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.
How to Value a Business and Discover the Intrinsic Value of a Business
Intrinsic Value of 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 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)]
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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 about.