Hi

Thanks for a nice post !

This is quite a nice way to think about valuing a stock.

I am thinking of building a generic DCF model for US stocks, but I stumble in making a tax allowance.

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Thanks Jordi!

No matter what the tax code is, businesses have to generate excess cash to fuel their growth. If you put too much importance on how a company does based on tax rates, you end up missing a key concept – great businesses generate excess cash no matter what is happening with interest rates, tax rates, or politcal elections.

When it comes to investing in stocks, you are a silent partner in a business. You have no say over the tax rate, the daily operations, or most other aspects that go into running a business. If you look at it in that light, you’ll soon see that your investment dollars should be concentrated in wonderful companies that can grow no matter how good or bad management is and no matter what the politicians decide the tax rate should be.

Ruling out “handbasket” risk (the risk of everything going to hell in a handbasket), JNJ appears to be one of those great companies, selling at a great discount, offering a very attractive return – assuming it’s business as usual.

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Hello-

I am working this out in excel and I am having a hard time figuring out where the $201.7 billion came in. Can you please tell me how this number was generated in your calculations?

Thanks in advance.

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Tim,

As I mentioned in my email, I think your question would be better answered in a full post. You can see it here.

I gave a somewhat intermediate Excel^® user response. If you need more clarification, let me know.

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that was an excellent post! it was the first time i’ve seen a valuation worked out in such clear detail, and it was quite useful. i’ll be checking back to this blog!

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Hello,

Could you please explain how do you find the Cash Return On Invested Capital.

Thanks

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Oliver,

Great question and worthy of its own post. The quick answer is:

CROIC = Free Cash Flow divided by (Shareholder Equity plus Long Term Liabilities)

If that makes sense right away, great! If not, don’t sweat. I’ll put together a full explanation and post it online next week.

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Hello, can you share that excel you use? You use =NPV(..), =PV(..) but the KO sheet that you shared is diferent.

Thank you

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I have edited the post to include the spreadsheet at the end.

Enjoy!

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Hi Joe,

I wrote to you earlier on seeking alpha

a couple of clarifications

1. how do you assess a financial sector stock-I can’t get the free cash flow no’s on morningstar

2.any reason on why you use a return of 15%; would a return of 11% (avg return for the S&P) be more realistic for small time investors (double the risk free return of US treasury bills)–by using a rate of 15% do we run the risk of not picking up a stock (as future value could be understated and we may pass the stock over because of the discomfort on the margin of safety)

As usual, look forward to your future posts

Cheers

Sridhar

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A visitor (Mike) had the same question on the American Eagle post. My responses are here. Morningstar is apparently working to get the financial sectors onto their screener. Until then, we have some legwork to do at the EDGAR database. Let me know if that answers it for you.

If you are willing to accept an 11% return, then you may be able to buy an index fund and hold it for the long term. Personally, if I am going to accept risk, I certainly want to earn more than the return offered by a combination of wonderful, mediocre, and bad businesses – like those in the S&P or other indices. The S&P returned 11%; however, if you removed the mediocre and bad businesses from the index, the S&P’s return would have been much greater. Wall Street has us shooting for 11% returns because they have sold us a bunch of mediocre and bad investments, put them into an index (along with wonderful ones), and told us we can’t do better than the total return of the basket of businesses they were able to sell. (Make sense?)

As far as running the risk of missing an opportunity, you aren’t. The stock market will never offer you such a wonderful opportunity that you have to invest in it, you have to put all of your money in, and you won’t find any more opportunities in the future. Sure, you’ll miss some opportunities that would have made you a lot of money. You’ll also find some. You don’t need to be in every wonderful business, so long as you aren’t in a bunch of bad ones. To put it another way, you are never missing the boat because another one is right around the corner. While that is hard to see in everyday life, it is extremely easy to see in the stock market. Give it some time.

Buffett says he only needs one idea a year. He typically jumps on more than one. If you can find one to five wonderful ideas a year, you are sailing. Don’t stop at five, don’t limit yourself to one, and don’t fret if you find yourself anywhere in between. There is no “right” amount of opportunities. Don’t be in a race to own investments, jog your way to riches.

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“Because of JNJ’s multi-year consistency in the past, we can reasonably expect JNJ to grow its Free Cash Flow 16.1% in the future – at least for ten years.”

I doubt this is the kind of margin of safety, Graham or Buffett has in mind. A FCF growth of 16% over long periods of time for large companies is a rather aggressive estimate.

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Great point V. It is difficult, which is why you should have a large enough Margin Of Safety (discount) when you buy a company. Industry leaders like JNJ have an easier time growing free cash flow because they can do so much to control prices, scoop up or squash competitors, or reduce expenses. Smaller companies require a much greater discount.

Will JNJ grow its free cash flow at 16.1? We don’t know, so we can’t pay full price for it. What we do know is that it has done so for a long time – since at least 1991 (the earliest data available on the SEC website). If JNJ’s business model has allowed it to grow at more than 16% for the past 16 years, there is no reason to think it will stop dead in its tracks today.

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I noticed that you referred to liabilities as debt, when in fact (as of course you know) they are 2 very different concepts. Note that if JNJ actually had $31B of debt, it would not be a AAA-rated company.

Also, don’t think I’ve ever seen IC defined as Equity plus Liabilities; Equity plus total debt seems like a more useful definition to me – your thoughts?

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John,

I couldn’t agree more – and that is precisely what CROIC attempts to tell us. As you hint to in your comment, many companies can use debt as an asset, generating high amounts of cash above and beyond interest, inflation, and taxes.

As far as Invested Capital, the calculation is Equity + Total Liabilities – Current Liabilities. This IC calculation gives us the sum of all the assets and all of the liabilities that are due in a year or later. If you just use long-term debt, you do not account for some other long-term items that the company can delay paying in an attempt to generate more cash.

An example of this would deferred employee benefits or taxes – two non-interest bearing, long-term liabilities that the company has chosen not to pay today because that cash is (hopefully) better used to generate more cash.

We also subtract all Current Liabilities because that money is owed in the next twelve months and can not be used in the company’s long-term plan to generate cash.

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Hi Joe,

I’m grateful that you are sharing with us your calculations. Being a novice value investor, I have a few questions in mind that I hope you can help me with.

I saw from your spreadsheet that you used 20 years of FCF projection to come up with your dcf valuation. Is there any particular reason in using 20 years as opposed to only 10 years or 30 years of projection? Won’t the number of years of projection that is being taken into account significantly affect your final valuation and hence targetted buy price?

Thanks,

Ed

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Hi Ed,

Take a look at this discussion I had with Georgia.

You are right – the number of years will significantly impact the valuation. I use 20 years because I only buy businesses that I think will be operating for at least that long. Projecting 30 years into the future adds so much uncertainty and so little to the valuation that it is (in my opinion) worthless.

Hope that helps, but let me know if it doesn’t.

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Joe,

I was looking at JNJ’s balance sheets and noticed that from 1/06 to 1/07 JNJ’s accounts receivables were up 22% and inventories were up 31%. Is this something to be concerned about?

TIA,

Mike

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Hi Mike,

If you were focused on GAAP (Wall Street) earnings, that might be a cause for concern because Wall Street earnings don’t reflect changes in inventories and other important balance sheet numbers.

Owner Earnings that we use take inventories, accounts receivables, and other cash expenditures or inflows that do not yet show in Wall Street earnings.

For example: Johnson & Johnson had $210 million more in inventory in 2007 vs. 2006. That cash outlay is reflected in Owner Earnings, but not Wall Street earnings.

That $210 million reduced our owner earnings. If JNJ were spending a ton of cash and building its inventory in an attempt to sustain high Wall Street earnings growth, we would see it in Owner Earnings because our Owner Earnings would plummet, and possibly turn negative.

Fortunately for business investors like us, falling Owner Earnings usually precedes falling Wall Street earnings (usually by two or three years). As such, you’d likely be out of a failing business long before the gamblers run for the hills – plummeting the stock price in the process.

Hope that helps!

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You used the median FCF growth rate for 5 year time-periods which gave you 16.1%…is there a reason you consider this to be more accurate than say, the growth rate for the past 5 year period? The past two rolling 5 year periods (ending in 05 and 06 respectively), are considerably lower than the 16.1% median used in your calculations. Indeed, if you change that 16.1% to 10.2% in excel (the 01-06 rolling period), you would get a per-share value of $61.75- not far off from where JNJ currently trades.

A few things to keep in mind- that $61.75 is if you are going for a 15% return, which is better than the S&Ps ~11% or whatever it is. The 10.2% is pretty conservative because, as you pointed out, the median over a longer period of time (which one would think is a more reliable number) is substantially higher. What concerns me about the 10.2% is that it is significantly lower than any of the other multi-year performances. Perhaps something has changed about the actual business that would cause it to grow at a lower rate from now.

Do you know why JNJ has grown at a much slower clip over the past couple of years?

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Hey Kevin,

I think a lot of people have the same question and it warrants a long response, so I made it the subject of today’s post. You can check out the response here.

Thanks for contributing!

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Hello Joe:

Here is a collection of quotes by Mr. Warren Buffett on the issue of intrinsic value and what discount rate to use:

“We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

At the 1998 Berkshire Hathaway annual meeting, Mr. Buffett defined intrinsic value as follows: “In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

At the 1994 Berkshire annual meeting Mr. Buffett stated that “In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play. We have to feel pretty certain about anything before we’re even interested at all. But there are still degrees of certainty. If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we’d use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises.”

After reviewing your analysis on JNJ and attempting to apply and reconcile with the above quotes, two questions arise:

1. Why do you use a 15% discount rate when Buffett would probably use something much less given a wide-moat company like JNJ?

2. Given Buffett’s specific definition of intrinsic value, “In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value,” why do you include the additional step of adding book equity to the PV of expected future cash flows? Please explain why you differ from Buffett on this step.

Also, thanks for a great website!

Sincerely,

Michael M.

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Hi Michael,

For a good portion of the 1970s and 1980s, the 10-year treasury was above 8%, and at times close to 14%. With his original partnerships, Buffett’s goal was to beat the risk-free treasury rate – likely by discounting at a rate higher than the 10-year treasury. As he stated in 1998, the 10-year treasury is a common yardstick – not necessarily the best discount rate for all businesses.

My goal is not to just beat the 10-year treasury, but to earn at least 15% on an average annual basis. If the treasury rate skyrocketed, I’d have to raise my discount rate to take additional risk in the stock market. At 15%, I get a much lower business value than if I were to use the 10-year treasury + a risk premium (3-4%). This adds an additional layer of safety for me.

That’s my long way of saying:

The 10-year treasury is a common measure when comparing businesses – apples to apples. But, as Buffett said in 1998, it doesn’t give you the return you need – you must use a greater discount rate. You are buying the future cash so your discount rate should be your minimum acceptable average annual return.

As for your second question, I think Buffett was offering insight into part of the intrinsic value calculation in 1998. In his 1999 Owners Manual, he said:

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

How much cash can be taken out of a business? The future cash it generates and the current cash that can be realized by selling assets and paying liabilities (the net worth). Of course, we can’t discount the net worth because we are buying it today at today’s value.

In all of this, it is important to remember that we are trying to put a number on a business as if we were buying the entire company. Part of that is buying the assets, and part of that is buying the future cash. Our number has to be based on our acceptable return (the discount rate) or else we will overpay and end up with a lower return.

Hope that clarifies it – let me know if it doesn’t.

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Joe,

Thanks for your response to my question on accounts recievable and inventories. Again you taught me much and I appreciate it.

I was in Alaska for 10 days on vacation, never logged on to the internet, and why I did not get a chance to thank you till just now.

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Hi Joe,

I am concerned that you may be double counting value when you add the book value of equity to the discounted cash flows – reason being, the market value of the assets is determined by the cash flow those assets can generate. It doesn’t matter what price was paid for that asset. So it doesn’t make sense to me to value the assets of the company using the discounted cash flows from those assets and then adding to that the net book value of those assets today.

I know you’ve somewhat addressed this question before, but I’d appreciate some clarification.

PS – love your approach. As a CFA, I’m well-versed in efficient market theory, CAPM and Beta, but lucky enough to understand that it’s all a bunch of garbage, therefore your analysis is quite refreshing (though a tad too simple, I suspect).

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Hi John,

The value of a business, according to Buffett, is the value of the cash that can be taken out of the business during its remaining life. Though he’s never said, “Here’s my formula,” I take that as the future cash that the business can generate while it operates and then the cash that can be disbursed at the company’s break up.

As a simple example, look at a lemonade stand. The kids buy the table for $70, clear $50 for selling lemonade, then shut down. What is that business worth?

If you were to invest in it, you would buy your share of the $50 of cash that it generates, and a piece of the table when they shut down and sold the asset. All owners should benefit from the sale of the table in addition to the cash that it produced while the business was operating.

If Johnson & Johnson ever breaks up, I should be entitled to my fair share of the desks, phones, real estate, and whatever other net assets they convert to cash upon liquidation.

Is my method simple? Yes. The calculation always is. The hard part (the art of investing) is knowing what data to plug into the equation. Fortunately the gamblers provide us with enough opportunities to buy with such large margins of safety that we don’t have to be precisely right, we simply have to not be completely wrong.

Hope that clarifies my views. There are other ways to calculate value – so long as they all come to roughly the same result, they can all be right (or wrong!)

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Thank you, that’s helpful. The lemonade stand analogy is a good way to look at it. Question is whether taking today’s book value of equity is the best way to estimate value of assets upon termination. I’m assuming you don’t choose to discount this value to the present because you’re making the implicit assumption that the asset base will at least grow through time, and thus it’s a reasonable approximation – is that correct? Another issue I have with book values is they can get very muddled due to accounting, especially through purchase accounting where you’re adding assets at market value to existing assets at a depreciated book value.

However, all these issues are well-addressed through your key point – buy good, predictable businesses at a good price.

Keep up the good work.

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hi guys,

i’m from Taiwan and came across this web site by accident and was so amazed by the analysis here on Johnson & Johnson.

as English is not my native language, thus some of the tems used in the analysis by Joe are quite unfamiliar to me and would for help here.

eg, what exactly is this Free Cash Flow and where did you come out with $11.6 billion of Free Cash Flow in 2006 by Johnson & Johnson?

i assume Free Cash Flow is the amount of cash generated from operating activity, so i had a quick look at its annual cash flow statement ending 31 Dec 2006, cash from operating was 14.2 billion……

any1 mind to share your thoughts on this?

cheers

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hi

i did a google search and found out about what Free Cash Flow really is so please ignore my last posting.

but then, with regard to this Cash Return on Capital Invested, though Joe has explained quite clear in the article, but how do you calculate it or what is the formula for it ?

cheers

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well…i have figured out the formula for calculating the cash return on invested capital by one earlier post here.

but again, when trying out the formula – CROIC = Free Cash Flow divided by (Shareholder Equity plus Long Term Liabilities)

Free cash – 11.6

shareholder equity (toal equity?) – 39.318

long term debt (total long term debt?) – 2.014

CROIC = 11.6/(39.318 + 2.014) * 100% = 28.065 % !!

which is different from Joe’s finding of 20.8%

what went wrong ?

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Hi Tien,

The 20.8% CROIC was a median of various multi-year timeframes. When analyzing a company, you can’t focus on a single year.

As far as your numbers, you have the wrong Long Term Liabilities. JNJ reported $19.2 Bil in short-term liabilities and $31.2 Bil in Total Liabilities. Subtract the short-term from the total and you will see the long term liabilities (not just long term debt).

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Hi Joe

it’s wonderful to see your quick response to my questions

you are awesome !

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hi Joe

i wonder if you will be giving a “lesson” on Korea steel company POSCO in the near future?

thanks

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Hi Joe,

Fun site. Quick question. I’m not seeing anything about dividends. Am I missing this in the calc? As an owner won’t I receive dividends along the way? This would come out of FCF, so I understand that it is in the number. However, since dividends come out of the business and allow you to either pocket it, or purchase more equity, should it not have a different attribute attached to it?

Looking forward to your response.

Thanks,

Brian

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Hi Brian,

When we buy businesses, we are getting a right to the future cash. We can’t control what management does with that cash.

If we own 10% of a company that earns $1,000 this year of excess cash, we are entitled to $100 of that. The company can choose to pay that (or part of that) as a dividend, or to rinvest that $100 back into the business to increase our ownership and generate more cash.

If the company pays down $100 of debt, we own an additional $100 of assets (because shareholder equity increases). Or, the company can buy back $100 of shares so our ownership increases. Or, they can acquire an additional $100 of assets or spend the $100 on marketing to try and generate more cash.

Whatever management decides, we earned that $100. The only question is: Who gets to choose how it is reinvested, you or management? If it is paid as a dividend, we can touch, spend, and reinvest the money. If it is retained, we often feel like we didn’t earn anything. In reality, we might as well have earned that $100 dividend, but gave it back to management to grow our stake in the business.

Hope that helps! (Of course, let me know if it doesn’t!)

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Hi Joe; writing from Spain and just starting in value investing. i’ve already bought JNJ at 61.11$!!! I think that for us, it’s just a great opportunity in the long run ’cause of the euro.

I’d like to kinow your opinion on two companies a like quite a lot: CNQ and PFE. Do you have an opinion on them? I also want to buy some BRK.B, which I think it’s the safer place someone can invest.

Thanks for sharing your knowledge,

Daniel

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Daniel,

This is MikeR, formally Mike posting here. There are now more than one Mike posting, so to be distinct I am adding the R.

CNQ is bleeding cash. Go to Morningstar and check out the FCF at the bottom.

PFE looks like it is worth running the numbers to determine the intrinsic value.

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Hi Daniel,

Two things (thanks Mike R):

1. I can’t give stock tips. I offered Wal-Mart as an example of a growing business that did not appear to be growing. If you like and understand CNQ or PFE, you should definitely look into them. I think there is enough information here for you to be able to rip them apart.
2. Still, Mike R. is right – at least I think so. CNQ, at a quick glance, has been burning through cash lately. A ton of cash. I wouldn’t go near it. PFE generates tons of cash and is on my list to analyze. Of course, when I do so, I’ll probably post it here.

Glad to see F Wall Street made it to Spain – my wife is from Cadiz. Maybe the next time we visit a flamenco show in Jerez, someone will yell, “Ole – F Wall Street!”

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Thanks a lot MikeR and Joe for your insight. I’ll study CNQ with more detail. I’m afraid of the cyclical aspect of oil.! PFE seems to be so contrarian that it could be a good bet, although I seem to preffer JNJ because it is more diversified. And Buffet is in! I really thank you.

Joe, didn’t know your wife was from Cadiz, la tacita de plata, a beatiful city indeed. Although I’m from Majorca, my sister lives in El puerto de santa Maria near Cadiz and Jerez.

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I’ve been to Jerez and Sevilla, but I don’t know exactly where. I’ve also been busted for speeding and blowing a red light (I was following her cousin), but a few American dollars took care of that. Of course, that was back in 1998 when the US dollar meant something in Europe!

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Hi Joe,

I just discovered your blog and I found my way to this post. I was going over your Excel spreadsheet on JNJ. I can’t seem to figure out why you add current shareholder equity to the total present value of discounted cash flows to get at “Total Value”. Shouldn’t the value of equity be the sum of the discounted cash flows plus cash minus debt? I don’t think shareholder equity equals cash minus debt.

Thanks,

George

Fat Pitch Financials

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Hey George,

Take a look at this comment regarding that exact question. When buying a business (public or private), we don’t just acquire the cash, debt, and future owner earnings – we get everything that comes along with it.

Those desks in the corporate office? Ours. Those phone bills that have to be paid? Ours too. Picture it in the context of a small, private business. If you were to acquire a small business that had a ton of real estate and assets, but didn’t generate much cash – say, $1,000 of future cash, no debt, no current cash, and $10,000 of assets – you wouldn’t be able to offer the seller $1,000 (or $500 assuming a 50% margin of safety).

Let me know if that makes sense.

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Thanks for the response Joe. So you are adding in net assets to the sum of discounted cash flows with the addition of shareholder’s equity. I didn’t realize that was what you were doing when I first looked at the spreadsheet.

I think adding in net total assets could be a problem in most cases. It actually double counts the value of the income producing assets.

Using your of example of JNJ, their manufacturing plants and labs have an asset value. We are valuing those assets on their cash flow producing capabilities (i.e. their service value). Those assets can only produce cash flows when being utilized. If we sell those assets off, they stop producing future cash flows for us. You can either value those assets based on their future free cash flow generating capabilities or you can value those assets on their liquidation value (i.e., selling it to someone). For the unique and high return assets like those of JNJ, the liquidation value of those assets is going to be a lot lower than their value to produce future operating cash flows.

If you want to include all those net assets in your valuation, you need to assume the business is going to liquidate those assets in the future, and therefore you need to discount the assets to the present just like you did with the future free cash flows. In your JNJ spreadsheet, I noticed that you assume free cash flows continue until 2026. Therefore, net assets should then be assumed to be sold off in 2027 and then discounted to the present using your discount rate. This will give you a more appropriate and conservative enterprise value.

I think the easier method is to assume that all assets are being utilized by the company to generate free cash flows. Only excess cash and equivalents net of debt can be easily extracted from the business without disrupting future cash flows. I assume as a buyer of a company, that I can capture all the owner’s earnings by buying out debt using cash and equivalents immediate when I purchase the company, selling off any unproductive assets (excess land, under utilized machinery, unused patents, etc.) the way you see some hedge funds doing, and then I can earn all future free cash flows (Buffett calls this owner’s earnings) for myself. With a high quality company like JNJ, I think we need to assume that just about all their assets are being utilized to generate their current and future free cash flows from operations. Wouldn’t you agree?

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Hey George,

There are a number of ways to value a business. As such, I agree with your method as well.

In my method, I don’t value a business as a break-up or reorganization (i.e., use cash to pay off debt, sell excesses, etc. like hedge funds tend to); rather, I value the company as if I were buying it and it was going to continue its operations – business as usual for me.

I don’t expect the company to break up in twenty years; however, the present value of cash beyond year 20 is so small that it doesn’t greatly affect today’s value.

As for double counting the value of the assets, consider this: If a company has a printing press that it uses to generate $1,000 in owner earnings, its value is both the $1,000 it generates and its liquidation value. If the company stops operating tomorrow, that $1,000 is now worth zero but the printing press has a liquidation value. Anywhere in between now and when it closes down, the value is both the liquidation value and the value of the cash it can generate.

I agree – if I believed that the company were going to close down in 2027, I’d have to project and then DCF the assets. If I believed that the company would operate forever, I’d be able to ignore the assets altogether because I’d only get the owner earnings. But anywhere in between those two scenarios, I have to take into account the value of both.

Again: Mine is one way to value a business. If you are looking at a complete takeover and reorganization, you would look at it differently. If you knew the life (short or indefinite), you would look at it differently.

My two cents. Hope that explains it!

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Joe – I follow where you are going with all of this and the numbers tend to make sense. One question, though. I don’t see anywhere on your blog where you explain how you account for dividends? It seems that the intrinisic value the day before the dividend is distributed is higher than it is the next day. Does a single one-time dividend demand different treatment than a history of a regular quarterly dividend?

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Great question Michael. I’ll post something about that next week once I get through these requests.

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Hi Joe,

I just found this blog a few days ago and I am tearing through it. This site is absolute gold! I have a question about your excel valuation spreadsheet. Is there an easy way to use your format as a template and import financial data from any company into this. Or have you entered in all the information manually? It looks like the only fields that are not calculated within excel are current liabilities, total liabilities, shareholder equity, and free cash flow. I guess what I am asking is, how do I use this spreadsheet for analysis on any company? Thanks for doing this blog. You are really helping me learn a great deal.

Thanks,

Ryan

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Ryan, based on what I have been doing. Use the Morningstar link for the finanicial data and plug it into the spreadsheet.

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Someone over at ROIC Community did some fancy Excel work and automated the spreadsheet. I haven’t seen the spreadsheet so you may want to head over there and ask.

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Joe:

I do like the layout, and also the activity on your site, very lively.

In regards to this analysis, I would have to agree with the double counting approach that a few commenters have mentioned. In an effort to avoid further redundancy, my reasons are the same as those already mentioned. Nevertheless, I do own JNJ and still think it is a decent buy. My approach was a little simpler. Looking at some assumed perpetual growth rates on the current cash flows, it is not hard at all to get a fair value estimate above the current market value. Add in some additional qualitative factors such as international exposure, brands, management competence, and the offer sweetens.

My next consideration is WMT. Your post on that is also greatly appreciated.

Grant

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Hi Joe

There is no doubt your posts are excellent and you know what you are talking about. Your thorough understanding of most stock-related issues is quite evident and appreciated.

First of all, let me say that there is no one way to value stocks. As long as a method makes good common sense, has reasonable back-testing success and is followed consistently along all stocks, it should work over time (with some adjustments along the way), because its all a matter a ‘relative valuation’. Even if my ‘level’ of valuation differ from yours, i will still find, more or less, the same stocks cheap (relative to others) as you would find by your method. Thus, even if there is a ’systematic error’ in one’s method, it is fine because he/she will adjust the error consciously/unconsciously over time. The most imp thing is that: no matter what method we use, we should consistently use it for all the stocks, and then just buy the ones that offer the ‘best quality per unit of price paid’.

Now let me come to the point. I do not agree with your approach of adding shareholder’s equity to the discounted value of FCFs (as is highlighted by some others). Like i said, its fine if it works for you, however, i would still give you my reasons for disagreement:

You said – “If a company has a printing press that it uses to generate $1,000 in owner earnings, its value is both the $1,000 it generates and its liquidation value. ”

Not quite true. The value of an asset is either ‘discounted value of its cash flows’ or ‘its liquidation value’. It is all a matter of – is that business a going concern? If it is, the value is ‘discounted cash flows’, if its not, the value is its ‘liquidation value’. It is never both at the same time.

But this is not really a big issue, as all methods are fine as long as they work. Eventually, every successful investor comes up with his own variation, and i would just accept it as ‘your method’. Every method has its own strnegths and criticisms, and whatever i highlighted above, was not to prove you wrong or anything, but just to make you aware of the theoretical criticims of your calculation.

You dont actually need to pay one bit of attention to such criticims, however it may be philosophically useful to be aware of them.

Nish.

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Nish,

Check out this comment I posted about that exact thing. Every company has three values, each adding up to the discounted sum of the cash that can be taken out of the business during its remaining life. How you calculate those values is up to you, and there is no perfect “right” or “wrong” method – just what works.

I admit: There is more than one way to value a business. We can all have different methods; but, so long as our data and reasoning are right, we can all be right as well.

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Is this the real “Nish” or someone with a blog monicker trying to be Mohnish?

If it is the real Nish, thanks for the added wisdom, we are all greatful you would take the time to impart your thoughts for us.

Casey

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Hi Casey

I am not Mohnish Pabrai, but incidentally, i share the same first name as him, Mohnish. ‘Nish’ is my nick. Actually, i didnt put my full first name there, in order to avoid any confusion.

Nish.

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Hi Joe,

Do you have some analysis on DFC ?

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Hi Ashok. My goal here is not to offer specific stock advice or recommendations. I will offer this: If you’re having second thoughts or doubts, it probably isn’t a good buy for you. Put it in the “Too Difficult” pile and go find yourself a no-brainer.

I know that’s not the exact answer you were hoping for, but I hope it helps.

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Hi Joe

Could you pls let me know how you came up with the Free Cash flow number of 11.6 billion?

Thanks

arr

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I think i know the answer now..figured it myself….

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I think i know the answer now..figured it myself….

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Joe,

I have been trying to figure out how you got the number of shares you used in your spreadsheet for JNJ. The 10 K lists in footnote 19 the average number of shares outstanding as 2,936.4 (in millions) for 2006. Morningstar in the 10 year income statment shows 2896 (in millions) for 2006. You have the number 2896558000. How did you get that? Thanks.

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Hi Rick,

If you take a look at the company’s 10-Q (Quarterly Report) filed on May 10, 2007 (the then most recent one), you’ll see (just before the Table of Contents):

On April 29, 2007 2,896,558,402 shares of Common Stock, $1.00 par value, were outstanding.

I rounded down a bit and lopped off 402 shares so I could format my spreadsheet a touch.

Hope that helps!

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Thanks.

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Joe,

I am intrigued by your using shareholder’s equity + the discounted cash flows to arrive at a business’s intrinsic value. On a certain level it seems like double counting, as we need the equity value (the net assets) to grow the free cash flow. But actually it seems like you are using the equity value as a proxy for terminal value. What about asset light companies with minimal book value? What about companies in which goodwill accounts for a large portion of the equity value – what is left when that business is liquidated? I believe Monish Pabrai uses 10 years of discounted free cash flow and then takes year 10’s free cash flow multipled by a factor (I believe 10) and discounts that back to serve as terminal value.

Keep up the great work!

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Hi Joe,

thank you for the work and effort you are putting into the blog. I wanted to ask you whether you have you seen any discussion/research on the topic of calculating terminal value and discounting it to the present along with the discounted future cashfows vs using current shareholder equity and adding that to the discounted future cashflows when calculating intrinsic value.

thanks

jc

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Hi Steve,

The value of asset-light companies lies more in the cash flow than in the assets; still, the calculation is the same.

Don’t ignore goodwill. Buffett (and I have to find the quote again) once said that he no longer puts heavy emphasis on tangible book value, thereby ignoring goodwill, because the goodwill accounts for a premium that, in the event of a break-up, should be able to be recaptured. Basically, if you company paid a premium above book value for a subsidiary (hence the goodwill), someone else likely will if the company breaks up or sheds that subsidiary.

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Jean-Claude,

I am a fan of the John Burr Williams/Mohnish Pabrai method of terminal value as well. There are three rational ways to value and buy a business – for a definite timeframe (a la F Wall Street), for a resale (a la Pabrai/Williams), and for a break-up. If you can buy at a steep discount to any of those three, you should be just fine.

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Joe,

Just a big thank you. While I think ‘m already a value investor, I am going over you 4 part valuation series and this JNJ discussion.

Well, I’m almost a value investor. I used to rely on PE. I do even today. I even bought into JNJ for under $60 using PE ratio. Heck, that is better than 90% of “investors” out there in my observation.

After over a year, I am finally breaking down and learnings about FCF based valuation.

I just want to extend a BIG THANK YOU for putting the information on your web site out there for us.

OK, I’ll ask a question. If JNJ is calculated at be worth around $80 and the 25% discount is applied to give you a buy target og $60. What is Intrinsic Value, $60 or $80? I suppose it is $80, and the $60 simply represents the additional margin of safety. I think I answered my question, but am I correct?

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Joe:

Thank you for the post. I have some questions:

Why use 20 yrs to discount FCF? A good business, I think, should last more than 20 yrs. Do you have any explanation or is this just a common practice? (I could not find any reference that Buffet used 20 yrs for discounting purpose. Berkshire held Coke about 20 yrs now. Was the last 10 yrs FCF growth rate 5% as assumed?)

Also, at the end of of 20 yrs, you can sell your shares or the business. Should the sale price be discounted and included into the intrinsic value too? (Some people used future Equity*ROE*PE to estimate future per share price.)

Thanks,

John

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John,

I assume Joe will have a better informed take on this question, but I can offer some insight (I hope) on the question. There are a number of books on Buffett, which attempt to explain DCF. Several use the 20-year model, which, I assume, is based on the original conventions of the creator, John Burr Williams. Beyond relying on convention, there is, in fact, a statistical justification for doing so. The further out you project, the smaller the influence the later-years’ contributions have on the current value of the company. After 20 years, the calculations become nearly akin to an annuity in perpetuity — thereby simplifying the calculations.

It is also the case that, over time, the profitability of a firm is expected to achieve an equilibrium as competitors are attracted to the market space (seeking the profits enjoyed by the company you are valuing). Consequently, it is expected that the return on invested capital will eventually achieve parity with the weighted average cost of capital. The market, which is efficient but more slowly efficient than the Efficient Market Theorist contend, will promote this equilibrium. To quote Scott, from his comment under Joe’s “Strategy Review: Robert Hagstrom’s The Warren Buffett Way”, “… notice he (Buffett) picks individual companies, not industries, because the first rule of economics is that profits are always under constant pressure and long-run excess rates of return tend towards 0.”

[Note: I love this blog because, agree with each or not, so many brilliant contributors congregate here.]

As for whether a firm is likely to last more than 20 years, most new start-ups fail in the first five years. They, however, are not typical candidates for IPOs, but corporate bankruptcy (even among publicly-traded firms) is more common than most believe. This is why Trout and Reise place such emphasis on the first entrant benefit, and it is why Peter Drucker advised Jack Welch (as he was taking on the CEO slot at GE) to be, either, first or second with any product offered by GE or exit the market for that product. [Note: Welch is often given credit for this policy, but it was Drucker who first voiced this concept.]

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Roert:

Thank you for your response. I agree perhaps 20 yrs is a reasonable statistical assumption for average companies.

But how about the companies which are not average, particularly companies with durable long-term competitive advantage?

When I looked at Berkshire’s holdings, (e.g., KO. AXP, WPO), 20 yrs seems short, and furthermore, 5% FCF growth for the second 10 yrs is low.

I don’t need to know the intrinsic value for companies in general, certainly not the companies that won’t last for 20 yrs. For companies with durable competitive advantage, I feel 20 yrs discounting period and 5% growth rate for the second 10 yrs perhaps are too general and not practical.

Has anyone looked at past 30 yrs financial data of some Berkshire holdings to validate these assumptions?

John

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I hope this question hasn’t been asked already, but I am new here and haven’t read everything yet. I understand the concept that wall street is simply the place you go to buy and sell stock, and we should think of stock as purchasing the company. However, let’s say I pay $10 a share and after 5 years it’s “value” has doubled, or increased 15% per year. It may still only be trading at $14 or $15 a share, even though the value has doubled.

I guess I’m having a hard time seeing where the shareholder equity and free cash flow growth actually translate to “street price” growth. After all, the only way you will double your money is if you can get twice what you paid for it.

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The idea is that the marketplace is irrational in the short term, being strongly effected by small things like a slight dip in revenue or some bad press. Those times where people freak out and sell off their shares. But then, with time, people realize that the company isn’t going out of business and is infact strong and growing.. So they buy, and price catches up to the value.

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Hi, i´m investor from Brazil and would like to know if you have interviews with Mr Warren Buffett talking about the discount rate?I found one little interview in the internet that he gaves to some Journal( i don’t remember if it was WSJ, NYT or WP)with important point of views, unfortunately i couldn’t find the interview again, could you help me?

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I follow Warren Buffet closely.The guru website says buffet has 61 million shares.The long term chart on jnj is incredible.When I compared jnj to EXXON,ANHEUSER-BUSCH,PROCTOR-GAMBLE and PHILLIP-MORRIS only big MO beat jnj.The charts on jnj look dismal short term but I believe it is a fabulous value play given the demographics of 78 million baby boomers and the recent acquisition of Pfizer consumer staples brands.The company has increased its dividend every year for the past 44 years!CASH IS KING!!!

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Hi Joe,

Very nice website! One of my favorites at the moment…

I believe there is a flaw to the reasoning that you have used. Please note that I’m am new to investing and unproven in the market place. But I would like to post my reasoning nonetheless. Perhaps someone will prove to me that MY reasoning is in fact incorrect.

My name is Tim but I am not the Tim that posted before. Strangely enough we both ask a very similar question. I looked over your excell spreadsheet and am still having difficulty figuring out where the $201.7B comes from… I do arrive at $966.9B worth of future cash flows… But it is the discounted value that I’m having problems with…

My issue is as follows:

At a 15% discounted interest rate you’re money doubles roughly every 5 years.

So this works backwards as well:

At 15%… at present your money is worth half of what it will be in 5 years time

simple….

So my issue with the $201.7B is this…

At 15% over 20 years, the value of the future cash flows will half 4 times (once at 15, once at 10, once at 5, and once in the current year)

therefor: $966.9/2/2/2/2=$60.4B

This is vastly different from the $201.7B you worked out!

However… because you are on the side of Warren Buffet… and I am a nobody (in the investing world) I would like to offer an alternative as to why JnJ is still a good buy.

JNJ is a great company and I believe it will be around for many more years beyond the 20 used in our calculations. Assuming this is correct, will JNJ trade at 1x book value in 20 years? Doubtfull!…

So I can look at the price/book value for the last 10 years and see that it has traded as high as 8.3 and as low as 4.4. So to err on the side of safety let us assume that JNJ will be trading at 4x book value in 20 years time.

We can now multiply MY discounted value of future cash flows by 4:

$60.4B x 4 = $241.6B

and adding $39.3B in todays shareholders equity brings me to $280.9B that JNJ is worth in todays dollars.

Divided by 2.9B shares: $280.9B / 2.9B = $96.80 per share

minus 25% safety factor

$96.80 / 1.25 = $77.49 per share

So you can see my dillemma… I am a new investor whos nature and personality tend towards the teachings of Buffet… but I have calculated a target price for JNJ that is wildly higher than Joe’s (who has been a Buffet disciple for much longer than me)… If anyone would like to pick holes in my reasoning please feel free to do so… I’d rather be proven wrong now early in my life than in 20 – 30 years time…

TIM

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I am new too, but I’m going to give it a shot explaining it, Tim2.

First, you missed the part where the first ten years would be 16%, and the second ten years growth is reduced to 5%.

So when the free cashflow is grown at 16.1% for 10 years, then 5% for the ten thereafter you get the number 966B(or thereabouts). 966B is the free cash generated by the business over the next 20 years, and it is assumed that the cash is invested in the company(which accounts for any additional shareholder equity 20years from now) or given to you. AKA This is the cash you have bought the right to. This number is then discounted 15%(since this is the return we’d like to earn on our investment) by the formula “NPV”(Net Present Value) in the spreadsheet. Finally, the current Shareholder Equity is added in, since you’re buying a part of that as well. This is all done under Company Valuation: Total Value (B28) on the spreadsheet.

The number that we finally arrive at, and is displayed in Company Value ($239,379) is our estimated value of the company today in order to earn a 15% return on our investment. However, this is FULL PRICE for our desired 15% return. We don’t want to pay full price because it is entirely possible that JNJ will disappoint our estimates of their future for one reason or another.

However we are pretty confident in JNJ, their being such a strong industry leader, and are willing to buy them them for 25%(Desired Discount) less than we expect them to perform in order to reach our 15% goal.

As far as your valuation method goes, it is flawed because it is based on the market’s behavior. The market’s behavior has practically nothing to do with your business’s day-to-day activity and doesn’t effect its actual value. Relying on market indicators to value a business is more risky than relying on the actual business’s performance. Your method reminds me of Phil Town’s Rule #1. Check out Joe’s blog on that. http://www.fwallstreet.com/blog/62.htm

I haven’t proofread this, and I am not the best writer. Sorry. Let me know if anything confuses you.

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Night…

Thanks for the reply. I just have a couple of minutes. Then I have to shoot out and repair my snowblower before the sun sets.

The issue I have is… that if I add 15% to $239B, I get $275B at the end of the first year. Then I add 15% again I get $316B at the end of the second year.

I keep doing this until… at the end of the 20th year I get $3917B… almost 4 times higher than $966B

I don’t use the NPV formula… instead I tend to multiply by (1 interest rate) to get the value at the end of each year. Or alternatively to work backwards I divide by (1 interest rate)

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Night…

Thanks for the reply. I just have a couple of minutes. Then I have to shoot out and repair my snowblower before the sun sets.

The issue I have is… that if I add 15% to $239B, I get $275B at the end of the first year. Then I add 15% again I get $316B at the end of the second year.

I keep doing this until… at the end of the 20th year I get $3917B… almost 4 times higher than $966B

I don’t use the NPV formula… instead I tend to multiply by (1 interest rate) to get the value at the end of each year. Or alternatively to work backwards I divide by (1 interest rate)

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Tim2,

I think I can help you here. The problem with your calculation is that although it seems logical, it misses out on the compounding effect on our free cash flows moving forward from year to year. The best way to see the difference is just grab an old fashioned paper and pencil and sit down to grind it out. Once you’ve adjusted all of the future cash flows for the next 20 years according to our growth projections of 16.1% for then next 10 years and 5% for the following 10 years, start a new column and adjust each years cash flow to get your net present value, ie, 2010 was 2009 multiplied by 1.161, divided by 1.15 to the 4th power. Once you have completed your second column of present value cash flow figures, simply add them all up. You should arrive at the same number as Maestro Ponzio, $201 billion. The key is to actually write everything out so you can see for yourself.

Hope that helps.

Nick

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Adding the FCF from years 1-20 doesn’t mean anything. If you want the value at some point in time of all the FCF you have to figure out the PV or FV of all the other years’ FCF at the particular year of interest. So adding the FCF from years 1-20 to get $966B is not a measure of anything. That is why Joe gets the PV, today’s value, of those 20 years of FCF to come up with a value for JNJ’s FCF.

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And Nick has clearly outlined the correct procedure to follow. You have to discount each years’ FCF to its present value before adding.

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Thanks a lot guys!

I see exactly where I went wrong. I followed your notes and also double checked it against my book “The Warren Buffet Way” by Robert G. Hagstrom.

And yes indeed, the way you guys described it is also how the “Coca Cola” example is done in the book.

But even though I now knew that my reasoning was faulty and you guys were correct, I still could not figure out why. I had to really think about why you would work out the PV for each year before adding them up. It just did not make sense.

Then all of a sudden it just clicked.

MikeR is right… adding the FCF for years 1-20 doesn’t mean a thing! Because you would be adding across multiple years. You have to bring all the values to a single year before adding them… wether that’s the present or some pie in the sky future year…

Now I will update my spreadsheets and redo any companies I have already looked at. I wonder if doing the formula the correct way will help me find more, or less, suitable companies? Because so far the pickings have been slim…

Many Thanks

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Tim2,

Almost everyone has trouble with the concept of PV the first time. You are doing the right thing, digging into the details. You will do well.

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Joe and others,

I am currently analyzing a foreign subsidiary of YUM! Brands and they don’t provide the free cash flow. So I guess I have to do it myself. In the cash flows from operating activities section, they do not add depreciation and amortization to the net income. The constituents of cash flows from operating activities is only :

1.Cash receipts

2.Cash payments for operating expenses

3.payments of interest

4.payments of corporate income tax

net cash used in operating activities $……

In the Cash Flows from Financing Activities section they provide the CAPEX number. Then, in the supplemental cash flows information section they have non-cash activities : acquisitions of vehicles through capital lease transactions.

The question is how do I calculate free cash flow? Do I need to make adjustments to working capital (current assets-current liabilities)? Do I need to add non-cash charges to net income?

Warren Buffet suggested the following in his 1986 letters to shareholders:

(a) reported earnings PLUS

(b) depreciation,depletion and amortization and other non-cash charges [e.g special non-cash inventory cost or non-cash inter period allocation adjustment] MINUS

(c) average annual amount of capitalized expenditures for plant and equipment that the business requires to fully maintain its long term competitive position and unit volume

Any feedback would be much appreciated, Thanks

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Thank You Warren Buffet for helping me see the “product moat” of JOHNSON&JOHNSON!!!The beta on J&J is just getting better.The economy is in the doldrums but I can count on consumer staples!!!Buffet analyzed J&J and now holds 61 million shares,which means he is increasing his holding since the last annual report!!!I am sure that BUFFETS analysis is much better than any I could make.I think its safe to say if buffet spent almost 3,,000,000,000 dollars buying J&J you would be alright buying some mor shares as long as P/E is under 20.I tend to focus on Buffets mentor BEN GRAHAM,greatest investor on the entire EARTH,and his principles:MARGIN OF SAFETY and MR.MARKET.I would “LOAD THE BOAT” on J&J before the ship sails off into the sunset,with the stock glistening at 90 dollars a share and the margin of safety gone;P/E goes over 20!!!JOHNSON&JHNSON has increased its dividends 10% a year for the past 44 years!!!CASH IS KING!!!

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I recently discovered your site, and I really love it. I’m wondering if there is a minor error in the JNJ spreadsheet linked to above. In row 19, the cells are =MEDIAN(x19:y19) (for various x’s and y’s). I think the x’s are all one too high. For instance, cell B19 I think should be =MEDIAN(B13:I13), rather than =MEDIAN(C13:I13).

I’ve used this spreadsheet for analyzing a few other companies, also using the Morningstar data. If you’re interested, I can email them to you.

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Hi Tim,

That has been a point of some initial confusion for many. Sorry for that. You are looking at the “CROIC” figure for 1997-2004. The median value of C13:I13 is, in fact, the value I was going for. We are trying to figure out the median CROIC for the seven years of business operations – from the end of fiscal year 1997 (or better said, from the very beginning of 1998) through 2004. That would be fiscal years 1998 through 2004.

Make sense?

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Moneychanger: The company may not have depreciation or amortization charges, though I doubt it. You likely have some digging to do. You also need to take into account balance sheet changes.

You have the Buffett formula correct. If the company isn’t presenting GAAP financials, it may be hard to calculate free cash flow and you’ll likely have some digging and reading to do. That said, US companies weren’t required to provide Statements of Cash Flows until the late 1970s or early 1980s and Buffett did just fine. Lesson: It is absolutely possible assuming the company is providing you with enough and accurate information.

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Moneychanger,

Stick with Buffett’s definition of owner’s earnings. The key is to normalize the capital expenditures. For companies that have heavy capex, try to seperate maintenence capex from new expenditures. For more info on that, check out Joe’s wonderful post on Walmart somewhere here. Forget about adding back in taxes and interest paid. It’s ridiculous to try and act like those aren’t expenses. Don’t get me wrong, I understand why they do it. They’re trying to isolate operating earnings, but it’s irrelevant. Check out what Buffett and Munger have to say about using EBIT and EBITDA figures.

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Hello guys, (this is a bit off topic I’m afraid)

Do any of you ever start to doubt yourself when you find a company that seems just to good to be true?

My method for looking for bargains is to find good companies in battered sectors. I don’t know much about financial companies so I steer clear of those. But I can understand companies that supply the housing market. Seems to me that every company involved in the housing market has taken a huge nose dive. From flooring to air conditioning suppliers. (I’m in Canada, but the US market is getting hammered)

Now I have discovered a great company. I have read the letters to the shareholders for the last 5 years. In every single one they talk about increasing shareholder equity. The company is buying their own shares like crazy. They have had steady FCF increases for the last 10 years. ROIC is 25%.

When I run the figures through my spreadsheet they seem to be 65% undervalued. (And I don’t even add the equity after calculating Owner Earnings)

And now…. I doubt myself… crazy eh?

Everyone else seems to think this stock will keep falling but everything I have learned tells me otherwise.

I’d be interested to tell you guys the name of the stock so that we could discuss the pros and cons of it. Perhaps you’ll see something I don’t.

I don’t blog very often and don’t want to overstep some kind of unwritten rule, that’s why I’m asking if you are interested first.

TIM

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Hello guys, (this is a bit off topic I’m afraid)

Do any of you ever start to doubt yourself when you find a company that seems just to good to be true?

My method for looking for bargains is to find good companies in battered sectors. I don’t know much about financial companies so I steer clear of those. But I can understand companies that supply the housing market. Seems to me that every company involved in the housing market has taken a huge nose dive. From flooring to air conditioning suppliers. (I’m in Canada, but the US market is getting hammered)

Now I have discovered a great company. I have read the letters to the shareholders for the last 5 years. In every single one they talk about increasing shareholder equity. The company is buying their own shares like crazy. They have had steady FCF increases for the last 10 years. ROIC is 25%.

When I run the figures through my spreadsheet they seem to be 65% undervalued. (And I don’t even add the equity after calculating Owner Earnings)

And now…. I doubt myself… crazy eh?

Everyone else seems to think this stock will keep falling but everything I have learned tells me otherwise.

I’d be interested to tell you guys the name of the stock so that we could discuss the pros and cons of it. Perhaps you’ll see something I don’t.

I don’t blog very often and don’t want to overstep some kind of unwritten rule, that’s why I’m asking if you are interested first.

TIM

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Tim,

I don’t believe you are off-topic. You have done a valuation and wondering if you are missing anything in valuing this company. Can a stock be 65% undervalued by Mr. Market? Yes it can. I would be interested in learning the name of the company so I can look at it and see if I come up with the same valuation as you did. I figure the more of these I evaluate and see what eveyone else gets and thinks the more I am learning.

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Of course we’d be interested. Another learning and maybe an investing opportunity. Might even help Joe think of content for the blog, etc. I’ve only been encouraged by everyone here (especially Joe) to ask questions, personally. So feel free to provide input of any constructive variety IMO.

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OK that would be excellent!

The name of the company is ‘NVR inc’… They trade under the ticker symbol ‘NVR’… They build homes in various states…

Like I said in my earlier post… housing is a battered sector… but people will still need houses in 20 years time… Does this company have a wide moat? I don’t know… a house is a house is a house… but they do seem a lot more fiscally responsible than their competitors… They are only in the business of building homes, and NOT in the land development business, which is what is killing a lot of their competitors (Bought land that is now worth a lot less than they paid for it)

I won’t give you my valuation yet as it may influence you… I have to go to work now… but will check in the morning…

TIM

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OK that would be excellent!

The name of the company is ‘NVR inc’… They trade under the ticker symbol ‘NVR’… They build homes in various states…

Like I said in my earlier post… housing is a battered sector… but people will still need houses in 20 years time… Does this company have a wide moat? I don’t know… a house is a house is a house… but they do seem a lot more fiscally responsible than their competitors… They are only in the business of building homes, and NOT in the land development business, which is what is killing a lot of their competitors (Bought land that is now worth a lot less than they paid for it)

I won’t give you my valuation yet as it may influence you… I have to go to work now… but will check in the morning…

TIM

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Why use CROIC? couldn’t we simply base our DCF calcuations on the historical growth rate of FCF if that data is available to us wouldn’t that provide a more accurate representation, as we are focusing the actual end result?

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MikeR & Night

Did you have a look at NVR?

I bought at $482 and change… just a small amount for now while I’m learning to trust my own analysis…

Like most people I was brought up to believe that investing is best left to the experts… (Although my mutual funds are doing horribly!)… One thing that amazes me is that the market did terribly today yet ALL my stocks were up… so far this value investing thing seems to be living up to its reputation!…

I’m sure it will in the long term. But when you are as new to this as I am it kinda sucks to buy something and watch it plummet even further.

TIM

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Tim,

I have looked at NVR, and just based on an 8.5% FCF growth for the first 10 years, I am getting a value of $1,622 including the current shareholder equity. Without the current shareholder equity I get a value of $1,395. I have not had a chance to look at the actual company.

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Hi Mike,

Thanks for the reply… I would have gotten back to you sooner but I have just become a dad for the first time…

So back to NVR. I guess my real question is: The calculated fair value for NVR is about 3 times higher than the current share price. Does that make this company the deal of the century? or is it kind of ‘ho hum’ for you? Is there something else for me to consider that perhaps I’m not doing? (besides the math).

Sorry for the dorky questions. So far based on my calculated value this is by far the best company I have come across and cannot believe it is trading so low. So I am attempting to find reasons for the low valuation. Reasons I may not have considered.

TIM

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TIM,

Congratulations on becoming a dad. Life will never be the same, mainly in a good way. Try to get sleep when you can.

I don’t know if NVR is a good deal. It probably depends on how the mortgage thing plays out.

You will often find even larger discrepancies between price and DCF modeling of IV. For instance for AEO I get a value of $148 and it is trading under $20. For UNH I get a value of $225 and it is trading at $55. For AAPL I get a value of $28 and it is trading at $161. I am long AEO and UNH, but I am not short AAPL.

I am too new at this, so I just don’t know about NVR. For me at this time a stock has to pass my valuation test, plus I have to find others, like Buffett and Joe, who like it to give me the confidence to take a position.

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Tim: Congrats on becoming a father! I have two now and there are no words – especially on a website – that can express the joy you are going to have!

The major problem with builders is that they have huge capital outlays and heavy interest charges while they work. If they need cash, they have to borrow at unfavorable rates or sell stock.

In addition, their revenues (and hence, owner earnings) are directly tied to the amount of cash they outlay to build. There is no “ATM” or “annuity” aspect to their business.

All things considered, I’d rather invest in companies that can generate just as much cash while deploying much less capital.

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Hi Joe,

I typed in the numbers for Nucor Corp. (NUE) into your evaluation spreadsheet of Johnson&Johnson. The results are kind of strange: the discounted per share value is at about $218, while the current share price is only $51,22. I checked the numbers again and everything seems alright. I used the numbers from Morningstar. The market cap is at about 14,7 bil. and the shareholder equity is around 4,8 bil. Those numbers seem to not fit together.

Does anyone have an explanation?

Thanks for answers in advance!

Jens

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Hi Joe,

I typed in the numbers for Nucor Corp. (NUE) into your evaluation spreadsheet of Johnson&Johnson. The results are kind of strange: the discounted per share value is at about $218, while the current share price is only $51,22. I checked the numbers again and everything seems alright. I used the numbers from Morningstar. The market cap is at about 14,7 bil. and the shareholder equity is around 4,8 bil. Those numbers seem to not fit together.

Does anyone have an explanation?

Thanks for answers in advance!

Jens

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Hi Joe,

I typed in the numbers for Nucor Corp. (NUE) into your evaluation spreadsheet of Johnson&Johnson. The results are kind of strange: the discounted per share value is at about $218, while the current share price is only $51,22. I checked the numbers again and everything seems alright. I used the numbers from Morningstar. The market cap is at about 14,7 bil. and the shareholder equity is around 4,8 bil. Those numbers seem to not fit together.

Does anyone have an explanation?

Thanks for answers in advance!

Jens

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Jens,

Did you put in that the 2.86bil shares JNJ has out is quite a bit more than 287mil. You need to change the numbre in the per-share value calculation to 287930000 from 2896558000.

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Joe, Nick and Others

Thanks for the generous feedback.

Referring to answers to my post on 8th of January 2008, actually the statement of cash flows from Operating Activities look like this:

Cash receipts xxxx

Cash payments (xxxx)

Cash Generated from Operations $…….

payments of interest (xxxx)

payments of corporate income tax (xxxx)

net cash used in operating activities $……. [1]

supplemental cash flows information section – non-cash activities : acquisitions of vehicles through capital lease transactions xxx [2]

As the depreciation and amortization numbers are not provided, I simply calculate Free Cash Flow (FCF) as follows:

1. net cash used in operating activities xxx [1]

2. other non-cash charges from [2] xxx

3. maintenance CAPEX (xxx)

Free Cash Flow $……

Correct me if I’m wrong..Thanks!

Moneychanger

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Hi Nick,

I already did that and STILL the per share value is about 309$, making it 232$ with a 25% discount. I can send you the exel file or you can calculate it yourself. It just doesn’t seem to be right that a company is supposed to sell at a 83% discount. Can someone calculate the intrinsic value per share and tell me what’s going on? If my numbers are right this would make Nucor a 6-bagger if the price catches up with the value.

Another thing: current liabilities are only a third of current assets. Nucor’s current ratio is therefore way better than other steel mills. I looked at different other numbers and calculated the intrinsic value with Joe’s Excel spreadsheet. The numbers kick ass.

Does anyone have an explanation for the huge discount Nucor is selling at? Especially because the steel industry is consolidating pretty fast.

Thanks for answers in advance!

Jens

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Moneychanger,

That looks right!! Remember, the key is to “normalize” capex using different time periods. Good Luck.

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Jens,

You did do the calculations correctly, I also get $309 as the per share intrinsic value just looking at 10 year historic CFC and projecting that to the future.

Probably the market does not believe NUE will grow at 30%. Also their CROIC is very low, I get 7.2%.

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Obviously, I can’t tell you to buy or pass. I did look at NUE, and I can say that I am moderately impressed with the company’s growth. But, I would be extremely cautious. Here’s my rationale:

The company deals primarily in scrap steel, converting it for use in non-residential construction and, to a lesser extent, shipping and automobiles. That is a great business to be in when steel prices more than triple over four years, but not so great if and as prices come back down or when the economy slows. From their annual report:

Demand for most of our products is cyclical in nature and sensitive to general economic conditions. Our business supports cyclical industries such as the commercial construction, energy, appliance and automotive industries. As a result, downturns in the United States economy or any of these industries could materially adversely affect our results of operations and cash flows. Because steel producers generally have high fixed costs, reduced volumes result in operating inefficiencies.

The company is also in direct competition with Chinese steel companies doing it cheaper:

Global steel-making capacity exceeds global consumption of steel products. This excess capacity results in manufacturers in certain countries exporting significant amounts of steel at prices below their cost of production. These imports, which are also affected by demand in the domestic market, international currency conversion rates and domestic and international government actions, can result in downward pressure on steel prices, which could materially adversely affect our business, results of operations, financial condition and cash flows.

Overcapacity in China, the world’s largest producer and consumer of steel, has the potential to result in a further increase in imports of low-priced, unfairly traded steel to the United States. In recent years, capacity growth in China has significantly exceeded the growth in Chinese market demand. A continuation of this unbalanced growth trend or a significant decrease in China’s rate of economic expansion could result in China increasing steel exports.

Then, you have to consider the capital expenditures. Steel companies are very capital intensive, and that eats into your owner earnings.

All things considered, this is a very tough business to value simply because it:

1. has fierce competition that can (and does) compete on price alone;
2. enjoyed great success from the economy and real estate boom which may be turning for the worse;
3. is capital intensive; and,
4. has no durable competitive advantage or moat.

Though the historical numbers may show that this company is grossly underpriced, it is up to you to predict the future with a degree of accuracy and confidence.

If you choose to buy, make sure you do so for the right reasons. If not, don’t worry about the outcome. Make sure you have the confidence you need to feel comfortable with your companies.

And, of course, remember that there are thousands of other opportunities out there and that another one is right around the corner.

Hope that helps!

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Hi again,

Oi yoy yoy! Am I ever sleepy! This whole feeding routine every two hours is getting old…. Oh well… sure I’ll get some sleep in a years time…

Anyhow… back to the stockmarket…

I made some recent purchases… a small amount of AEO at about $19.50 (I’ll get back to this in my question because something is bothering me in the way we are calculating future cash flows)… I also purchased SBS at $40.50 (ish)… And Zale corp. at $14.00…

So my question is this:

For our calculations about future cash flow to be correct we should be ensuring that for every dollar made in FCF that Equity increases by at least a dollar. This is NOT happening at AEO or for that matter some of my other stocks. I just reread the “how to value a business” section of this site and I don’t see mention of it in there. This is bothering me.

At AEO for example there is $523 in Free Cash (in 2007). They paid $62 in dividends leaving $461 for investment in the company. But equity only increased $261. Leaving a shortfall of $200 that just ‘disappeared’.

Is my reasoning correct? Should I add a line into excell?

Equity Growth Dividends – Free Cash flow

If the outcome of this is positive thats good. Negative would be bad as money would be disappearing (bad investments or whatever).

TIM

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Typo:

line in Excell should read

Equity Growth Dividends – Free Cash flow

Basically I want to know… Is free cash flow being reinvested in the business and creating at least the same amount in equity the following year. Or is it returned to me as dividends.

Worst case scenario is the company growing equity at a lower value than the free cash flow withheld.

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Tim2,

Check the balance sheet and cash flow statement again. Looks like they increased their treasury stock account by buying back their undervalued shares, which is actually a debit in the stockholder equity account. Shareholders are compensated, however, by having a larger stake in the company, which is why we applaud share repurchases when the price is right. Any leftover balance would be pretty small and wouldn’t really reflect in any valuation attempts. Hope that helps.

Nick

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Thanks Nick,

I’ll look into that later tonight… I’m still fairly new at this and have been pleasantly suprised at how willing people are to help me out, on this excellent website!

I’m sure it won’t be the last question I’ll post. Hopefully I’ll be in a position to help other newbies one day.

Tim

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Thanks a lot Nick!

Moneychanger

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Glad to help guys.

Nick

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Nick,

Could you clarify the following? I still calculate a shortfall.

If I use the AEO 2007 cash flow statement I get (to the nearest million):

Free Cash Flow = $523

Dividends paid = $62

Share Repurchase = $126

This leaves me $336 of growth money (523-62-126=336)

Equity for 2007 increased $261 from the previous year

So the way I calculate it the company grew $261 from an input of $336. What happened to the $75 that appears to have disappeared?

TIM

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Tim2,

One thing I think that you are missing Tim, is that when calculating Free Cash Flow, Depreciation and Amortization are added back into income. So the full calculation for finding Free Cash Flow, on Morningstar.com, (which I assume you are using) is:

Net Income

Depreciation and Amortization

/- Deferred Taxes

Other Income

-Cap Ex

– Other Expenses

—————————-

= Free Cash Flow

However, when calculating the total asset value of a company, depreciation and amortization are considered expenses. This lowers the value of the shareholder equity, since the companies tangible assets have had there sale value decreased because they are now 1 year older.

In 2007, AEO reported $88 million in Depreciation/Amortization charges. So, as I understand it, this is where the extra $75 million you have left over from the FCF comes from. I%u2019m not sure why the numbers don%u2019t match up perfectly though, but this is where the ’shortfall’ comes from between the increase in shareholder equity and the increase in free cash flow for the year.

Here is a quote from ivestopedia.com as to why Dep/Amort is added back:

%u201CIt might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment, however, is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past.%u201D

Alex

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Hi there,

I often use the spreadsheet Joe posted some time ago to evaluate a company value based on DCC. Quite often I get a lovely discount of over 90%, which makes me perplex. If you look at Chico’s FAS Inc. (CHS) for example, the discount using the spreadsheet would be 96%. Feel free to run the numbers through yourself.

Please tell me how a company can trade at such a big discount. Even if you change the numbers for the worse quite a bit you get a nice discount.

Me being a novice just doesn’t understand such a huge gap in price and value.

Thanks for the explanation in advance!

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Make sure you understand what values go into the equity as some values are carried on the books but have no “real” value to an owner (e.g., overstated intangibles). Also, double check your future owner earnings. Just because a company has grown at x doesn’t mean it will always grow at x. You must predict the future, not just rely on past results.

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Thanks for the great website Joe.

Do you have any opinion on Pfizer (PFE)? It seems to be trading at a 75% discount to its intrinsic price. It appears quite substantial.

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Joe,

I’m new to the site and it is fantastic. I have a question about the discount rate (what you call your expected return of 15%) in this example. In their book, Valuation, Kohler et al say to use WACC for the discount rate to get the PV of operations. They then subtract debt to get the Equity Value. Equity Value is what they divide by the # of shares to get the Equity Value per share. I’ve read and believe I understand your explanation of your use of expected return. But I’m having a hard time reconciling these two different approaches to the use of a discount rate. Can you help? Thanks.

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Joe,

I just recently found your site. It has been extremely helpful and educational. I have worked my way through the JNJ analysis. My question is whether or not to add stock options to the outstanding shares in valuations. Is that something you consider? -or is it something you account for through the Margin of Safety?

Thanks!

Dustin

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Dr. Pete: There was an interesting quote in Damn Right! — the story of Charlie Munger — about this very thing. Basically, Buffett and Munger were more or less laughing at the concept of WACC. I believe their rationale was that you should purchase businesses that generate high returns on invested capital, use good discount rates, and insist on a good margin of safety. Do that, and you won’t have to worry about WACC.

Dustin: I always use fully diluted shares and try to invest in companies that do not issue so many options that ownership is greatly affected. If I wanted to invest in a company that issues a lot of options, then yes — I would definitely consider the effect on my ownership and valuation both today and in the future.

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Hi

Can I ask why you use JNJ’s Free Cash Flow growth as a basis for valuation as opposed to owner’s earnings growth, like you did for your analysis of WMT?

Looking forward to your book!

cory

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Dear Joe,

Thanks very much for your great site….

Wouldnt analyzing a company purely on ROE basis a bit tricky?

For example, lets take 2 companies which purchases identical buildings right next to each other. Company A buys the building for 5million bucks cash and starts to rent it out for 10% or 500,000 rent per year. Company B buys it for 1million dollars cash and 4million interest only debt lets say at 6%. On year one A’s ROE will be just below 10%(after expenses) and B’s ROE will be 500K rent – (240K interest payment) will be just below 260 on 1million dollars capital or just under 26%.

If they were listed companies and both were able to jack up the rents by 5% per year….Wall Street.will probably start going crazy over company B. But when the tide receeds B is the one to be a potential candidate for a federal government bailout…if only they were deemed too large to fail.

Its in the interest of company insiders with large stock options to operate on a thin capital base….to attract higher share prices during good times by showing ever growing ROEs. Not many iCEOs stay around for decades…

The two bust investment banks had very high ROEs. Large reported earnings until the write offs started….but they all seem to have had huge cash out flows financed by a huge increase in debt since about 2002-2003. This mode of operation includes the stars like GS.

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Cory: Sometimes owner earnings and free cash flow are substantially the same (like in Johnson & Johnson) because the company doesn’t have a lot of extraordinary items that affect the cash flow. Other times, the two differ greatly (like in General Motors). In this case, free cash flow was a perfectly acceptable proxy for owner earnings.

Chris Lazos: You asked:

Wouldnt analyzing a company purely on ROE basis a bit tricky?

You bet!. That’s why we don’t use ROE. Return on Equity is a great place to look when screening for opportunities and is usually a great indicator of a strong business; but, it is in no way a number to be relied upon blindly.

The problem with ROE is that it relies on easily manipulated GAAP earnings, and I never rely on GAAP earnings:

• The Importance of Earnings
• From Free Cash Flow to Earnings and Back

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My 2 cents for our discussion,

a)

Agreed, ROE is simply a measure to figure out if the net income is comparable to the equity that remains in the business. This is a sign that the company is generating SOMETHING(good sign). Regardless, the situation warrants more scrutiny.

for example:

Your company could be better served through sharebuybacks => lifts ROE (this is the tricky part..figuring out if it was worth it ! Consider that equity was returned to the owners)

b) HTB to answer your question about PFE. Its definately a BIG bargain based on HISTORICALS. However, the value of PFE depends on the future; in fact, major patent losses could shrink those historical FCF levels as much as 40-50% <–this would KILL your investment if you OVERPAY for growth

(BTW this future growth DEPENDS on the viability of Research efforts AND pipeline developments in a timely manner).

Hope YOU ALL the VERY best!

AMit

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hi Joe,

truly, an informative and educational site, God bless you.

My question is about “how can one speculate or calculate future interest rates volatility (as a percentage)”, you may want to give your readers a brief definition of the subject in question, and then answer my query.

Thank you

Mamdouh Ali

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Mahmoud, You obviously havent been reading. Nobody here will teach you to speculate and figure out what future interest rates will be. Especially not Joe lol

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Hi Amit, the way i see it, and correct me if i’m wrong, that there’s an obvious link between using the “right discount rate” and the “interest rate volatility” at the time you decide on a specific discount rate. Maybe my question is not directly related to J&J case, but after all it’s related to the subject in general. So, can any of the distinguished participants here guide me to get an answer to my question. Thanks

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Well we decide on a 15% discount rate which is obviously higher than anything you will get on the risk free rate, which hedges you in case interest rates go up…

Mamdouh, when was the last time you’ve seen the risk free rate or Corp AA bond at 15%?

Buffet wouldn’t try to estimate future interest rate volatility , neither should you! Just use an appropriate discount rate.

I don’t need to tell you 3% is not a good discount rate in most situations…but in the end it really depends on you.

If your worried about interest rate risk, just boost your discount rate, its not rocket science. You dont need some magic formula, neither should you be looking for it on this website.

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Thanks Amit for your advice, sounds quite rational to me and I’ll work wih it. Bye

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Np =), and I’m sorry I was too blunt about it!

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A good discount rate that works seems to be 5% (if you are feeling adventurous).. but 9% (to be more conservative).

This two seems to be discount rate that buffett is using most of the time.

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Hi Joe,

Great article and discussion on valuing a business.

I do believe you have to reproduce the asset value to current market price.

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Joe,

I had a quick question for you. I just downloaded the new spreadsheet, which I love by the way. Thanks so much for that.

My question has to do with Owner Earnings vs. FCF. Am I right in thinking that OE is always (or most always) going to be lower than FCF?

You have previously stated that you look for a 14% CROIC as a minimum hurdle. Is this when looking at OE or FCF? Does your hurdle rate change depending on which method you use to evaluate the company?

Thanks!

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Hi Joe,

After following the discussion above, I have to say that I’m left with some confusion – some say you should add SE, some say only the book value, some say add the 20th year’s cash flows (going indefinitely into the future with 0% growth rate, amortized) and some say don’t add anything.

I’d looove to hear your view about all this.

All the different views got me confused.

Thanks! Keep up the amazing work =)

Ziv.

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Hey I am a 22-year-old student from Valencia, Spain.

I have been reading some posts and it is amazing the amount of useful information available in this website. I just want to thank Joe for creating this site, it is impressive.

I also want to thank the rest of the people that are making comments because they provide very interesting points of view too.

I am graduating in Dec2010 and i want to do my final project on value investing.

Hopefully I can ask you guys for recommendatios when it is time.

Thanks

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Hi Joe,

I read your comment above about how Charlie Munger laughed at WACC calculations. When I was trying to get a real handle on DCF valuations I reviewed a series of different techniques to arrive at a DCF valuation and actually the quality of the business and the assets can have a huge bearing on margins of error making the whole WACC calculation seem very tortuous for the value it gives.

For WACC, I found the calculations all a bit convoluted, and having gone through the exercise of working it all out I came to the conclusion that actually the error margin in choosing the appropriate profit margin, cost of capital or revenue growth made the whole WACC question totally meaningless, in fact doing as you recommend and picking a rate of 9 or a ten year bond rate if above 9 gives results that are well within any possible errors we might introduce in estimating one of our other parameters.

I don’t know, perhaps the fact that the maths geniuses on Wall Street can hack together immensely complicated computer models to give them three decimal places in precision gives them some comfort.

Here is a very interesting point, and it’s meaningless to pure mathematicians as their training is the stuff of ideal models and not of measurement. Precision and accuracy are completely different things. The best example I have is throwing three darts at a dartboard and aiming to hit the bull’s-eye. If all three darts arrive at the edge of the board within millimetres each other, our throwing is very “precise”, but totally inaccurate. At his point, Buffett’s quote, “I’d prefer to be approximately right than precisely wrong” really hits home.

For me working out the WACC, is a way of being precise but it’s a meaningless exercise if we are looking for businesses that A) demonstrates a strong return on capital and B) The management of those businesses are vocally committed to strong returns on capital in all capital allocation activities. In these cases the WACC looks after itself as management have already done the work on a project by project basis.

If I don’t get the impression that the business is orientated that way I simply won’t buy it, unless it’s a net net assets value play, and then I’m buying dollars for cents anyway.

Approximately right on a 50% margin of error is where I’d rather be than precisely wrong with none at all.

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