CHECKLIST ON HOW TO VALUE SHARES

BIGGEST RISK:  PAYING TOO MUCH

The biggest risk you face to be a successful investor in shares is paying too much.   

It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high-quality and safe company.  

Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

USUALLY HAVE TO PAY UP FOR QUALITY

Be careful not to be too mean with the price you are prepared to pay for a share.  

Obviously, you want to buy a share as cheaply as possible, but bear in mind that you usually have to pay up for quality.

Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.  

Some shares can take years to become cheap and many never do.

CHECKLIST ON HOW TO VALUE SHARES

When valuing shares, you can use the following checklist to remind of the process to follow:

1.  Value companies using an estimate of their cash profits.

2.  Work out the cash yield a company is offering at the current share price.  Is it high enough?

3.  Calculate a company's earnings power value (EPV) to work out how much of a company's share price is explained by its current profits and how much is dependent on future profits growth.  Do not buy shares where more than half the current share price is dependent on future profits growth.

4.  Work out the maximum price you will pay for a share.  Try and buy shares for less than this value.   At least a discount of 15% or more.

5.  The interest rate use to calculate the maximum price should be at least 3% more than the rate of inflation.

6.  You must be very confident in continued future profits growth to pay a price at or beyond the valuations estimated here.

7.  The higher the price you pay for profits/turnover/ growth, the more risk you are taking with your investment.  If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

The importance of growth

If you are going to buy and own expensive shares, you must be very confident that high rates of growth can continue for a long time into the future.   Since no one can predict the future accurately, you need to protect yourself by not paying too high a price for shares.

Knowing how to value shares and understanding the crucial relationship between cash profits and interest rates are important.  Know how much of a company's current share price is based on its current profits and how much is related to future profits growth.  

Though profits growth is important in valuing shares, you should also know how to not pay too much for it.

High share prices can unravel very quickly when profits stop growing.  

Companies which investors like tend to command very high valuations because they are growing turnover and profits rapidly, or are expected to do so   Their shares will have very high multiples of profits and cash flows and very low yield attached to them.  

This can persist for a long time but the dangers for investors of owning expensive or highly-rated shares can be significant when profits stop growing.  

Investors in these shares may often lose a large amount of their investment and learned a brutal lesson of the high risks of owning expensive or highly-rated shares.  This experience has been repeated countless times in the past and will surely happen many times again int he future.

• Using owner earnings to value shares: Setting a ma...
• Using owner earnings to value shares: Earnings Pow...
• Using owner earnings to value shares: Cash yield ...

Using owner earnings to value shares: Setting a maximum price method

Setting a maximum price and buying price for Company X shares

Current cash profit per share 11.6 sen

Divide by interest rate [inflation +3%]  4.4%

Maximum price (cash profit / interest rate)   $2.636

Current price  $3.20

Ideal price at 15% discount $2.24

Cash yield at ideal price (cash profit/ideal price)  5.18%

ANALYSIS:

This approach is saying that Company X shares are currently too expensive to buy.

The most (maximum price) you should pay is $2.63 per share, compared with a current share price of $3.20.

If you want even more of a buffer (margin of safety) compared with the maximum price - a good rule of thumb is 15% - you will only want to pay $2.24.

Additional notes:

You might be waiting a long time for a share to reach your target price and it might never do so.

However, it is far better to wait or even risk missing out on the few shares that are too expensive than to risk paying too much and lose money.

When to sell?

This kind of analysis can also give you some guidance of when to sell a share.  

If a share that you own reaches a maximum price, it doesn't mean that you should automatically sell it.   Shares can and do go beyond and below their fair valuations.   

In the above example, Company X, one would not sell at $2.63 but if the share price exceeded this (maximum price) by 25% ($3.29), you might sell and then look for something cheaper to buy.

Using owner earnings to value shares: Cash yield or Interest rate method

This approach is very simple.

Take the owner earnings or the cash profit per share and divide it by the current share price to get a cash interest rate (or yield)

Cash interest rate = cash profit per share / share price

Rational

The whole point of owning shares is to get a higher return on your money so that you can grow the value of your savings. 

If you are going to get only a small cash interest rate on your shares at the current share price, it could be a sign that the shares are overvalued.

What a low interest rate is telling you is that cash profits are going to have to grow a lot in the future to allow you to get a decent return from owning the shares.

Investing is all about interest rates.  

To make money you should aim to try and get the highest rate of interest on your investments as you can without taking lots of unnecessary risks.

Only you can decide what rate of interest is high enough.

EXAMPLE of using cash yield or interest rate method to value share

Let's say that you want to get a 10% cash flow return on buying shares in Company X where the cash profit per share is 11.6 sen.  At its present share price of $3.20, you are currently getting a cash yield or interest rate of 3.6%.   You need to work out what annual rate of growth over what length of time would be needed to get to 10%.  (Best way is to set up a spreadsheet and play around with some growth scenarios.)

Assuming a 10% annual cash profit growth:  

In year 3, the cash profit per share is 15.4 sen, giving a cash yield of 4.8%.

In year 10, the cash profit per share is 30.1 sen, giving a cash yield of 9.4%.

Scenarios analysis

This kind of exercise can teach a great deal about what a $3.20 share price for Company X says for the company's future cash profits.  A lot of future growth is already baked into the share price.  It takes a reasonably long time with a reasonably high growth rate to get a reasonable cash yield on buying the shares at $3.20.

Profits are going to have to grow faster than 10% per year to get to an acceptable cash yield in a shorter time.  Even if you wanted a 7% return, you would have to wait seven years at a 10% growth rate.  That is a long time to wait.

What if growth is a lot lower than 10% or even if profits fall?   The chances are that Company X's share price would fall, which means you could end up losing money.

What does a low cash yield means?

It means that you are paying for growth in advance of it happening.  

It will take years of high growth in cash profits to get a reasonable return on your $3.20 buying price.  

This is one of the most risky things that you can face as an investor.  

You can protect yourself by insisting on a higher starting interest rate when buying shares in the first place.  

Look for an interest rate of at least 5% and even then, you have to be very confident that growth would be high for many years in the future.

How to set your buying price for a 5% or 8% initial cash yield?  

Take the cash profit per share and divide it by 5% or 0.05.  For Company X with a cash yield of 11.6 sen, this gives:

11.6 sen/ 0.05 = $2.32

Even more cautious, and wanted a starting yield of 8%, then your buying price would be

11.6 sen/ 0.08 = $1.45

These results of $2.32 and $1.45 make Company X share looks well overpriced at $3.20

Warren Buffett has looked at owner earnings (cash profits) of businesses for many years.

 In his 1986 letter to shareholders, Warren Buffett described how he worked out what he called the "owner earnings" (referred here as cash profits) of a business.  He did this because he believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.

Owner earnings 

= net income + depreciation & amortisation + other non cash items - maintenance capital expenditure.

Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintenance, or stay in business capex) often exceeded the depreciation and amortisation expense and therefore, profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintenance capex figure.  Generally speaking, though, this calculation ignores changes in working capital that are included in free cash flow.

The hardest part of this calculation is trying to estimate what maintenance or stay in business capex is.  As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this. 

So how do you get an estimate of stay in business capex?

There are three reasonable methods:

1.  The company tells you.  This figure may be in the annual report.

2.  Use a multiple of the current depreciation or amortization expense.  For example, use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate sometimes, but for some companies it can be way off if the cost of replacing assets is falling.

3.  Use a 5 or 10 year average of capital expenditure or capex.  This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.  This is a good approach to use if the company does not state the figure outright.  As a rough rule, if the 5 year capex figure is higher than the 10 yr average you should use the higher figure.

Annual depreciation expense <<<  average 5 or 10 year capex.

This is the case in asset intensive companies.  These companies usually have very poor free cash flow track records and modest ROCE and CROCI performances.   These are two good reasons against investing in them.  Avoid them unless they have been able to produce a good ROCE whilst investing heavily.

Capex <<< depreciation and amortization.

Normally this kind of behaviour would make you suspicious, thinking that a company has been      under-investing, which would hurt its ability to make money in the future.

On the other hand, there maybe nothing bad going on.  You need to study the company's history on this issue to make sure that it is not under-investing.

Using average capex figures to estimate of cash profits (owner earnings)

If the 5 year capex figure is higher than the 10 year average, use the higher figure.

Comment:   Note the key outlier is Tesco.  Its cash profit is negative.  If you come across a company that looks as if it is losing money when estimating its cash profits you need to either do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or look for another share to buy.

Here is the process to derive owner earnings or cash profits again:

• Use the most recent annual underlying or normalised net income/profit
• Add back depreciation and amortization
• Minus an estimate of maintenance or stay in business capex.
• From these, you derive cash profit (owner earnings)
• Divide by weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.

Knowing the company's cash profits, you can use these to value shares.  HOW?

Coca Cola's intrinsic value when Buffett first purchased it in 1988.

Buffett first purchased Coca-Cola in 1988.  In 1988:

• Owner earnings (net cash flow) of Coca-Cola = $828 million.
• Risk free rate of 30 year US Treasury Bond = 9% yield.

Discounted value of Coca-Cola's current owner earnings.

If Coca-Cola's 1988 owner earnings were discounted by 9% (Buffett does not add an equity risk premium to the discount rate):

• the value of Coca-Cola would have been $828m/9% = $9.2 billion.

$9.2 billion represents the discounted value of Coca-Cola's current owner earnings.




Was Buffett paying too much for Coca-Cola?


When Buffett purchased Coca-Cola, the market value of the company was $14.8 billion, indicating that Buffett might have overpaid for the company.

Because the market was willing to pay a price for Coca-Cola that was 60% higher than $9.2 billion, it indicated that buyers perceived part of the value of Coca Cola to be its future growth opportunities.

People asked, "Where is the value in Coke?"

The company's price was
- 15x earnings (30% premium to the market average), and,
- 12x cash flow (50% premium to the market average).




Where is the value in Coke? Its net cash flows discounted at an appropriate interest rate.


Buffett first purchased Coca-Cola in 1988.

Buffett paid 5x book value for a company with a 6.6% earning yield.

The company was earning a 31% ROE while employing relatively little in capital investment.

The value of Coca-Cola, like any other company, is determined by the net cash flows expected to occur over the life of the business, discounted at an appropriate interest rate.

When a company is able to grow owner earnings without the need for additional capital, it is appropriate to discount owner earnings by the difference between the risk-free rate of return (k) and the expected growth (g) of owner earnings, that is (k-g).




Using a two-stage discount model

Analyzing Coca-Cola, we find that owner earnings from 1981 through 1988 grew at 17.8% annual rate - faster than the risk-free rate of return.

When this occurs, analysts use a two-stage discount model.  

• This model is a way of calculating future earnings when a company has extraordinary growth for a limited number of years, and 
• then a period of constant growth at a slower rate.

We use this two-stage process to calculate the 1988 present value of the company's future cash flows.

In 1988, Coca-Cola's owner earnings were $828 million.

If we assume that Coca-Cola would be able to grow owner earnings at 15% per year for the next 10 years (a reasonable assumption, since that rate is lower than the company's previous seven-year average), by year 10, owner earnings will equal $3.349 billion.

Let us further assume that starting in year 11, growth rate will slow to 5% a year.  Using a discount rate of 9% (the long term bond rate at the time), we can calculate that the intrinsic value of Coca-Cola in 1988 was $48.3777 billion. 

(see Appendix A below for the detailed calculations.)




Using different growth-rate assumptions

We can repeat this exercise using different growth-rate assumptions.

• If we assume that Coca-Cola can grow owner earnings at 12% for 10 years followed by 5% growth, the present value of the company discounted at 9% would be $38.163 billion.
• At 10% growth for 10 years and 5 % thereafter, the value of Coca-Cola would be $32.497 billion.
• And if we assume only 5% throughout, the company would still be worth at least $20.7 billion [$828 million divided by (9% - 5%)].

Market price has nothing to do with value

The stock market's value of Coca-Cola in 1988 and 1989, during Buffett's purchase period, averaged $15.1 billion.

But by Buffett's estimation, the intrinsic value of Coca-Cola was anywhere from

• $20.7 billion (assuming 5% growth in owner earnings), 
• $32.4 billion (assuming 10% growth), 
• $38.1 billion (assuming 12% growth), 
• $48.3 billion (assuming 15% growth).

So Buffett's margin of safety - the discount to intrinsic value - could be as low as a conservative 27% or as high as 70%.




"Value" investors using P/E, P/B and P/CF considered Coca-Cola overvalued and missed purchasing it.

"Value" investors observed the same Coca-Cola that Buffett purchased and because its price to earnings, price to book, and price to cash flow were all so high, considered Coca-Cola overvalued.





===========

Appendix A: 

The Coca-Cola Company Discounted Owner Earnings Using a Two-Stage "Dividend" Discount Model (first stage is 10 years)

First stage:
Owner Earnings in 1988  $828 m
Growth rate 15% for next 10 years
Discount factor 9%

Sum of present value of owner earnings   = $11,248 
(Year 1 to 10)


Second stage:
Residual Value or Terminal Value

Owner earnings in year 10  $3,349
Growth rate (g)  5%
Owner earnings in year 11   $3,516
Capitalization rate (k-g)  4%
Value at end of year 10   $87,900
Discount factor at end of year 10  0.4224

Present Value of Residual                           =  $37,129


Intrinsic Value
Intrinsic Value of Company                        =  $48,377


Notes: 
Assumed first-stage growth rate = 15%
Assumed second-stage growth rate = 5%
k = discount rate = 9%
Dollar amounts are in millions.



Descriptive step-by-step approach to the above DCF:

The first stage applies 15% annual growth for 10 years. 

In year one, 1989, owner earnings would equal $952 million; by year ten, they will be $3,349 billion.

Starting with year eleven, growth will slow to 5% per year, the second stage.

In year eleven, owner earnings will equal $3,516 billion ($3,349 billion x 5% + $3,349 billion).

Now we can subtract this 5% growth rate from the risk-free rate of return (9%) and reach a capitalization rate of 4%.

The discounted value of a company with $3,516 billion in owner earnings capitalized at 4% is $87.9 billion.

Since this value, $87.9 billion, is the discounted value of Coca-Cola-s owner earnings in year eleven, we next have to discount this future value by the discount factor at the end of year ten  1/(1 + 0.09)^10 = 0.4224. 

The present value of the residual value of Coca-Cola in year ten is $37.129 billion. 

The value of Coca-Cola then equals its residual value ($37.129 billion) plus the sum of the present value of cash flows during this period ($11.248 billion), for a total of $48.377 billion.

Free cash flow to equity

From Wikipedia, the free encyclopedia

In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.

Contents

  [hide] 

• 1Basic formulae
• 2FCFF vs. FCFE
• 3Negative FCFE
• 4Uses
• 5References
• 6External links

Basic formulae[edit]

Assuming there is no preferred stock* outstanding:

${\displaystyle FCFE=FCFF+Net\ Borrowing-Interest*(1-t)}$

where:

• FCFF is the free cash flow to firm;
• Net Borrowing is the difference between debt principals paid and raised;
• Interest*(1–t) is the firm's after-tax interest expense.^[3]

or

${\displaystyle FCFE=NI+D\&A-Capex-\Delta WC+Net\ Borrowing}$

or

${\displaystyle FCFE=NI-[(1-b)(Capex-D\&A)+(1-b)(\Delta WC)]}$

where:

• NI is the firm's net income;
• D&A is the depreciation and amortisation;
• b is the debt ratio;
• Capex is the capital expenditure;
• ΔWC is the change in working capital;
• Net Borrowing is the difference between debt principals paid and raised;
• In this case, it is important not to include interest expense, as this is already figured into net income.

FCFF vs. FCFE[edit]

• Free cash flow to firm (FCFF) is the cash flow available to all the firm's providers of capital once the firm pays all operating expenses (including taxes) and expenditures needed to support the firm's productive capacity. The providers of capital include common stockholders, bondholders, preferred stockholders, and other claimholders.
• Free cash flow to equity (FCFE) is the cash flow available to the firm’s common stockholders only.
• If the firm is all-equity financed, its FCFF is equal to FCFE.

Negative FCFE[edit]

Like FCFF, the free cash flow to equity can be negative. If FCFE is negative, it is a sign that the firm will need to raise or earn new equity, not necessarily immediately. Some examples include:

• Large negative net income may result in the negative FCFE;
• Reinvestment needs, such as large capex, may overwhelm net income, which is often the case for growth companies, especially early in the life cycle.
• Large debt repayments coming due that have to be funded with equity cash flows can cause negative FCFE; highly levered firms that are trying to bring their debt ratios down can go through years of negative FCFE.
• The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the FCFE to be negative in the big reinvestment years and positive in others;^[5]
• FCFF is a preferred metric for valuation when FCFE is negative or when the firm's capital structure is unstable.

Uses[edit]

There are two ways to estimate the equity value using free cash flows:

• Discounting free cash flows to firm (FCFF) at the weighted average cost of capital (WACC) yields the enterprise value. The firm’s net debt and the value of other claims are then subtracted from EV to calculate the equity value.
• If only the free cash flows to equity (FCFE) are discounted, then the relevant discount rate should be the required return on equity. This provides a more direct way of estimating equity value.
• In theory, both approaches should yield the same equity value if the inputs are consistent.

https://en.wikipedia.org/wiki/Free_cash_flow_to_equity

*Where there are preferred shares and minority interests, the dividends paid to them must be subtracted from the FCFF to get the FCFE.

KEY INPUTS TO FREE CASH FLOW (FCF)

KEY INPUTS TO FREE CASH FLOW (FCF)

Free Cash Flow (FCF) is calculated by taking the Operating Income (EBIT) for a business, minus its Taxes, plus Depreciation & Amortization, minus the Change in Operating Working Capital, and minus the company’s Capital Expenditures for the year. This derives a much more accurate representation of the Cash that a company generates than does pure Net Income:

FCF = EBIT x (1-tax) + D&A - Changes in Working Capital - Capex

Free Cash Flow For The Firm - FCFF

What is 'Free Cash Flow For The Firm - FCFF'

Free cash flow for the firm (FCFF) is a measure of financial performance that expresses the net amount of cash that is generated for a firm after expenses, taxes and changes in net working capital and investments are deducted. FCFF is essentially a measurement of a company's profitability after all expenses and reinvestments. It's one of the many benchmarks used to compare and analyze financial health.



BREAKING DOWN 'Free Cash Flow For The Firm - FCFF'

FCFF represents the cash available to investors after a company has paid all of its costs of doing business, invests in current assets (such as inventory) and invests in long-term assets (such as equipment). FCFF includes both bondholders and stockholders when considering the money left over for investors.

The FCFF calculation is a good representation of a company's operations and its performance. FCFF takes into account all cash inflows in the form of revenues, all cash outflows in the form of ordinary expenses and all reinvested cash needed to keep the business growing. The money left over after conducting all of these operations represents a company's FCFF.



Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital



Benefits of Using FCFF

Free cash flow is arguably the most important financial indicator of the value of a company's stock. The value, and therefore the price, of a stock is considered to be the summation of the company's expected future cash flows.

However, stocks are not always accurately priced. Understanding a company's FCFF allows investors to test whether a stock is fairly valued. 

FCFF also represents a company's ability

• to pay out dividends, 
• conduct share repurchases or 
• pay back debt holders. 

Any investor who is looking to invest in a company's corporate bond or public equity should check its FCFF.

A positive FCFF value would indicate that the firm has cash left after expenses.

A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.

• In that instance, an investor should dig deeper to assess why this is happening. 
• It can be a conscious decision, as in high-growth tech companies that take consistent outside investments, or it could be a signal of financial issues.

https://www.investopedia.com/terms/f/freecashflowfirm.asp




Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:

FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex

FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital

FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital

Rearranging the equations:

*FCFF = [net income + interest x (1 - tax rate) + non-cash charges  - investments in working capital] - long-term investments.

Other equations include:

FCFF = [Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate )] - Capex

*FCFF = [earnings before interest and taxes x (1 - tax rate) + depreciation  - investments in working capital] - long-term investments.

FCFF = [earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate  - investments in working capital] - long-term investments

EBIT x (1-tax rate) 

= PBT x(1-tax rate) + Interest x (1-tax rate) 

= Net income + Interest x (1-tax rate)

Cash Flow from Operation 

= Net income + non-cash charges - investments in working capital

Calculating Owner Earnings of Buffett or the Company's Cash Profits

Buffett in his 1986 letter to shareholders described how he worked out what he called the "owner earnings".   

This is also referred to as the cash profits of a business.

Buffett believed the reported profits of a business were not a conservative estimate of the amount of money that really belonged to the shareholders of a business.



How to calculate owner earnings or cash profits of a business?

Owner earnings are calculated as follows:

Owner earnings =   net income
                               + depreciation & amortisation
                               + other non cash item
                               - maintainance capital expenditure.


Buffett's view was that the amount of money a company needed to spend to maintain its competitive position (known as maintainance, or stay in business, capex) often exceeded the depreciation and amortisation expense, and therefore profits were overstated.

Also, if a business needed extra working capital (more stocks, or more generous credit terms to customers), this should be added to the maintainance capex figure.



The difference between Owner Earning of Buffett and FCF

Generally speaking, in the owner earnings of Buffett or cash profits of a business, the calculation ignores changes in working capital that are included in free cash flow.



Hardest part of calculating owner earnings is estimating maintainance or stay in capex

The hardest part of this calculation is trying to estimate what maintainance or stay in business capex is.

As a company outsider without intimate knowledge of its assets and their condition it is virtually impossible for you to be exactly right on this.

But the good thing is, you don't need to.

The whole purpose is to get a figure for the amount of cash needed to keep fixed assets in good working order so that you can then have a conservative estimate of cash profits to value a company

Basing your valuation on a conservative figure is more prudent and lowers your changes of paying too much for a share, which in turn lowers your investment risk.

(Additional notes below)



What to do when the owner earnings or cash profits of a business are negative?

If you come across a company that looks as if it is losing money when estimating its cash profits you need to either

• do some more research to see if you have missed something - such as the company investing in lots of new assets rather than replacing them - or 
• look for another share to buy.

Summary:

In summary, here is what you need to do in calculating owner earnings or company's cash profits:

1.  Take the company's most recent annual underlying or normalised net income/profit.

2.  Add back depreciation and amortization.

3.  Take away an estimate of stay in business capex.

4.  Divide by the weighted average number of shares in issue for the latest financial year to get an estimate of cash profit per share.


Knowing a company's cash profits, we can use these to value shares.  




Additional Notes:

How do you get an estimate of stay in or maintainance business capex?

There are 3 reasonable methods:

1.  The company tells you.

Some companies are very good at simply stating what the figure is.  They give this figure in their annual reports.

2.  Use a multiple of the current depreciation or amortization expense.

Use a figure that is bigger than this, such as 120%.  This can be a reasonable estimate, sometimes.

For some companies, it can be way off if the cost of replacing assets is falling.

3.  Use a five or ten-year average of capital expenditure or capex.

This is likely to include money spent to grow a business but these assets will need to be replaced in the future and so this could provide a good proxy for cash needed to stay in business.

This is a good approach to use if the company does not state the figure outright.

Warren Buffett's Owner's Earnings Calculation

How Warren Buffett valued Washington Post Company

Washington Post Company (WPC)

1973: 
Total Market cap $ 80 million.
Most security analysts, media brokers, and media executives estimated WPC's intrinsic value at $400 to $500 million.


Here was Buffett's reasoning.

1. Owner's earnings for that year:
Owner's earnings =
net income $13.3 million
+ depreciation & amortisation $3.7 million
- capital expenditure $ 6.6 million

Owner earnings = $10.4 million

Long-term U.S. government bond yield 6.81%.

The value of WPC = $10.4 / 6.81% = $ 152.7 million; this is almost twice the market value of the company but well short of Buffett's estimate.


Buffett's further reasoned that:

Over time, the capital expenditures of a newspaper = depreciation and amortization charges.

Therefore, net income = approximately to owner earnings.

Knowing this, the value of WPC
= net income / risk-free rate
= $ 13.3 million / 6.81%
= $ 195 million.


His other assumptions:

1. The increase in owner earnings will equal the rise of inflation.
2. However, newspapers in the 1970s have unusual pricing power; because most are monopolies in their community, they can raise their prices at rates higher than inflation.
3. If it is assumed that WPC has the ability to raise real prices by 3%, the value of the company is
= net income / (risk-free rate - 3%)
= $ 13.3 million / (6.81% - 3%)
= about $ 350 million.
4. WPC's pretax margins were 10%, which were below its 15% historical average margins. If pretax margins improved to 15%, the present value of the company would increase by $135 million, bringing the total intrinsic value to $ 485 million.



Buffett bought WPC at an attractive price.

Market cap $ 80 million.

Based on the above calculations, Buffett bought the WPC for at least half of its intrinsic value.

However, Buffett maintained that he bought the company at less than one-quarter of its value.

Either way, he clearly bought the company at a significant discount to its present value.

Buffett satisfied Ben Graham's premise that buying at a discount creates a margin of safety.

Does a High P/E Ratio Mean a Stock is Overvalued? The Answer May Surprise You!

A mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time (see Tweedy, Browne & Company’s publication What Has Worked in Investing), it is not the ideal situation.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost(typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, you have a much higher likelihood of experiences good, if not great, results over long periods of time.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.

In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to thereturn on equity generated by the underlying company. Anything else, such as relying on abull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.

The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.

The Importance of a Margin of Safety

The danger with this approach is that, if taken too far as human psychology is apt to do, is that any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company, you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990’s, the cheapest stock in retrospect was Dell Computers at 50x earnings. That’s right – had you bought it at that price, you would have absolutely crushed nearly every other investment because the underlying profits really did live up to Wall Street’s expectations, and then some! However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipeout a huge portion of your net worth? Probably not.

The Ideal Compromise

The perfect situation is when you get an excellent business that generates copious amounts of cash with little or no capital investment on the part of the owners relative to the profits at a steep discount to intrinsic value, such as American Express during the Salad Oil scandal or Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980’s and early 1990’s. A nice test you can use is to close your eyes and try to imagine what a business will look like in ten years; do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem.

http://beginnersinvest.about.com/od/beginnerscorner/a/aa021207a.htm

Owner Earnings or Free Cash Flow

WARREN BUFFETT ON OWNER EARNINGS

Warren Buffett has referred to the ‘owner earnings’ of a company as the true measure of earnings. 

He has defined ‘owner earnings’ as:

Reported earnings 

+ depreciation, amortization, other non-cash items

 - average annual amount of capitalized spending on plant, machinery, equipment (and presumably research and development).

REASONING BEHIND OWNER EARNINGS

His thinking seems to go like this.

Depreciation

You should not consider depreciation because this is generally a fixed percentage of an amount spent in the past that does not necessarily reflect the true cost of replacing things when they are obsolete.

Amortization

Buffett has often criticised accounting amortisation of things such as economic goodwill. Economic goodwill, including things such as brand name, reputation, monopolistic or market dominance, might actually increase in value rather than depreciate.

Capital expenditure

It is difficult to estimate true capital spending. Items may be deferred or brought forward. Averaging actual expenditure is a more reliable guide of a company’s true capital needs.

Buffett (1986): The concept of Owners Earnings and Maintainance Capex

We got to know the master's views on his textile business. Let us go a year further and try to discuss what the guru has to say in his 1986 letter to shareholders.

The letter, as usual, though did contain quite a bit of commentary on the company's major businesses, it also had general investment related wisdom. This time around the master chose to speak on himself and his partner's role. This is what he had to say:

"Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn't been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary - if my job were to manage a golf team - and if Jack Nicklaus or Arnold Palmer were willing to play for me - neither would get a lot of directives from me about how to swing."

"The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so - 

• we earn more money than average; 
• we retain all that we earn; and, 
• we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow. 

Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today's capital allocations than are the results of a business earning 10% and distributing half of that to shareholders. If our retained earnings - and those of our major investees, GEICO and Capital Cities/ABC Inc. - are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say 5% to net worth annually, capital-allocation decisions, though still important, will change the company's economics far more slowly."

The master's non-interference in the management of the businesses he owned is now almost legendary. But just like the companies he invested in, he made sure that the people he put in charge had outstanding track records. Once that was done, he would completely move out of their way and let them manage the business. Indeed, when a business with favorable economics is run by an exceptional manager, the last thing one would want to do is upset the applecart. Yet again, while the line of thinking is simple yet extremely effective, it must have stemmed from the master's own experience of managing the operations of the textile business of Berkshire Hathaway. Having been at the wheels for years, he must have realised how difficult it is to successfully run a business and deliver knock out performances year after year.

Berkshire Hathaway, from the time Buffett has been at the helm, has never paid dividends to shareholders. This is because the master has always felt that he would be able to find a better use of capital than paying out dividends. And find he did! The returns that the company has generated for its shareholders have vastly exceeded returns by any other American company. A very difficult task indeed, especially over a very long period of time. He is also very right in saying that a company that earns above average returns and retains all earnings is likely to see its economics deteriorate much faster than a company retaining only 5% if the retained capital is not put to good use. In the end, the honours should definitely go to the company that makes the most effective use of capital.

The master rounded off the 1986 letter by introducing a concept of owner earnings, the one he frequently uses to evaluate companies. It is nothing but

(a) reported earnings plus 

(b) depreciation, depletion, amortization, and certain other non-cash charges minus

(c) the average annual amount of capitalised expenditures for plant and equipment that the business needs to fully maintain its long-term competitive position and current volumes.

While owner earnings looks similar to cash flow after capex and working capital needs, it does not take into account capex and working capital investment required for generating more volumes but instead takes into account capex that is required to maintain just the steady state operations. In other words, what we call as the maintenance capex. Since inflationary pressures can make maintenance capex look very large, analysts who do not consider it are bound to overestimate the worth of the company. In fact, this is what he has to say on those who do not consider the all-important (c) item in their evaluations.

"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). Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all US corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%."

http://www.equitymaster.com/detail.asp?date=8/30/2007&story=3