12-1 Module 12 Continuing Valuation- the Critical Element “But I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate.” Warren Buffett So let’s operationalize this puppy….. First, Can you actually beat the markets? If that sounds nutty, consider the emotion-driven mistakes that most of the rest of us make. For starters, most investors get scared when the market tanks and sell low before buying back high, sacrificing huge potential gains. As a result, the average stock investor has trailed the market average (Standard & Poor’s 500 index) by more than 4 percentage points over 20 years, according to Dalbar, the market research firm. Are the pros any better? Maybe not. Last year, 79 percent of so-called active fund managers, the pros who are supposed to be experts at picking stocks, failed to match their own benchmarks for market averages, according to Morningstar, the investment research company. http://www.ozy.com/rising-stars-and-provocateurs/to-get-rich-tell-your- emotions-to-shut-up/38678.article? utm_source=dd&utm_medium=email&utm_campaign=01192015
Transcript
12-1
Module 12 Continuing Valuation- the Critical Element
“But I think that there’s no magic to evaluating any financial asset. A financial asset means, by definition, that you lay out money now to get money back in the future. If every financial asset were valued properly, they would all sell at a price that reflected all of the cash that would be received from them forever until Judgment Day, discounted back to the present at the same interest rate.”
Warren Buffett
So let’s operationalize this puppy…..
First, Can you actually beat the markets?
If that sounds nutty, consider the emotion-driven mistakes that most of the rest of us make. For starters, most investors get scared when the market tanks and sell low before buying back high, sacrificing huge potential gains. As a result, the average stock investor has trailed the market average (Standard & Poor’s 500 index) by more than 4 percentage points over 20 years, according to Dalbar, the market research firm. Are the pros any better? Maybe not. Last year, 79 percent of so-called active fund managers, the pros who are supposed to be experts at picking stocks, failed to match their own benchmarks for market averages, according to Morningstar, the investment research company. http://www.ozy.com/rising-stars-and-provocateurs/to-get-rich-tell-your-emotions-to-shut-up/38678.article?utm_source=dd&utm_medium=email&utm_campaign=01192015
George Soros 29% for 37 years
Eddie Lampert 29% for 18 years
Peter lynch 29% for 18 Years
David Tepper 27% for 15 years
Warren Buffett 21% for 40 years
Timing
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It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income, and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standards of value. If he wants to be shrewd he can look for the ever-present bargain opportunities in individual securities. (Benjamin Graham)
If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume. (Benjamin Graham)
Note what he says about gains on selling the stock.
….not by selling it to someone else, that is just a game of who beats who.
Not by selling it to someone else, but what the asset will produce.
Does a stock have an intrinsic value?
Is it different for different investors?
3rd Law is You can’t change the deal!
12-4
2nd Law is There is always interest and it is being charged at the current rate!
Kirch’s First Law of the Universe
The financial worth of an investment is equal to the present value of it’s future cash flows.
“First law valuation is a powerful tool. It should be on page #1.” John Ohsner, Financial Advisor and former student
Every time you forget the period, it will cost you an average of $10,000.
Time period is not defined!
12-5
Operations for profit should be based not on optimism but on arithmetic.
Benjamin Graham
Once upon a time the following add appeared in the Athens newspaper-
For Sale: Apartment Building
30 Units
Average Rent for 2020 is expected to be $800 per month per unit
2 years old
Price __________
Upon investigation you found that it would require little or no work on your part. There was a rental agency which would keep the books, rent apartments, do evictions and other administrative tasks for 20% of the rent. Your investigation showed that the apartments stayed about 95% occupied and that occupancy rate is likely to continue. Additionally, the rental agency told you that you can expect rents to increase about 5% per year after 2020 year for the following three years (2021, 2022, and 2023) because the building is new. The repairs and maintenance costs are about $1,000 per month for 2020, 2021, 2022, and 2023. You want to earn at least 20% on your investment. You figure you will hold on to the apartment for four years and then sell it for $800,000 (on Dec 31, 2023). All other cash expenses run $1,000 per month and will rise at 5% per year after 2020. Assume it is Jan 1, 2020- what is the price you would pay for the apartment? Ignore taxes.
Cash Expenditures: Rental Company Fees Repairs & Maintenance Other Cash Expenses Total Cash Expenditures
Net Cash Flow
The IRR What rate of return are you earning?
Use excel for instance =IRR(c15:f15)
The critical assumption What you could sell it for.
Terminal Value
And if we expected the investment to last forever, how would we value it?
12-7
As Buzz Light Year would say….to infinity and beyond……
The basic ROI calculation, assuming no growth.ROI = Return on Investment
ROI = cash flow / amount of investment
So you put $100 in a bank paying 2% interest
Your ROI is X = 2/100 = 2%
You can turn the equation around to find the investment
Investment = Return / interest rate
X = $2 / .02
= $100
12-8
Let us introduce a growth rate for the investment.
Suppose you had a special investment opportunity. You want to earn 10% on your money. The investment pays a return of 8% (which you constantly reinvest in the security- like compounding). The unique part of the investment is that, in addition to the 8% return, the investment grows your principal at a rate of 2% per year.
The Gordon Growth Model
Value of an investment is = (Dividend X Dividend Growth Rate) Required Rate of Return – Growth Rate
So for our example we have(.08 X .02)
.10-.02
Modified
The terminal growth rate
12-9
Now the apartment building
Apartment
2020 2021 2022 2023
Rents 30(95%)(800)(12) 273,600
287,280
301,644
316,726
Cash Expenditures:
Rental Company Fees 54,720 57,456 60,329 63,345
Repairs & Maintenance 12,000 12,000 12,000 12,000
Other Cash Expenses 12,000 12,600 13,230 13,892
Total Cash Expenditures 78,720 82,056 85,559 89,237
Net Cash Flow 194,880 205,224 216,085 227,489
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PV of Net Cash Flows @ 20% 162,400 142,517 125,049 109,708 539,674
Growth rate of Net Cash Flow 12.243% 12.256% 12.268%
Terminal Growth Rate 5%
But we are not going to assume we will sell it.
Additionally, the rental agency told you that you can expect rents to increase about 5% per year after 2020
All other cash expenses run $1,000 per month and will rise at 5% per year after 2020.
Modified
ROI = Cash Flow X (1 + Growth Rate) Required Rate of Return – Growth Rate
The terminal growth rate
227,489 X 1.05 .20 - .05
The Terminal Value of the Apartment Building is
Last year’s cash flow X (1 + growth rate) Required Rate of Return – growth rate
227,489 X 1.05 .20 - .05
= 238,863 .15
= $1,592,420 Terminal Value
12-11
You told me that last year, the net cash flow was $227,489, and that that was expected to grow at exactly 5% until the end of time, then the apartment building is worth $1,592,420 to me today!
In other words, if I put $1,592,420 in a bank that paid interest at 20% and where the principal grew at 5% every year, I could collect the 20% forever and ever and never touch the principal!
Growth rate of Net Cash Flow 12.243% 12.256% 12.268%
Terminal Growth Rate 5%
Terminal Value
PV of Net Cash Flows @ 20% 162,400 142,517 125,049 109,708PV of Terminal Value
Clr tvm1,592,420 FV
20 I/Y4 n
Cpt pv 767,949So value of the Aparment isPV year 1 162,400.00 PV year 2 142,516.67 PV year 3 125,049.19 PV year 4 109,707.72 PV terminal value 767,949.46
1,307,623.04$
So if I put $1,307,623.04 in a special bank that paid interest at 20%, I would be able to withdraw $194,880 after one year, 205,224 at end of 2nd year, 216,085 at end of 3rd year, $227,489 at the end of the fourth year and then, from that point on withdraw an amount equal to the prior year plus 5% for each year until the end of time!
12-13
Now let’s do the Mercedes problem
Homework for Module 12Mercedes
Year 1 Year 2 Year 3Rents 100(365)(70%) 35,040 80(365)(70%) 25,550 60(365)(70%) 13,140
20%, 1 period 22,028 20%, 2 periods 12,265 20%, 3 periods 3,610
Assume a 4% terminal growth rate after Year 3.
What is the value of the Mercedes deal if you are never going to sell the car. In other words we are assuming the Repairs and Maintenance will keep the car in operating condition forever!!
Google “Terminal Value of a Stock”
“Gordon Growth Model”
12-14
Let’s do some stocks
________________
Growth Year 1 _______%
Growth Year 2 _______%
Growth Year 3 _______%
How far out to go?
12-15
________________
Growth Year 1 _______%
Growth Year 2 _______%
Growth Year 3 _______%
12-16
How to Determine a Realistic Growth Rate for a Company
By Nick Kraakman
Value investors like Warren Buffett have only two goals: 1) find excellent businesses and 2) determine what they are worth. But in order to determine what a company is worth, you will have to predict how fast the business will be able to grow its earnings in the future. How to come up with a realistic growth rate for your intrinsic value calculations is what this post is all about.
"The investor of today does not profit from yesterday’s growth."Warren Buffett
As the above quote highlights, all your returns depend of the future growth of the company you are investing in. Therefore the growth rate plays a crucial role in valuing a company. Imagine two identical companies which both earn $10 million this year. However, company A will grow its earnings with 15% a year for the coming 10 years, while company B will grow its earnings with just 5% a year. This way company A will be earning $40.5 million in year 10 ($10 million x 1.15^10) while company B will only be earning $16.3 million.
So while both companies started out from the exact same position, I'm pretty sure you would rather own company A than company B. This goes to show how much impact the growth rate has on the value of a company. And it is exactly because the growth rate is so important that we have to be extra careful when inputting one into our calculations. So how can you determine a realistic growth rate for the company you are analyzing?
ANALYST ESTIMATESBy far the easiest way to come up with a growth rate is to see what analysts are saying. Analysts are employees of financial institutions who sniff through every available piece of information that is known about a company and then make a prediction about how well they expect the company to perform in the next few years. For example, on Yahoo Finance you can find out that, on average, analysts expect that Apple (AAPL) will grow its earnings at a rate of 12.24% per year for the coming 5 years.
12-17
Seems like a great plan to listen to what these analysts are saying, because they are the experts, rights? They studied for years and then had to pass a host of brutal tests and interviews to finally become a recognized financial analyst. Still, research by McKinsey & Co.concluded that Wall Street analysts are as good as always too optimistic.
But what is too optimistic? Well, the authors state that “on average, analysts’ forecasts have been almost 100 percent too high.” 100%!! So if analysts say they expect a company to grow its earnings at 10% a year, the actual growth will most likely be closer to 5% a year. This is an embarrassingly big difference which will render your valuations wholly inaccurate. So while you could use analysts estimates, take them with a grain of salt. Although a bag of salt might be more appropriate.
The sheer lack of sell ratings and the consistently too-high target prices in the above chart further highlight the general over-optimism of Wall Street analysts.
HISTORICAL EPS GROWTHAnother way to get an idea of the future growth potential of a company is by looking at how fast the company has been able to grow its earnings over the last ten years. Let's take Google (GOOGL) as an example. Looking at the company's financials on GuruFocus.com tells us that the company had earnings per share of $0.73 in 2004 and current earnings per share of $19.37. This is equal to an impressive 38.8% annual compounded growth rate ($19.37 / $0.73 ^ 1/10).
12-18
So over the last 10 years Google has, on average, grown its EPS with 38.8% a year. Now ask yourself, is it realistic to expect that Google will keep growing at that rate for the coming 10 years? Keep in mind that this means Google will have to earn 26 times more in ten years time than the $13.2 billion they are earning today! This seems highly unlikely. Even our over-optimistic analyst friends agree and expect a 16.7% growth rate, which is still really good, but not nearly as high as the historical growth rate of 38.8%!
"In the business world, the rearview mirror is always clearer than the windshield." Warren Buffett
You just can't extrapolate historical earnings growth into the future, because as a company becomes bigger and bigger, it becomes harder and harder to keep up a high growth rate. This phenomenon is called the Law of Large Numbers. So expect growth rates to shrink over time and don't blindly apply historical growth rates to the future.
RETURN ON EQUITY AS GROWTH RATEImagine Toothpick Inc., a company selling, as you might have guessed, toothpicks. They collect $20 million from investors to manufacture their initial batch of toothpicks. This money shows up on their balance sheet as Shareholders' Equity. With this $20 million they are able to generate $5 million in net income, which results in a Return on Equity (ROE) of 25% ($5 million / $20 million).
Toothpick Inc. now has $20 million in equity and $5 million in earnings. In theory, they could reinvest all of these earnings into the company (such earnings are called Retained Earnings) which would increase their Shareholders' Equity to $25 million. In this case, they grow their Shareholders' Equity by 25% ($25 million - $20 million / $20 million), which is equal to their ROE. The next year they earn a 25% ROE over their now bigger pile of equity, which is why the ROE can be seen as a growth rate.
However, using the ROE as a growth rate would be a severe oversimplification of how things work in the real world. For example, some of the earnings might not be reinvested but paid out as a dividend instead, and some of the earnings might be needed for maintenance and replacement of equipment and will therefore not directly contribute to the growth of the business. Let's look at how we can tweak this ROE ratio to provide us with a more realistic growth rate.
SUSTAINABLE GROWTH RATEThere exists something called the Sustainable Growth Rate. The name suggests that this is exactly what we need, so let's take a closer look.
The Sustainable Growth Rate is the maximum rate at which a company can grow without taking on additional debt. This is good, because we want to invest in companies which are able to fund their growth with their own earnings. The Sustainable Growth Rate is calculated as follows:
ROE x (1 - dividend payout ratio)
It takes the ROE ratio and adjusts it for any dividends that are paid out, because only Retained Earnings (Net Income - Dividends) can be used to grow the business. If Toothpick Inc. would pay out 40% of its Net Income as dividends, their Sustainable Growth Rate would be 15% (25% x 60%). This indicates that
12-19
Toothpick Inc. should be able to grow at a maximum rate of 15% per year without having to take on additional debt.
A REALISTIC GROWTH RATEHowever, what we are looking for is a realistic rate at which we can expect a company to grow over the coming years, not a maximum rate. This makes the Sustainable Growth Rate far from perfect. If, for example, the company decides to take on $10 million in Long-Term Debt to generate more earnings, the amount of Shareholders' Equity would remain the same, but the ROE figure would nevertheless rise because of the higher earnings. So ROE is flawed because it does not take debt into account and because ROE is a key input for the Sustainable Growth Rate, it too is flawed. In addition, some of the Retained Earnings will have to be used for the maintenance and replacement of machines, and will therefore not directly result in growth.
So how do we fix this? Well, we could add Long-Term Debt to Shareholders' Equity before calculating the return, which essentially means we are no longer using the Return on Equity but the Return on Capital. This way we take debt into account. Also, we could use Depreciation & Amortization expenses as a proxy of maintenance and replacement costs of machines, and therefore subtract this from retained earnings to get a more accurate view of the amount of money that can be used to grow the business. Let's call this the Sustainable Growth Rate+, which is also what I have implemented in the Intrinsic Value models of the brand-new PREMIUM Value Spreadsheet.
So is this then the perfect formula for growth? Not quite. We are still basing this formula on a lot of assumptions. That is why I suggest you compare this rate to the analyst expectations and historical EPS growth rate to make sure you are not being overly optimistic. Also, look at how consistent the earnings of the company have been over the past ten years. If earnings have been steadily increasing year after year, you can have a certain amount of confidence in your growth rate. If, however, earnings fluctuate wildly, an accurate prediction is as good as impossible to make and you should use a considerable Margin of Safety in your calculations. Finally, compute the Sustainable Growth Rate+ for the last couple of years to see if it is relatively stable or highly volatile.
CONCLUSIONIn this article I have tried to highlight the importance of growth rates in calculating the value of a company, as well as showing you that it is not an easy task. The key lesson is that there isn't one perfect way to determine a growth rate, but by combining several sources and by being conservative, you should be able to make a realistic estimate of future growth as long as the company has shown consistent, stable earnings. Good luck guys!
12-20
Sources of information
Google it!
https://finance.yahoo.com/
https://www.zacks.com/
https://seekingalpha.com/
12-21
Planting a Trillion Trees May Be the Best Way to Fight Climate Change, Study Says
SETH BORENSTEIN / AP JULY 4, 2019(WASHINGTON) — The most effective way to fight global warming is to plant lots of trees, a study says. A trillion of them, maybe more.
And there’s enough room, Swiss scientists say. Even with existing cities and farmland, there’s enough space for new trees to cover 3.5 million square miles (9 million square kilometers), they reported in Thursday’s journal Science. That area is roughly the size of the United States.
The study calculated that over the decades, those new trees could suck up nearly 830 billion tons (750 billion metric tons) of heat-trapping carbon dioxide from the atmosphere. That’s about as much carbon pollution as humans have spewed in the past 25 years. Much of that benefit will come quickly because trees remove more carbon from the air when they are younger, the study authors said. The potential for removing the most carbon is in the tropics.
“This is by far — by thousands of times — the cheapest climate change solution” and the most effective, said study co-author Thomas Crowther, a climate change ecologist at the Swiss Federal Institute of Technology in Zurich.
Six nations with the most room for new trees are Russia, the United States, Canada, Australia, Brazil and China.
Before his research, Crowther figured that there were other more effective ways to fight climate change besides cutting emissions, such as people switching from meat-eating to vegetarianism. But, he said, tree planting is far more effective because trees take so much carbon dioxide out of the air.Thomas Lovejoy, a George Mason University conservation biologist who wasn’t part of the study, called it “a good news story” because planting trees would also help stem the loss of biodiversity. Planting trees is not a substitute for weaning the world off burning oil, coal and gas, the chief cause of global warming, Crowther emphasized. “None of this works without emissions cuts,” he said.Nor is it easy or realistic to think the world will suddenly go on a tree-planting binge, although many groups have started, Crowther said. “It’s certainly a monumental challenge, which is exactly the scale of the problem of climate change,” he said. And as the Earth warms, and especially as the tropics dry, tree cover is being lost, he noted.
The researchers used Google Earth to see what areas could support more trees, while leaving room for people and crops. Lead author Jean-Francois Bastin estimated there’s space for at least 1 trillion more trees, but it could be 1.5 trillion.
That’s on top of the 3 trillion trees that now are on Earth, according to earlier Crowther research.The study’s calculations make sense, said Stanford University environmental scientist Chris Field, who wasn’t part of the study. “But the question of whether it is actually feasible to restore this much forest is much more difficult,” Field said in an email.
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