thanks for your response…i apologize for misinterpreting ponzio…you are right…share price does not have anything to do with the owner equity he uses…however, i still have trouble with this…to me, to add what he does use (straight book value OE) to the sum of discounted future expected FCF still doesn’t sit right…assuming for simplicity for the moment the omission of growth value, it is analogous to adding graham+dodd asset value to the graham+dodd EPV…however,EPV already implicitly includes the value of assets, and only differs from the asset value by the amount of the franchise value, if any…even taking his example (pg 104), he selects a hurdle rate for J&J of 9%…however, he will not achieve his 9% IRR if he pays the PV of the future projected FCF *plus* book value OE…it is one thing to come up with a (hopefully) properly adjusted asset value net of debt and use this as a standalone value possibility and contrast this to EPV (non-growing or growing) or DCF value in attempting to isolate the various components of the total value a la graham+dodd, but you can’t mash them together…this is double counting…thus, i still think ponzio’s “buy-and-hold” valuation is simply a flawed interpretation of plain old DCF, imho. anyways, thanks again for your thoughtful reply jae

I get asked this question a lot and I’ve thought through it from different angels, dissected and discussed this in length.
From a modern finance perspective, it will make no sense. From a value investing perspective, it somewhat makes sense. If you think in terms of real businesses, it makes perfect sense.

I don’t agree that the share price factors in shareholders equity at all. I’m fully convinced that share prices are made up of a good amount of emotion, which is why there are so many companies selling below tangible net net working capital.

From a business perspective, shareholders equity is what the investors are entitled to at the current point in time. DCF is the “sum of the future cash flow”. I emphasize future because DCF doesn’t consider the current assets at all.

If I’m starting a business where I spent $1000 for office equipment, electronics and other goods and I am able to generate $100 a year consistently. If somebody offered me $1000 dollars for the business saying that is what the cash flow of the business is worth, the offer would be turned down immediately, because it doesn’t account for all the office equipment that he is getting with the deal.

Regarding wacc.. I’m not much of a fan of beta so wacc never works for me either.

Like Joe, most of what I write and say will make no sense unless you are thinking in terms of owning your own business. I always imagine that I own a little corner grocery store and base my decisions and investing rationale and approach like that. And WACC isn’t what a grocery owner will know about. All I know is that my inventory is worth this much now, and I can generate this much cash now and in the future.

thank you for your wonderful website…very informative and really shows a dedication to rational valuation and educating your fellow investor…don’t know what your latest thinking on the subject is, but just wanted to get your thoughts on ponzio…actually, the more i read of the fwallstreet book, the more i wonder about the methods presented therein…specifically, the simple addition of owner equity straight from the balance sheet to the summed discounted future stabilized cash flows…hmmm…this is circular in the sense that the current stock price is utilized to calculate this, despite the fact that the whole valuation exercise is geared toward determining this value independently (and highlights ponzio’s own misunderstanding of price vs value imho)… also his discussion of discount rates is nonsensical if you really read it carefully (whatever happened to wacc?!?!)

your thoughts?

thanks, jae!!

I don’t believe this is that “huge” of a difference. After all, the whole point of DCF is normalize.

Rather than normalizing over 5 straight years, I think what Joe did by using timelines is brilliant.

“These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges…less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume….Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes…All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract (c).”

Morningstar adds Deferred Taxes & Non-Cash Items in their FCF. Wasn’t sure if you knew that and wanted to bring it to your attention since Warren Buffett’s definition of Owner Earnings doesn’t include those items.

I was looking at what you said over the weekend but I couldn’t see how you came up with that formula. In the spreadsheet, I take Morningstar values which is just the normal FCF formula of cash from operations – capex.

Regarding taking out intangibles from the equation… another reader on F Wall Street mentioned the same thing previously, but I’m not quite sure enough to give an answer right now.

On your 5 year DCF (probably 10 year as well but I didn’t look yet) your FCF is being computed as Net Income + Amortization/Depreciation + Deferred Taxes + Non-Cash Items – Changes in Working Capital – Capital Expenditures.

The difference between the two calculations as you can see is HUGE. Which do you believe is the correct way to define FCF?

My second question is this: Since value investors typically deduct intangibles & goodwill from total assets when valuing a business, wouldn’t it make sense to also deduct them when coming up with the Invested Capital figure which would also significantly, in many cases, change CROIC?

Thanks. Hope everything is going well for you and look forward to hearing from you.

I’ve looked into EPV slightly over the weekend but I’ll do some more study and try to add it my bag of tricks.

In the case f CPY, its CROIC is 7.6% after smoothing the data over 10 years, but its FCF growth is 0% or negative.

The growth of 0% or below may be unrealistic, but it seems like 7.6% is also being a little unrealistic. So I reverted back to the conservative side of FCF. Obviously I make my adjustments if FCF is too high as well.

Thanks for letting me know. I’ll have to update it.

I haven’t noticed if anyone else has brought this up already but I wanted to make you aware of it concerning your 5 year DCF spreadsheet. The growth rate projection is suppose to use the CROIC number, Cell K33. Instead your spreadsheet is using Cell K32 which is the free cash flow percentage. So, all your extremely high Intrinsic Values are coming from the FCF percentage rather than the CROIC that should be used. I haven’t looked at your 10 year yet but i’m guessing its the same. Just wanted to point that out to you. I’ve made the adjustment already. btw, your spreadsheet is put together nicely. The one I made is very comparable but it doesn’t look as pretty

I re-read this post but still cannot figure out how to use the “RCHGetElementNumber(Ticker,25)” function to get the ticker price for a stock I am interested in. I am trying to get a spreadsheet to auto-populate the current stock prices on my sheet. Can you help?