake - is the 25% invested after tax?

Hi V

Either or.

AWOTE is around $70K gross which would give you approx $55K after tax.

In the case of a 5% return;

If you save 25% of $70K you will end up with 20 x 70K in 33 years which means you can fund a before tax income of $70k without eating into your capital.

If you save 25% of $55K you will end up with 20 x 55K in 33 years which means you can fund a before tax income of $55K without eating into your capital.

There are lots of nuances you can factor in to suit your own needs. For example you may be happy to run your capital down when living off it so you may need less than 20 times income to fund a given level of income. Also if you have been saving 25% then you are used to living on 75% of your earned income - so again you may need less than 20 times income. And finally as you know taxation rates are different between accumulation and pension phase if you are using a SMSF again meaning you may be able to get away with a lower multiple of income to be financially independent if you will be over 60 by the time you reach your goal.

The key is to model your plan, which can easily be done in Excel. Set your target, be realistic about the return you can achieve (I would recommend 3 – 5% after inflation and tax as it is better to be pleasantly surprised then disappointed down the track) and calculate for yourself what % of income you need to save to reach your goals.

Incidentally, changing variables in such a model is quite revealing as well. To get to your goal faster you can earn/save more or focus on learning how to make a better return. It takes an awful lot of earning/saving to compete with being able to increase your return by just a couple of % over the long term. This understanding changed the direction of my life.

[Vesupria]

I'll play around with it later. I'm currently saving about 60% of my wage before tax. I am however, under the average wage at the moment. Until my career experience increases. However, in the accounting profession, if I work hard and smart I should be able to increase it above the average wage in the future.

I am currently using a different model. Attachment 45233

It seems to work on a similar principle.

[McLovin]

It takes an awful lot of earning/saving to compete with being able to increase your return by just a couple of % over the long term. This understanding changed the direction of my life.

Einstein said his greatest discovery was compound interest, so the story goes. Human brains aren't very good at understanding exponentials, which is a shame because the power of compounding is one of the most important things to know about investing.

[craft]

http://www.youtube.com/watch?v=xVOn371TCPo

An interesting WB interview. I'll post it here so I can find it again in the future.

[oddson]

Hi craft,

Do you use reverse DCF? Michael Mauboussin and James Montier seem to rate it as a valuation tool.
If you were to use reverse DCF, what assumptions would you use?
How do you calculate cashflow that you use for the DCF?
Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.

Cheers

Oddson

[craft]

Hi craft,

Do you use reverse DCF? Michael Mauboussin and James Montier seem to rate it as a valuation tool.
If you were to use reverse DCF, what assumptions would you use?
How do you calculate cashflow that you use for the DCF?
Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.

Cheers

Oddson

Reverse DCF or reverse anything is just determining what discount rate causes the model to produce the current price (given your assumptions). Tells you what discount the market is applying.

A quick and dirty I use initially is to reverse the dividend growth model to see what perpetual growth rate is embedded in a price.

I don't think your FCF shortcut is going to be very accurate expect by chance. The assumptions are everything - no shortcuts, you have to understand the business and how capital flows through or sticks to it and you need to understand it across a range of revenue and expense possibilities. - The valuation is just some mechanical model(s) applied to the assumptions.

[McLovin]

Do you use any rules of thumb? I have read that for most companies FCF per share =0.8 * EPS over the long term. This allows for some quick and dirty DCF calculations.

The problem with using too many rules of thumb is that each time you use one you're giving up some possible advantage. If your whole analysis is built on rules of thumb then I'd argue you have not really gained any insight. If you're going to get to the stage of calculating FCF, then the benefit to your analysis is in actually calculating FCF not a proxy of it.

Having said that, as a screener, it might be worth seeing what it tosses out.

ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.

[oddson]

Reverse DCF or reverse anything is just determining what discount rate causes the model to produce the current price (given your assumptions). Tells you what discount the market is applying.

A quick and dirty I use initially is to reverse the dividend growth model to see what perpetual growth rate is embedded in a price.

I don't think your FCF shortcut is going to be very accurate expect by chance. The assumptions are everything - no shortcuts, you have to understand the business and how capital flows through or sticks to it and you need to understand it across a range of revenue and expense possibilities. - The valuation is just some mechanical model(s) applied to the assumptions.

Interesting, I would approach a reverse DCF to work out the implied growth rates and compare the implied growth rates to historic long term industry growth rates. This is due to my understanding that DCF is the correct way to calculate the intrinsic value if the investor knows with certainty the future cash flows over the long term, therefore discount rate that should applied in the reverse DCF should be equal to the stock market long term returns (12.4%). Just my thoughts.

I am going to step away from DCF and FCF as it creates too many questions in my head and suspect the effort required to fine tune DCF will not actually pay off in improved portfolio performance. Thanks for the feedback. I am going to stick with the PE ratio and dividends paid.

If you have not read the following you may find it interesting.
http://www.smartmoney.com/invest/str...1328818316857/

http://www.smartmoney.com/invest/sto...1332271348707/

His big bet seems sensible to me, borrow at 1.5% then put half your fund in Berkshire Hathaway, whatever happens to WB, Berkshire is an economic powerhouse.

[oddson]

The problem with using too many rules of thumb is that each time you use one you're giving up some possible advantage. If your whole analysis is built on rules of thumb then I'd argue you have not really gained any insight. If you're going to get to the stage of calculating FCF, then the benefit to your analysis is in actually calculating FCF not a proxy of it.

Having said that, as a screener, it might be worth seeing what it tosses out.

ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.

Good points. No more DCF or FCF for me!

Altman Z score. As mentioned in another thread there becomes a point with accounting that I lose interest or am too lazy to understand. Two or three ratios are sufficient for me to have confidence that a company will not go broke in the short term.

Cheers

Oddson

[Vesupria]

Craft - I found these. Share holder letters of Marty Whitman.

http://www.thirdave.com/ta/shareholder-letters-mf.asp

Do you know anything about them? Saw them mentioned as worthwhile reading for any value investor, especially since they are free.

[craft]

Craft - I found these. Share holder letters of Marty Whitman.

http://www.thirdave.com/ta/shareholder-letters-mf.asp

Do you know anything about them? Saw them mentioned as worthwhile reading for any value investor, especially since they are free.

Havn't seen them - will check them out.
Thanks for the link.

[McLovin]

If anyone is looking for something to read, I highly recommend the book reviews on the Aleph Blog

http://alephblog.com/categorized-book-reviews/

The blog is also pretty damn good.

[Vesupria]

Thanks I will certainly check it out.

[McLovin]

I'm about half way through this at the moment

http://alephblog.com/2012/03/17/book...portant-thing/

Great book, I highly recommend it.

[matches]

ETA: Does anyone here use the Altman Z-score? I've been playing around with it and it seems quite handy.

I found this interesting also
http://www.oldschoolvalue.com/blog/i...n-combination/