Calculating The Value Of A Business – Part III

July 23, 2007 | Joe Ponzio

In Part I, we looked at Shareholder Equity as the first step in calculating the intrinsic value of a company. Then, we looked at Buffett’s owner earnings and further explored intrinsic value in Part II. When you buy stock, you are buying a piece of a business-usually, a small piece. You are essentially becoming a silent partner in that business.

The Silent Partner Concept

When you buy a business, what do you really own? What rights do you have? Okay-they tell you that you can vote on shareholder proposals and attend annual meetings. Still, except for in extremely rare circumstances, proposals, elections, and other voting matters are controlled entirely by the majority shareholders-usually family members of management and pension funds, hedge funds, and mutual funds.

You don’t have say in the daily operations. You have very little voice in meetings or voting. You certainly don’t have access to an expense account or company BMW. Other than the net worth of the company when it shuts down and the excess cash the business can generate while it’s running, you don’t own anything. You are essentially a silent partner.

Generating Returns On Your Rights

Finding out the company’s net worth is easy (See Part I). But you also have a right to the future cash of the business. Maybe management will pay it out as dividends; maybe they’ll use it to increase net worth. If the business generates $10,000 of excess cash next year, and you own 0.5% of the company, $50 of that cash is yours (assuming management uses it effectively the following year-a bad assumption with many companies).

What are you willing to pay today to end up with $50 next year? Would you pay $50? $45? $20? Your answer to that is the basis for the next step in valuing a business. If your goal is to invest your money and earn 15% on average for the long term, you shouldn’t pay more than $43.47 today to get $50 of cash one year from now.

The Process

So, before we move on, let’s review the process. You know where to find net worth. You understand owner earnings. The next step is figuring out what your desired return is. How can I know my desired return? We’re not looking at anything right now! Right-except that your goal is to find the value of a company, regardless of the price that Wall Street sets for its stock.

The value of a business is not some fixed, stoic number that can be verified by facts. Value is what you are willing to pay based on how satisfied you are with the end result. Let’s explore:

The Value Of A Rock

I have a rock I’d like to sell. Nothing special-just a rock I found on the street. It’s grey. Roundish. About 2 inches in diameter. What do you think it is worth? What is its value?

Unless you are a serious collector of Chicago rocks, there is very little value in this rock. I can post it on eBay for $10,000, but I’d doubt I’d get any offers. Unless…

What if I told you that I’d give you $1 million (tax free) if you bought the rock, dipped it in chocolate, and then threw it in Lake Michigan? Now what is the rock’s value? Would you pay $500? $50,000? $820,000? Now, the rock has a value to you. It’s the same rock, but the end result is different. Instead of ending up with a rock, you have $1 million in cash.

The Value Of The End Result

Now, before you run to eBay to find my rock, consider what it is really worth to you? To complete the task, you have to dip it in chocolate and throw it in Lake Michigan. Pretty easy for readers here in Chicago-not such a quick and easy task for Pat, a New Zealand farmer and visitor of F Wall Street.

Some Chicagoans might pay $999,980 for my rock. For them, walking away with $20 is worth the effort. Others might not pay more than $999,000 because earning less than $1,000 for this task doesn’t justify the work that needs to be done. Pat can’t even pay that much because the round-trip ticket alone would cost him more than $1,000-not to mention the time lost due to all of the travel.

And how could you compete with the visitor who would be willing to pay $1.65 million just to say he got the rock? Mohnish Pabrai did it for lunch with Warren Buffett.

Price Versus Value

As Warren Buffett said:

Price is what you pay. Value is what you get.

Consider that quote in the context of my rock. What price would you pay for that $1 million-considering what you might have to do to complete my task? What value will Pabrai get out of his lunch with Warren Buffett? If Buffett takes out a notebook, leans over and whispers:

Pssst. Mohnish-can you keep a secret? This notebook details exactly how I did it-formulas and all. Take it, use it, and pass it on in sixty years.

Pabrai would certainly get much value from the $650,000 price tag the lunch carries. If, however, Buffett spent a few minutes with the formalities of an introduction, downed a bowl of soup, and ran out the door, the end result would not have justified the price tag (except perhaps for the charity that the $650k went to).

So, Step Three Is…

Know your desired return. We’ll shoot to beat that return, but you have to know your minimum rate of return when you consider everything that goes into it. When you buy stock, you have to do some research, you have to check up on your company every year, and you have to periodically seek out better value for your money. It’s not a full time job; but, there is a bit work involved.

Now, let’s look at the numbers.

http://www.fwallstreet.com/article/28-calculating-the-value-of-a-business-part-iii