Using the “ignore the assets” valuation (assuming 10 years of cash flow plus 10x the sale price), the valuation is similar – $5.63 million.

I don’t understand what 10x the sale price is?

Thanks,

Mike

Some time back, i disputed your approach of adding ‘net worth’ to ‘PV of future owner’s earnings’ to derive the ‘value of the business’. That was strictly from a theoretical point of view, but i understand now why you do so, from a practical point of view. Even at that earlier instance, i mentioned that everyone has to eventually derive and modify his own model of calculation, and i can see that is exactly what you have done.

The objective here is to find a link between ‘upside potential’ and ‘downside protection’ of a stock. When an analyst focusses only on P/E ratios or DDM, he is only looking at the earnings potential of a business i.e. the ‘upside potential’. However, if for some reason, this business suddenly loses its earning potential tomorrow, there is no protection/floor on this stock price. It can literally go to zero. On the other hand, if someone focusses only on the P/B ratio or ‘Net current assets’, he is only focussed on the downside protection of the stock; he will buy cheap stocks, that will have a good liquidation value, BUT there may be no earnings potential at all and hence, no point in buying such a stock.

Thus, an extreme focus on either approach may not be optimal, and hence the need to connect the potential returns (if the business keeps going) with the potential risk (if the business stops tomorrow). That is exactly what you have done, by introducing ‘Book value” into ‘DDM’. There are also other ways to achieve this objective.

Anyway i have one main feedback for you. Lets say we use your model to value two companies A and B. A has no net worth at all, but its present value of all future owner’s earnings is $100. So you will price it at $100. Then, we have company B, which has cash of $100, but no earnings at all. Even this company will be priced at $100 by your model. Quantitatively, you should be indifferent between these two, when actually you may never want to buy company B. Of course, qualitatively you will rule ‘B’ out, but what i want to know is that, quantitatively, do you have any way to address this problem. This is the only drawback of your model that i think of right now.

Cheers.

Nish.

You are precisely right – we should be figuring out what capital spending is for growth vs. maintenance. It is a question of growth; namely, is your company plowing money into capital expenditures because it is expanding or because it has to. As such, each company must be analyzed individually. I’ve said it before – just because I have posted my spreadsheets on particular companies doesn’t mean those spreadsheets will work precisely on all companies.

In the case of Johnson & Johnson, capital expenditures and depreciation are substantially the same. That is, JNJ does not need to make huge capital expenditures (in relation to depreciation) to maintain its ground competitively. Quite the opposite is true in, for example, GM which has had to spend $114 billion in capital expenditures (net of depreciation) just to try and keep competitive. That is money that we silent partners will likely never recoup.

What would happen to GM if it didn’t spend that money just to maintain its operations? It would shrink – in real terms – to nothing.

So, to answer your original question: this approach should be used for all businesses. I know that some people have modified my spreadsheet to quickly screen, analyze and present hundreds of companies at a time. While they are free to do so, it takes away from the whole point: Find quality companies, analyze them as a silent partner, and then buy when the price is right.

Make sense?

Thank you for the response….

While I used BNI as an example, my questions is more conceptual, in that I am wondering why this approach (Joe’s Wal-Mart analysis) is not used for all companies. It seems to me that to get the true picture of cash generation, you need to add back cash spent on expansion and cash returned to the owners. Then you can value the company and decide whether management is using cash appropriately before making an investment decision.

Thanks again.

Tom

1998 844 71 = 915

1999 513 636 1149

2000 133 918 1051

2001 126 738 864

2002 103 748 851

2003 488 559 1047

2004 239 850 1089

2005 389 859 1248

2006 450 1094 1544

This certainly makes BNI look more attractive and worth considering a purchase. However, the sub-par ROIC (consistent and averaging 4% for the last 10 years) makes me wonder if the expansion CapEx is a wise use of FCF.

Joe:

Why do you makes things so hard on yourself!!!! Any cash-based analyst or any good analyst worth his salt knows that NOT ALL ASSETS are on the balance sheet! Livnat covers this point in his book, Fried covers this as well, so many accounting professors go over this topic — deficiencies of financial statements. Take management for example.

Managament is not on the balance sheet per US GAAP. However, when you have a guy like Buffett or Munger or Jack Welch versus Bernie Ebbers or Kenneth Lay managing the same company — and thus the same assets, you get two different sets of value. That is enough to shoot that theory down period.

Again, I have no idea why this is even an issue. URGH!!! Going back to my hole.

Regards,

-C

Again, please link or refence the site — please do not post the message outside http://www.fwallstreet.com. Thank you.

The left column thus should represent item (iii) — the FCF available after cash is used for options (i) and (ii).

Thanks.

Tom

I posted this previously, but since BNI has come up again here I wanted to repost with some more detail. I believe, but I want to check with Joe and the group, that the “missing piece” to BNI is the “maintenance” versus “expansion” capex, similar to Joe’s prior analysis of Wal-Mart regarding the opening of addional stores. BNI is using cash every year to buy new engines, lay new rail and increase the size of its operations, and its potential future returns, which I believe should be taken into account in our analysis.

Really, it seems that this adding back of expansion capex is something that should be done for every business that we evaluate, as in theory, every business is trying to expand. For WMT that is additional stores, and for BNI that is additional tracks, engines, etc. to expand the business. Further, it seems we should add back in cash used for dividends and share repurchases, as this is cash the business generates that is available, and does, go to the owners.

So my question is when do we decide to undertake this additional evaluation? This is an exercise that clearly has a large effect on our valuation, but may not be immediately noticeable.

For what it’s worth, after this work-up I get a target price for BNI of $85 with a 25% margin of safety (total value is 112 per share using a 15% discount rate). (although anyone should feel free to poke holes or chime in…)

Here are the differences in annual FCF when you add “expansion” cap-ex and dividends/share repurchases back to morningstar numbers:

1997 — negative 368.0 (morningstar number) versus $425 (full cash flow)

1998 — 71 v. 1,051

1999 — 636 v. 1,675

2000 — 918 v. 3,133

2001 — 738 v. 1,362

2002 — 748 v. 1,398

2003 — 559 v. 1,455

2004 — 850 v. 1,680

2005 — 859 v. 2,914

2006 — 1,094 v. 2,584

So, the column on the right is the amount of cash that BNI generated each year. The choice was then whether to (i) return this cash to the owners via dividends and share repurchases, (ii) to invest in expanding the business or (iii) hold as cash for the future. The left column thus should represent item (iii) — the total FCF available.

To get the true picture of the business, shouldn’t our valuation be based on all three? We should also take into account the CROIC to determine if management is deciding wisely between options (i), (ii) and (iii) before we invest, but this seems to present a more complete overall picture.

Thanks again for the great blog, this site really is fantastic at breaking things down in a simple and easy way, and we all appreciate the time you put in!

Tom