{"id":17496,"date":"2018-11-29T06:47:29","date_gmt":"2018-11-29T06:47:29","guid":{"rendered":"http:\/\/thepatientinvestor.com\/?page_id=17496"},"modified":"2024-04-17T23:40:23","modified_gmt":"2024-04-17T23:40:23","slug":"payback-period","status":"publish","type":"page","link":"https:\/\/thepatientinvestor.com\/index.php\/payback-period\/","title":{"rendered":"Payback Period"},"content":{"rendered":"<p>We use a simple payback formula to measure the relative pricing of investments. Bear in mind that some investments are higher risk than others and therefore command a higher risk premium and shorter payback.<\/p>\n<p>The formula requires six inputs:<\/p>\n<ul>\n<li><strong>Free Cash Flow<\/strong> (FCF), normally calculated as either:\n<ul>\n<li>Operating Cash Flow (OCF) minus Capital Expenditure (Capex); or<\/li>\n<li>EBITDA (Earnings before Interest, Tax, Depreciation &amp; Amortization) minus Capex, Tax and expected Increases in Working Capital;<\/li>\n<\/ul>\n<\/li>\n<li><strong>Expected Growth<\/strong> in FCF, normally equal to Revenue growth plus any adjustment for improving margins;<\/li>\n<li><strong>Market Capitalization<\/strong> (Market Cap), the number of shares in issue multiplied by the current market price;<\/li>\n<li><strong>Investment in Associates<\/strong> (Equity Accounted Investments), but be careful to exclude earnings included in OCF or EBITDA;<\/li>\n<li><strong>Surplus Cash<\/strong> (Cash and Short-term Investments); and<\/li>\n<li><strong>Total Debt <\/strong>(including capitalized leases).<strong><br \/>\n<\/strong><\/li>\n<\/ul>\n<p>Using a spreadsheet, simply calculate the number of years of FCF, allowing for growth, that it will take to repay Market Cap plus Net Debt (Debt minus Surplus Cash), minus Investment in Associates (where this is a material number).<\/p>\n<h2>Potential issues<\/h2>\n<h4>Stock Based Compensation<\/h4>\n<p>Normally added to Operating Cash Flow (OCF), stock-based compensation is still an expense of doing business and dilutes the holdings of existing shareholders. Our preferred treatment is to exclude from OCF (as it is from EBITDA) and to treat stock-based compensation as a source of financing (Cash Flows from Financing Activities).<\/p>\n<h4>Software Development<\/h4>\n<p>Make sure that capitalized software costs (normally shown as Intangibles) are included as Capex. These are often stated as a separate item on the Cash Flow Statement and sometimes omitted as a deduction from FCF.<\/p>\n<h4>Acquisitions<\/h4>\n<p>Regular acquisitions may enhance revenue growth (and margins) but absorb free cash flow. Adjust projected revenue growth to exclude growth from acquisitions or deduct acquisitions from FCF, otherwise you will be double-counting.<\/p>\n<h4>Increases in Working Capital<\/h4>\n<p>Compare net operating assets multiplied by projected growth to capital expenditure plus projected increases in net working capital. Occasionally there are other operating assets that are also likely to expand in line with revenue and will need funding.<\/p>\n<h4>Disposals, Spin-offs &amp; Discontinued Operations<\/h4>\n<p>FCF needs to be adjusted for disposals, spin-offs and discontinued operations. If the operation was making losses then FCF will increase.<\/p>\n<p>Bear in mind when evaluating potential growth that discontinued operations may be excluded from past performance. Companies are often motivated to dispose of under-performing operations because they reflect poorly on management. Projected future growth should be adjusted to reflect the likelihood of further poor performance.<\/p>\n<h4>Franking Credits<\/h4>\n<p>For Australian investors, we allow for a partial refund of tax paid by the company through franking credits to shareholders who receive dividends. The calculation is fairly complex but recognizes the enhanced cash flow to investors such, as superannuation funds, with low marginal rates of tax.<\/p>\n<h3>Margin of Safety<\/h3>\n<p>We have simplified our model by eliminating margin of safety and instead using a single variable \u2014 the payback period \u2014 to reflect our estimate of risk\/uncertainty.<\/p>\n<h3>Payback Period<\/h3>\n<p>Stocks with stable revenue and earnings streams justify higher prices which are recognized through a longer payback period. We may use a payback period of 10 years for stocks with volatile revenue or earnings, while blue chip stocks with stable revenues may justify a payback period of 13 years or more.<\/p>\n<h3>Strengths<\/h3>\n<p>A simple formula with few variables, Payback eliminates the need for the following variables used to discount future cash flows in a normal DCF model:<\/p>\n<ol>\n<li>Estimated cost of capital, normally derived with the Capital Asset Pricing Model (CAPM), is open to by central bank manipulation of the risk-free rate; and<\/li>\n<li>Projected exit value or an exit multiple.<\/li>\n<\/ol>\n<p>Payback adjusts FCF for expected growth, providing a far more useful measure than normal multiples (e.g. P\/E) which do not.<\/p>\n<p>Payback does not assume a linear relationship between value (P\/E) and expected growth as in the PEG ratio. The true relationship more closely resembles an exponential curve.<\/p>\n<p>Payback does not need to be adjusted for dividends or stock buybacks.<\/p>\n<h3>Weaknesses<\/h3>\n<p>Future growth is still subject to forecast error.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>We use a simple payback formula to measure the relative pricing of investments. Bear in mind that some investments are higher risk than others and therefore command a higher risk premium and shorter payback. The formula requires six inputs: Free Cash Flow (FCF), normally calculated as either: Operating Cash Flow (OCF) minus Capital Expenditure (Capex); &hellip; <\/p>\n<p class=\"link-more\"><a href=\"https:\/\/thepatientinvestor.com\/index.php\/payback-period\/\" class=\"more-link\">Continue reading<span class=\"screen-reader-text\"> &#8220;Payback Period&#8221;<\/span><\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"parent":0,"menu_order":0,"comment_status":"closed","ping_status":"closed","template":"","meta":{"_mo_disable_npp":"","footnotes":""},"class_list":["post-17496","page","type-page","status-publish","hentry"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.2 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Payback Period - the patient investor<\/title>\n<meta name=\"description\" content=\"We use a simple payback formula to measure the relative pricing of investments. 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