How to Find the Intrinsic Value of a Business

Over the past few years of supplying intrinsic value calculators 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.

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.

How to Value a Business

The DCF method I use involves two parts.

• 1) Finding the sum of the future cash flow, which everyone agrees with.
• 2) Calculating shareholders equity to figure out the net worth of the company. I prefer to use tangible shareholders equity.

The intrinsic value formula then becomes

Intrinsic Value = Present Value of Future Cash Flow + Net Worth

I can rewrite this formula as

Intrinsic Value = DCF + Shareholders Equity

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.

As you can see, the asking value of the business can be defined as:

Intrinsic Value = DCF + Shareholders Equity

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.

Refer to the formula above and I hope you see that adding back shareholders equity is not double counting.

Disclosure

I am not the seller of the B&B