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11:03 am
November 24, 2010
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Jae Jun
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Yes definitely work your way through the statements.
CROIC growth shouldn't be used for a company like JNJ. FCF growth is much slower. I'm confident that if there was another company identical to JNJ but wasn't the market leader, CROIC would be lower.
I agree that trying to gauge the range of valuation is difficult and that is why I have 3 very different valuation methods in the spreadsheet.
When I see that all 3 valuation methods show that the stock is undervalued, it usually is more often than not. I even created a test portfolio to test this theory and so far, it is correct.
If I am unsure about a valuation range, the company is too hard to value and I skip.
The big winners for me is where I can immediately tell it is cheap after about 10min of looking at numbers. It is glaringly obvious. I double check with the spreadsheet but a strict formula will not be able to identify this.
The most important is truly understanding the company, industry and then seeing whether the numbers make sense.
If JNJ grew at 30%, Wall Street would jump for joy but by understanding the business, you know that it will be a trap as it is unsustainable.
Another example is NFLX. My spreadsheet and mostly everyone out there believe it is hugely overvalued.
I actually disagree. It may be overvalued, but not by much.
In the end, it all comes down to practice like everything else. At first it's frustrating trying to know which number and ratio you have to look at, but with practice, you'll instantly recognize undervalued companies easily.
I used to just enter about 30-40 tickers a day, try to come up with a value and then keep watch to see whether I was right.
I got a lot of value traps but as time passed, that number reduced.
http://www.tickerspy.com/portf…..?pid=93001
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10:47 am
November 24, 2010
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B
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Jae, first of all, I want to thank you for taking the time to reply to my posts. I'm not a complete newbie to investing, but am to Value Investing.
What I'm gathering from your response is that whether I use FCF, Owner Earnings, CROIC, or all three, I should still dive into the financial statements to get a feeling for where the numbers are coming from, and then decide on a case-by-case basis which indicator above will offer the best representation of the company's true growth.
It's just that, in absence of any glaring abnormalities in the financial statements, I would still like to understand the reasoning behind which numbers are used in the spreadsheets so that I know I'm getting a good read on the range of the Intrinsic Value. I mean, I can know that I have a good understanding of a company's cash growth and financial health, but if I can't get a decent read on the Intrinsic Value in respect to current share price, I still don't know whether I should buy or not.
In the JNJ example, I could have pored over the financial statements and known it had good growth. But if I had used CROIC instead of FCF growth in my spreadsheet, I could have led myself into disaster!
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9:27 am
November 24, 2010
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Jae Jun
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I believe the main cause of frustration is that you are trying to make this too much into a science where strict rules apply.
Stock valuation is 10% science and 90% art. All the numbers and formulas in the world cannot provide accurate valuations unless you know and understand how it is used.
I do refer to owner earnings but I also do refer to FCF. It all depends on the company I am looking at.
Joe Ponzio started using CROIC as the growth but may have changed to FCF growth.
CROIC doesn't need to be used for anything. Much like P/E or P/S, it isn't used for anyting except to understand the value of the company.
CROIC is used to understand the effectiveness, profitability and moat of the business.
I stopped using CROIC growth because I changed my mind that the growth of cash will increase intrinsic value rather than the cash that can be generated from invested capital.
As for how to identify non cash items, the best way to do it is by hand of course, but in the financial statements, there are line items such as "special income" or "impairments" etc that clearly outline non cash charges.
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3:15 am
November 24, 2010
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B
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Yeah, I read your FCF article and it makes sense – I agree with it. But even in your article, you say that you use Owner Earnings instead of the traditional FCF (which includes changes in working capital). So I guess when you refer to your version of FCF, you are actually refering to Owner Earnings (your and Buffett's modified definition of FCF)?
The frustration I have with F Wall Street is that the sample spreadsheet (JNJ example) uses traditional FCF growth instead of CROIC (as instructed in the book) to project future cash. The disparity is 16% for FCF growth vs 22% for CROIC. CROIC is not even used to calculate anything in the spreadsheet! By the way, the sample spreadsheet also uses a constant growth rate for the first 10yrs of future cash instead of a declining growth rate as suggested in the book.
So what was the impact of using FCF growth (16%) instead of CROIC (22%)? …using FCF growth, the intrinsic value was $83/share. …using CROIC, the intrinsic value was $113/share. A HUGE difference!
Maybe we're supposed to calculate both traditional FCF growth and CROIC, pick the lower of the two, and use that as the growth rate for projected future cash. Does this sound right?
Or maybe the sample spreadsheet uses FCF instead of Owner Earnings because Owner Earnings can't be calculated systematically like FCF? What I mean is that the "non-cash charges" portion of Owner Earnings can be identified only by careful analysis of which line items constitute a non-cash charge – too complicated or too much work to show. Easier to go with FCF which is readily shown on the Cash Flow Statement.
Jae, I'd like to hear how you identify the "non-cash charges" portion of Owner Earnings in your spreadsheets – whether it can be done systematically. To me, it seems like it requires visual analysis by a person.
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10:53 pm
November 23, 2010
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Jae Jun
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Yes it is different but they are under the same family.
A 4WD SUV is a car and so is a 2 seater convertible. Different purposes but both are cars.
Owner earnings and FCF can both be categorized under FCF. Slightly different uses and it depends on your taste, just like cars.
Owner earnings does not include changes in working capital.
FCF includes changes in working capital.
http://www.oldschoolvalue.com/…..-flow-fcf/
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11:01 am
November 23, 2010
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B
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Jae Jun said:
I just use FCF and CROIC interchangably. They are both classified under FCF.Jae Jun said:
But they ARE slightly different. Even F Wall Street's sample spreadsheet for JNJ has a side-by-side of FCF and CROIC, with quite a noticeable different between the two – about 33% difference between the FCF and CROIC numbers.
I looked through some old posts and even googled it. But I couldn't find a satisfactory explanation. Actually, FCF should be more akin to Owner Earnings, right? I'm just confused…it seems like the F Wall Street book and website are doing two different things. If Ponzio uses FCF too, then why not teach it in the book?
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11:09 am
November 22, 2010
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Jae Jun
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I just use FCF and CROIC interchangably. They are both classified under FCF.
Total – current liabilities is used for a simple reason.
A company is not expected to produce a return off it's short term borrowings. You borrow $1m for 1 year, it's highly unlikely that you will be able to make a successful return off it. This is why you need to subtract Current liabilities from the TOTAL liabilities rather than just have "long-term debt + other long-term liabilities" or some other combination.
F Wall Street does explain it, not in the book, but it is buried in the hundreds of posts.
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2:43 am
November 22, 2010
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B
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| Member | posts 9 |
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Jae Jun said:
CROIC = FCF / (Shareholders equity + total liabilities – current liabilities)
Just curious why you use FCF instead of Owner Earnings in your CROIC formula here. I saw a JNJ IV-calculation sample spreadsheet on Fwallstreet.com that also used FCF instead of Owner Earnings to calculate CROIC, even though the book tells us to use Owner Earnings, and that FCF should only be used as an approximation for large, stable companies.
Also, in calculating long-term liabilities, why use "total - current" liabilities? For example, in the balance sheets on Morningstar, long-term liabilities is just "long-term debt + other long-term liabilities" - equally as easy to calculate. Are there instances where long-term liabilities contain more items than just these two? I wish Joe Ponzio's F Wall Street would have told us if "total-current" were a more efficient or robust way to calculate long-term liabilities. I think the book's real-world examples needed to be a bit more step-by-step.
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3:18 pm
July 27, 2010
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infinitee00
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@Itconsultant,
As an aside, you may be already aware that Tenet healthcare settled a $900 million lawsuit of healthcare fraud with the DOJ in 2006 which required them to pay the amount over 4 years including interest.You can read about it here (page 8)
http://oig.hhs.gov/publication…..rt2006.pdf
As a result, their cash reserves have taken a hit somewhat and also kept them from paying down part of their debt. Although I agree that even without it, their Dt/Equity ratio is at dangerous levels. Ripe for chapter 11, in case of another major disaster in the economy or freezing of the credit markets.
-Ranajit
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2:43 pm
July 26, 2010
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Jae Jun
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Knowing about bonds, debt, interest rates will help a lot when valuing high debt businesses. You have to know when the debt is due, how the interest rates will affect business, whether it can be paid off from operations etc etc
Lots of things to consider but very profitable if done correctly. Problem is, I find it very hard to analyse.
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2:30 pm
July 26, 2010
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itconsultant
| | Irving, Texas | |
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Post edited 10:33 pm – July 26, 2010 by itconsultant
Ithink Graham said this he wants the company to own twice as much as they own. So I would AVOID companies where the leverage is so high, especially if most other firms in the industry are less levered. Also, i avoid financials due to the inherent leverage in those firms.
I looked at THC – Tenet Healthcare. One look at the balance sheet and I decided it was a Sell recommendation ( it was for a competition at school). Check it out as an example of high leveraged firm. Where Debt / Equity is 6x.
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2:04 pm
July 26, 2010
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itconsultant
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I heard from some expert investors about checking up returns on Incremental capital. I think thats different than ROC, or CROIC. Anyone know a way to measure that?
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4:20 pm
November 9, 2009
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Jae Jun
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When looking at a highly leveraged company you have to remember that gains will be greater and at the same time, losses will also be greater.
But it isn't always dangerous if you play it safe.
A company takes on debt but at the same time, a lender provides the needed capital because they believe they will get their money back with interest.
A company also believes they can make the payments. Think of your own situation. You wouldn't be able to get a loan for a Ferrari on a $20k annual income and if you are smart, you wouldn't try to.
With that said, a company will take on debt when they think they can generate a return on investment higher than the interest payments.
So as Floris stated, you could calculate the historical ROIC to see how it stacks up against the interest of the loan. A better choice would be CROIC (cash return on invested capital). If the company has been able to consistently return a higher CROIC or ROIC than the interest payments, you are likely to see higher returns in the company, equating to a higher stock price.
CROIC = FCF / (Shareholders equity + total liabilities – current liabilities)
Also, with high debt, if a company is able to reduce expenses, it also has the effect of creating a greater return. It only works for a short term though.
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3:08 pm
November 9, 2009
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Floris
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Post edited 8:11 pm – November 9, 2009 by Floris
Hey Sdev,
Isnt it an idea to simply use a much higher cost of equity? Value it the way you would value an all equity (or low debt) stocks but raise the expected rate of return.
I disagree with all the EMH nonesense, but this is one of the theories of modern finance I cant disagree with. The higher the debt load the higher your expected returns should be. Earnings will be more volatile and the chances of losing all your money are higher, which is something you should be compensated for.
Furthermore do use the EV value. With a high debt load the ROE is going to be lopsided and not representative. The only way to measure how succesful the firm is in making money in this case is to use ROIC = EBIT (normalized!)/EV
reg,
Floris
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12:08 pm
November 9, 2009
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Sid
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I'm trying to figure out the correct thought process to break down high debt companies. In particular, I have been looking at various media companies mentioned on this board and elsewhere. I have been looking at Gannet in particular because of the writeup at Value Investor Today. I find it very difficult to determine what to use as far as a shareholder equity value. Jae previously mentioned in reference to radio stocks, that using enterprise value instead of shareholder equity is something to consider when valuing these sorts of businesses. I have tried thinking about this for a while and it just doesn't click. Does anybody have a good explanation as to why this would hold or a good measure to use?
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