Hi Pedro,

I've been reading the materials on Clime Asset Management's website and have been trying for a long time to figure out the valuation method that they use. Your excel sheet was an excellent excellent help!

There is still one major point that I don't understand. The formula you put in the spreadsheet to calculate the eventual fair value, I saw that in a CAM article titled "When Share Price Falls Make Headlines and How to Avoid Them". Would you be able to explain how that formula works?

I understand that the numerator represents the "terminal value" that is n years away (e.g. n = 5). Then there is this complicated adjustment of the discount rate R in the denominator to adjust for dividends. Would really appreciate it if you could explain how that adjustment works.

Thanks much.

Selcon,
First off welcome to the forum.

The spreadsheet produced was just to show how it was constructed, and is based on information by Stockval's creator Brian McNiven, in his book "A wonderful company at a Fair Price".

There are various components that make up individual items (eg. C23 "Attributable Retained Earnings" ) ,relates to BROE (Benefical Retained Earnings - which is BE (Benefical Earnings "Grossed up dividends Plus retained profit and amortisation of intangibles,plus or minus changes in reserves, which also need to be adjusted for abnormals and changes in reserves that cannot be attributed to the core operating activity")
this figure is then divided by the average equity employed during the financial year.
Having said that you will see that the formula and principles involved need to be absorbed on a bit by bit basis and that is what the book sets out to do .
Formula involves the Equity Per share , BROE , IRR , required rate of Return on investment and the term.
Some of the terms are those chosen by author and , as I said above, need to be absorbed to see where he is coming from.
To do this it is probably best you read the book, which is well written and worth buying (mine cost $29.65 from Angus & Robertson a few years ago) and should give you the answers to what you are seeking.

Ah, so that's the connection. I went to a Roger Montgomery presentation, and was given a copy of Brian McNiven's "Market Wise" pub. 2006 (which is heavy going but full of sensible stuff)

At the presentation, Roger M said something that I have been mulling over. It is in relation to ROE and whether it is best to reinvest earnings or pay them out as dividends. His comment was along the lines that in the future, with Superannuation being a powerful and increasingly dominant way to hold assets, it won't matter whether a company pays a dividend or not, because in a zero or low tax environment, the asset holder can just sell a portion of the holding. No capital gains tax.

But to me this misses out accounting for the transaction costs, and ignores benefits of franking.

The context was that for high ROE companies, discounted cash flow calculations show that over the years, it is better, all things being equal and the company maintaining a similar performance, to reinvest any earnings than 'waste' the money paying it out. Performance of the company and net benefit to shareholder can increase at a faster rate this way. For low ROE companies a high dividend is the best way to spread the love around.

B.

Benthonic,
A quick and easy way to see whether retained earnings have been used profitably by company is to check out the increase in profit is above the increase in equity.

Put simply if the ROE has increased from year to year this is happening.

Another thread which discuss the profitability issue is
http://www.sharesguru.com/forum/viewtopic.php?f=4&t=4065

And this one on Brian McNiven Beneficial earnings

http://www.sharesguru.com/forum/viewtopic.php?f=1&t=1923&p=12876&hilit=brian+Mcniven&sid=b9cfa894a15e454c2021811d72d9f193#p12876

In the Stockval formula it takes into consideration the dividend and franking credit ,

Thanks Pedro, I knew they were somewhere. It isn't laziness on my behalf but hours in the day; but the SG institutional memory is something eh?

Hi Pedro,

Yes I understand Brian McNiven's terms (beneficial earnings, etc.) and his valuation framework, having read through chapters from two of his books: i) Stock Valuation using StockVal: How to Select Under-Priced Stocks, and ii) Market Wise. Though I agree with much of his reasoning, I think there's some logical flaws in the way he has implemented it. But putting that aside for a moment, I'm interested to understand his valuation formulas.

So far, I've seen 3.

In the "Stock Valuation using StockVal" book (1997), the formula was Intrinsic Value = EQPS * IRR / RR * (1 + EP%)^7, where EP% is the Excess Premium, defined as Min(IRR - RR, RB), where RB is the retained beneficial earnings (i.e. RB + D = IRR)

In Roger Montgomery's piece "Avoiding Share Price Collapses" (2002), which I assume follows Brian McNiven's stuff exactly, the formula was Intrinsic Value = ROE * (EQPS * (1 + RE / EQPS)^n) / RR / (1 + (R - EQPS / (EQPS*ROE/RR) * (DPS/EQPS)))^n. I think the StockVal program use n=5.

In Market Wise (2006/2007), the formula was Intrinsic Value = (APC / RR * RI + D) / RR * EQPS, where APC = Adopted Performance Criteria (which can be IRR or ROE), and RI + D = APC.

I've not read "A Wonderful Company at a Fair Price", so I don't know if there's a 4th formula. Basically, In both "Stock Valuation using StockVal" and "Market Wise", Brian did not go into the mathematical details of how the the formulas were derived, and that is what I'm interested in. For example, in the 1997 formula, how did he end up with this formula which has the EP% defined as min(IRR - RR, RB). In the 2002 formula, how did he end up with that complicated adjustment to the discount rate. In his 2006/2007 formula, he highlighted that some simplifications were applied, what were the simplifications?

If you're able to help with understanding the mathematical derivation of the formulas, that would be great.

Selcon,
Sorry for delay in replying , been away .

Also sorry I cannot give you any help with what is behind formulae.

However, I did receive from John Price a copy of updated version of Valuesoft and in it he has a formula for Dividend Discount methods which he calls "DDM"

Using the updated figures for TRS I input these into the spreadsheet previously posted and it changed the figures from estimates in 2007.
This had the effect of changing cell E21 from $8.90 to $5.74.
Using the Valuesoft DDM formula the price came in at $5.69.

In his email advice he mentioned

A few months ago I introduced new margin of safety functions into Valuesoft. Now I have introduced two more functions: DDM and SV.

DDM is a function for calculating the intrinsic value of a stock using the Dividend Discount approach. Its main inputs are return on equity and the payout ratio, the proportion of earnings that are paid out as dividends. It is a two-stege model meaning that you can assume different values of the inputs over, say, the first 10 years and for the remainder of the time.

SV is a restricted case of DDM using the based on calculations StockVal®. SV is included in Valuesoft so that you can compare calculations.

I have also added a new material on valuations using Discount Cash Flow methods and an entire new chapter on Dividend Discount Methods with a discussion of the strengths and weaknesses of these methods..

Valuesoft now contains 16 functions for calculating and estimating the value of stock 6 functions

Of course you will need to purchase the product from John Price, but if you contact him and tell him you are a forum member, and was told about the new DDM by Pedro .
He did post on here early in the piece and can be contacted at
johnp@sherlockinvesting.com

Contact details are

Hi Pedro-Egoli,

I have been looking around for various valuation tools. Have you found the Valuesoft tools to be of benifit?

Kind Regards

DiggerD

The Value Shares Investor - Regular thoughts, commentary and analysis in the area of "value" shares investing
by Roger Montgomery - Tuesday 6th July 2010.

Which 15 companies receive my A1 status ?

I like to invest in great quality companies when they are cheap. Nothing too special about that because that is true of a line of value investors from Buffett and Munger, all the way down to us. For me, ‘quality’ is not difficult to ascribe to a company, provided you remove the subjective elements. You can decide, for example, to simply look at the return on equity, but of course that alone will not be enough to separate two companies that each share the same return on equity. One company could have more debt, or two retailers with the same return on equity could have very different inventory turns or different cash flows from working capital. One retailer’s inventory management may be improving and the other declining. The absolute value of many ratios and their trends can all help to determine quality in an absolute and relative sense. That is how I arrive at my A1 ratings (not to mention A2, A3….C5 etc) – ratings that you have seen me discuss on the Sky Business Channel and heard me chat about on 2GB.

Perhaps the simplest way to think about quality is the way that Buffett has done it using his subscription (complimentary for life one presumes) to Value Line, which was launched in 1931 in the United States. Applying Buffett’s approach to an Australian company is delightfully simple. Start by having a look at the profit some time ago – lets use ten years. Compare that ten year-old profit to the most recent one, or even next year’s expected profit. Is it up or down? In his 1996 Chairman’s letter to shareholders Buffett said; “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

So the first step is to compare the change in earnings over a reasonable period of time. Ideally you would like the profits to be “marching upwards” and be confident that the future holds the same pattern.

The next step is to look at the change in the contributed equity. The reason you want to do this is explained with a simple example. Lets say I start a business with $10 million and in the first year I earn $2 million. The next year I earn $4 million and the year after I earn $6 million, and so on. I suspect you would be as thrilled as me with the decision to start this business. What if we started another business that produced the same profits over time as the first example, but in addition to the initial $10 million to get things started, we were required to inject many millions more in equity back into the business, annually? My guess is that you would be far less excited. Airlines are particularly adroit at performing these riches-to-rags economics. But having harped on about that for a decade, you already know my thoughts on airlines.

How about we take a look instead at Incitec Pivot (IPL)? Here is a business that in 2002, after two years of losses, reported a profit of $18.3 million. Equity contributed by shareholders amounted to $65 million at that time and retained earnings (profits that shareholders had not received as dividends) had built up to $84.4 million. Now fast forward to 2010 and Incitec Pivot is forecast to earn about $400 million. So in just 8 years profits have grown more than 20-fold!

As an owner of the whole business, you would be pretty happy with this result, particularly in light of Buffett’s comments about “marching upwards” and all. The real questions however are 1) have you had to contribute any additional money to the business or leave any in there? and 2) How much?

While profits have grown by $382 million, the amount of money the shareholder/owners have had to contribute to produce this result is even more startling. Imagine owning a business that grew profits from $18 million to $400, but required an initial investment of $65 million and then an additional $3.2 billion! And we haven’t yet mentioned that borrowings have increased from $120 million in 2002 to $1.6 billion at the end of 2009.

These sorts of economics do not receive my A1 accolade. The only A they get is the one for ‘Agony’. By comparing the increase in profits to the increase in equity, you can get an understanding of the returns the additional capital has generated. In the case of Incitec Pivot that number is about 11%. If the debt is included, the return on additional capital is 8%. Not as shockingly low as other companies (I can think of half a dozen off the top of my head), but not anywhere near the 30% rates achieved by Woolworths, for example.

At the 1998 Berkshire Annual Meeting, Buffett said: “Time is the enemy of the poor business and the friend of the great business. If you have a business that’s earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business.”

He was perhaps referring to Graham’s own metaphor about the market being a weighing machine over long periods. Over long periods of time, prices tend to track the underlying performance of the business. If returns in the business are low, so will be the returns be from owning the shares.

And thats why I like to stick to only the very best sbusinesses - I call them my A1s. And there’s not that many. So who are the A1’s? Well, here is fifteen. They’re ranked in order of market capitalisation (biggest to smallest). And don’t forget, this is a purely didactic exercise. Its educational, so you must seek and take personal professional advice before doing anything. Also remember I am offering no assessment about whether the shares will go up or down. The shares could all halve (or worse). I have no way of predicting what the shares will do.
CSL
Worley Parsons
Cochlear
Energy Resources
JB HiFi
Navitas
REA Group
Carsales.com
Monadelphous
Iress Market tech
Fleetwood Corp
ARB Corp
McMillian Shakespear
Sirtex Medical
Oroton Group

One of the most frustrating things about having high standards is that the pond gets very small. There just aren’t as many ”fish in the sea” as your parents may have led you to believe. But as John Maynard Keynes said in a letter to F. C. Scott on August 15, 1934: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.” My quality ratings can and do change. Not often, but they will. Recently, for example, quite a number of companies raised capital to pay down their debt. Even before they report their full year results, I can see that the raisings will dilute return on equity and dilute intrinsic value, but I can also see that the balance sheet will be stronger and so, the quality rankings will rise. Importantly however for me, my A1’s are those companies in which ‘I personally feel myself entitled to put full confidence’ (in terms of quality, not share price direction or prediction!).

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Roger Montgomery shares his step-by-step guide to valuing the best stocks and buying them for less than they're worth in his new book, Value.able, available exclusively at http://www.rogermontgomery.com. Roger also shares his stock market insights at this bloghttp://blog.rogermontgomery.com