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9:28 pm
August 27, 2011
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Jae Jun
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Yes looks there are formulas for what I was talking about.
But unless the company is distressed or has announced its intention to sell itself, you wouldn't want to use the second method. Even distressed companies keep finding ways to survive and lower their value each year.
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12:18 pm
August 22, 2011
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mclem1981
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Post edited 5:42 am – August 22, 2011 by mclem1981
Jae:
First of all, I just wanted to thank you for all of your hard work on these spreadsheets. I can only imagine the hours spent pouring over the detail required to get these sheets operable. They save me a ton of time. Great job!
Ok, I’ve done a bit of digging and I think I understand where lines have gotten crossed on this issue…
There are 2 ways to use DCFs to value a business…
Assumption 1: Business will go on as a going-concern forever. (Infinite CFs)
At the end of our estimated CFs, we must account for the remainder of the CFs in perpetuity (mathematically: a growing perpetuity). Also, we can add in non-operating assets/excess cash.
OR
Assumption 2: Business will only operate for so many years. (Finite CFs)
Because we are not accounting for the remainder of CFs in perpetuity (as in assumption 1), we must account for the liquidation value (or book/salvage value) compounded at the shareholder equity growth rate and discounted at the required rate of return for the number of CF periods estimated.
Example:
Let’s say we have ABC Corporation…
Assume:
BV = book/liquidation/salvage value per share at time 0= $10.00
CF0 = CF at time 0 = $1.00
R = required rate of return = 10%
G1 = CF growth rate = 7%
G2 = Terminal growth rate = 3%
G3 = BV growth rate = 12%
(Example for Assumption 1) ABC will sustain CF growth for 2 years at 7% then grow CFs at 3% indefinitely thereafter…
 
(Example for Assumption 2), ABC will grow CF at 7% for 2 years and then be sold off at book (at the end of year 2).
I think Ponzio, in using assumption 2, must have assumed his required rate of return was equal to the BV growth rate and the business could be sold at book (in the future), which is mathematically equivalent to simply adding shareholder equity to the PV of the terminal/finite CF estimates, as found in F Wall Street.
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9:39 am
August 22, 2011
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Jae Jun
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that's pretty much what I was thinking.
If we are valuing an REIT or a business where the main money producing asset is real estate (hotels mainly), then it makes sense. Otherwise for ongoing businesses such as JNJ, MSFT, KO there is no reason to add the additional equity because I don't want to value the company as if it was going to be put up for sale in 10 years. This itself could lead to overvaluation.
Regarding "where previous free cash flows have accumulated in the balance sheet", I haven't thought about this, but I would think it would go to the cash balance which is then allocated to working capital. Flow of FCF would be extremely hard to trace as you need to break it down into so many levels.
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3:01 am
August 22, 2011
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businessmaninvestor
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@JaeJun: regarding valuing a real estate, strictly speaking, you can actually value it basing on its future cash flows AND its liquidation value. Allow me to explain.
Just like a bond which you value by discounting all its future coupon payments, you also discount the principal value which you get on maturity date.
In the same way, if I buy a real property, say, a hotel, which generates cash profits for me, then later sold it at a certain price, then the bond analogy mentioned above can be applied–the cash profits being the coupon payments, and the hotel's liquidation value being the principal.
I think your "it has to be one or the other" would indeed apply if you intend to hold the asset forever, which would be the better choice when owning a quality, money-making business.
By the way, I'd appreciate if you can give me feedback on: where previous free cash flows have accumulated in the balance sheet. I've been thinking about it and feels it merits consideration when estimating an intrinsic value. After all, you do really have to put weight on free cash flows already earned/accumulated as much as those future free cash flows we're still projecting (and yet to be earned) and discounting.
Excellent site by the way
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BusinessmanInvestor.com
Touching base with the rational business psyche of stock market investors
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3:04 pm
August 21, 2011
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Jae Jun
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here is my opinoin in more detail.
The strongest argument against adding equity is that you need the assets to create cash flow. You can't run a shop without the land and the building, but it would be equally wrong to value a business based on the real estate AND the cash flow generated by those assets.
It has to be one or the other. If a company had assets from discontinued operations which no longer generated money, then you could add it back in.
Using your example of a company generating 0%, then on a DCF basis it is worth $0 because the future cash flow is worthless. After all, why buy a business that doesn't make or lose anything.
For such a case, you would just use asset based valuation, then decide whether the assets are cheap because you certainly won't be paying for the cash flow. (Remember though, as shareholders we don't have the luxury of flipping these assets over.)
While DCF is a good tool, it shouldn't be applied to every scenario and is why only non cash generating equity should be added.
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2:38 pm
August 21, 2011
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businessmaninvestor
| | Manila, Philippines | |
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@mclem1981: Thanks for the question. What I'm simply referring to is where all previous FCF's have accumulated. The net change in cash which accumulates in the Cash & Cash Equivalents section does not discriminate among CFO, CFI, and CFF. I tried to track and discriminate where FCF's have accumulated.
Maintaining a free cash flow bias perspective (i.e. how each asset account affects free cash flow), I was able to reclassify the balance sheet accounts. See: http://www.businessmaninvestor…..=BP_recent
If you think of it, assets can be reclassified into three:
Trade Assets (receivables, inventories, prepaid expenses, etc.)
Capex Assets (primarily PPE)
Free Cash Assets (cash, AFS, HTM, investments in subsidiaries, etc.)
Trade Assets and Capex Assets don't have any "free cash flow" value (i.e. receivables are not yet inflows, inventories and prepaid expenses have been outflows; Capex are actual cash outlays). FCF thus accumulates into the Free Cash Asset account.
Free Cash Assets, however, should still be further qualified since it maybe composed of cash which may have been externally sourced. That's why I deduct Financial Liabilities (externally sourced cash: short-term and long-terms debts) from it. I also deduct Accumulated Market Gains since these are gains yet to be realized in cash (to avoid double-counting, these gains will be aptly considered in future cash flows)
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BusinessmanInvestor.com
Touching base with the rational business psyche of stock market investors
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11:57 am
August 21, 2011
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mclem1981
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Businessman:
I've read your article and I'm having difficulty understanding what you’re trying to extrapolate from FCF. CFO is adjusted by CFI and CFF thus forming the bottom line of the cash flow statement (net change in cash), which “accumulates” in the cash & marketable securities section of the balance sheet. Are you suggesting the idea of FCFE (Free cash flow to equity) = Net Income – Net Capital Expenditure – Change in Net Working Capital + New Debt – Debt Repayment?
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5:52 am
August 21, 2011
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businessmaninvestor
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Hmmm… here's my thought on what should be added (other than equity) to arrive at an intrinsic value.
I came up with this "free cash hoard" or "free cash equity" concept. This is, in theory, where all (previous) free cash flows have been accumulating.
Please see this link:
http://www.businessmaninvestor…..=BP_recent
Would appreciate to hear your comments and get feedback =)
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BusinessmanInvestor.com
Touching base with the rational business psyche of stock market investors
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8:12 pm
August 19, 2011
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mclem1981
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Post edited 1:21 pm – August 19, 2011 by mclem1981
Consider also a comparison to a corporate bond:
Bonds have both a face value component (similar to shareholder equity in a business) as well as a coupon component (similar to cash flow in a business). Warren Buffett frequently refers to businesses as an "equity bond" with "expanding coupon."
When valuing a bond, simply put, we find the PV of both the future coupons as well as the PV of the face value using your required rate of return and add them together. Similarly, a security can be broken down to a PV of cash flow component (from DCF) plus the equity component.
This was just another thought that might clarify why Ponzio added the shareholder value to the DCF.
I think not adding equity overly lowballs the value of companies.
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7:41 pm
August 19, 2011
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mclem1981
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Hey guys, i'm not so sure that not including shareholder equity is the right way to go. Consider someone who uses Owner's earnings to value a company. Suppose these earnings are growing at 0.00% in perpetuity, which total $0, and there are no non-operating assets (or excess cash). So we have a company that just covers its bills, and shrugs off no cash for investors. Are we saying that this asset has no value to acquiring interests (possibly strategic) despite yielding a goose egg for investors? If this asset does have value (possibly a carefully derived tangible book value, taking into account on and off-balance sheet adjustments), which I think it does, shouldn't it be added to the DCF?
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11:37 am
March 14, 2011
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Jae Jun
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Well Joe explains is so that anyone can understand. If you go deeper in, a more accurate definition is to not add all of shareholders equity, but to add back just excess cash.
Excess cash is what the business does not need to operate the business.
Excess cash does not produce further cash, which is why it has to be added back as a single number.
The reason for why all of shareholders equity should not be added to DCF is that DCF makes an assumption of the cash flow based on the current assets that produce cash.
This means that if you are performing DCF with the cash producing assets, you should not add those assets back in as you have already accounted for it.
That is why you would want to add back only excess cash.
The spreadsheet does not double count and only adds the excess cash to DCF.
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12:04 am
March 14, 2011
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wcampb
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So wait…Ponzio's equation, and thus the book, are wrong? Jae, I know that this was talked about briefly in the link you posted, but do you mind elaborating on it a little more here? Also, I've been using a mac so I have not used the spreadsheet in a long time. Does the spreadsheet DCF "double-count"??
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4:04 pm
March 7, 2011
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Jae Jun
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I used to add equity but have since changed the equation because that would be considered double counting.
That's what I wrote here, but read the comments to see why equity should not be included.
http://www.oldschoolvalue.com/…..-business/
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1:53 am
March 6, 2011
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sergiovlc
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Hi everyone ! I have noticed that with this spreadsheet we don't add equity to the OE when calculatin the intrinsic value of a company. In Fwallstreet Joe taught us to do so…so I don't know why we are not doing it here.
Jae is there a particular reason you haven't include it?
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