# How to Find the Intrinsic Value of a Business

Written by

Jae Jun

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What You Will Learn

• How to Find Intrinsic Value and Why it is Important in Value Investing
• How to Use the Two Parts of the DCF Method to Easily Find Intrinsic Value

Over the past few years of supplying intrinsic value calculator utilizing Discounted Cash Flow to the masses, I receive many similar questions and I wanted to address the issue of adding back shareholders equity to the DCF method. You can use these methods to clearly determine the Intrinsic Value of a Business.

Backtracking a bit, I’m an engineer by trade so I have the tendency to be a little too analytical. When I first started studying DCF, it was all about theory.

But as you know, most of what you learn in school is never applied in the real practical world.

My calculations used to involve WACC (Weighted Average Cost of Capital) as the discount rate, and a simple method of finding the present value for each year (up to 5 or 10 years) and then adding it all up to get the “sum of future cash flows”.

(Check out Aswath Damodaran’s excellent presentation on DCF inputs (pdf) for a better understanding on the theory of DCF.)

But back to the point on adding shareholders equity.

### Intrinsic Value of a Business

What’s it worth? Intrinsic Value of a Business | Flickr: Alan Cleaver

The DCF method I use involves two parts.

• 1) Finding the sum of the future cash flow, which everyone agrees with.
• 2) Calculating the excess cash to figure out the net worth of the company. The excess cash is the cash that is left over by the business that is not used for any operations.

The intrinsic value formula then becomes

Intrinsic Value = Present Value of Future Cash Flow + Excess Cash

I can rewrite this formula as

Intrinsic Value = DCF + [Total Cash – MAX(0,Current Liabilities-Current Assets)]

#### A Real Life Small Business Example

To put it into perspective, toss aside the modern financial modeling hat for a second and think of yourself as a small business owner.

The truth is that most small business owners do not understand financial statements or much about accounting beyond the basics.

What the small business owner does know however, is how much cash the business generates and what their business is worth.

If you look in the local papers or do a quick search for businesses on sale on the internet, you will find a commonality for the asking price.

Take a look at this example of a B&B in the state of Washington where I live.

The intrinsic value as defined by the seller is very simple.

You have gross income to show how much business it gets, net cash flow, inventory, real estate and FF&E (Furniture Fixtures & Equipment) aka PPE.

These are all assets that produce cash flow and anything remaining will then be added to the intrinsic value, thus the formula above.

In theory you would rarely value a business in such a manner, but in the real world, not everyone is a finance graduate capable of applying multiples and Greek formulas to their business.

#### Applying it to Stock Market

As a value investor, you agree that the stocks listed on the indexes are real businesses and real business have chairs, desks, computers and other assets that must be included into the asking price for the company. You also have to distinguish between operating and non operating assets.

Assets that add to the cash flow are already included in DCF while the assets that are not, such as extra cash in the bank or an old property that still has value, would be added to the DCF value.

This is what the “Intrinsic Value of a Business” is all abouit.

• thetick

any portfolio update for july??? I see you skipped june’s update.
thanks.

• jman

Jae, thanks for your post. I’m not a CFP, but I’ve seen discussions on this point. It seems to me that adding shareholder equity would in fact result in double counting. It appears to me that, at least technically, what needs to be added to DCF is excess cash and other assets not used in the generation of the cash flow (i.e., non-operational assets). If it is your position that in the real world this doesn’t take place, that would be a different matter. Your point above regarding the real estate is noted. But the failure to pay rent for the property (since the company owns it) would increase your DCF and would, in affect, “value” the property that’s sitting on the books. Are you saying the investment world does not take this into account? Love to hear your response and anyone elses.
Thanks and really love the updated spreadsheets!

• By my reconnening, its selling at less than half intrinsic value, if cash flow / 4.5% mortgage rate = \$2.4MM

at the sales price of \$1MM … its a great value … \$2.4MM for \$1MM, yes?

I count only net inc or (i guess) your cash flow if it’s the same thing. This is the only real measurable in the end. Items like inventory, ffe … you couldn’t sell it in a garage sale for a quarter of the value for what the seller values it. Dont count any of it and build your value on the profits only. In the end if it is worth something, you essentally get it free.

• Chuck

I agree with jman. Since you cannot generate the CF without the real estate you can’t include the assets and the DCF. It’s either or. Only assets not required to generate CF should be added to DCF.

On an unrelated note, in valuing small businesses you need to be sure that expenses include a manager’s salary. Otherwise you are valuing your time at zero.

• Joe Farrell

Jae,

If you set up a Facebook group, I would be a fan immediately. I think you are the best at translating the math behind value investing analysis to the retail investor.

I’m blown away by how detailed your analyses are, yet how easy they are to read. Great job! // Joe Farrell

• @ jman & Chuck,

I was thinking about this and concluded that you hit the nail on the head.
The correct amount to add back in would be the excess cash or assets that are non operating but still worth money instead of shareholders equity.

So rather than net worth, it should be excess cash.

Thanks for the lesson guys.

@ Joe,
Thanks Joe.
As you can I’m not always right (that’s what you get from financial home schooling hehe) but I try my best.

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