Intrinsic Value of Simple Businesses

Hello friends, in today’s article we see the intrinsic value of simple businesses, and how it is calculated from the book ” the Dhanndho Investor ” Chapter 7. In this chapter the author Mohnish Pabrai gives the intrinsic value of any business, to help in investing in simple businesses.

so let’s start, with how to invest in simple businesses.

Previous Chapter 6

the Dhandho Investor:- Chapter 7 (Intrinsic value)

in this author explain, how we can invest in any business by knowing its intrinsic value. so let’s understand this concept

the author says, ” the advantage of buying a fraction of an existing business is pretty clear, but before we buy, we must know its intrinsic value. how else would know it’s a good deal at a given price? What is the intrinsic value of a business is there a general formula? How do we figure it out?

Every business has an intrinsic value, and it is determined by the same simple formula. John Burr Williams was the first to define it in his theory of investment value. published in 1938.

For William, the intrinsic value of any business is determined by the cash inflows and outflows discounted at an appropriate rate – that can be expected to occur during the remaining life of the business.

the definition is painfully simple.”

then the author gives one example of a gas station, and how the intrinsic value of that gas station.

the author says, ” To illustrate let’s imagine that towards the end of 2006, a neighborhood gas station is put up for sale, and the owner offers it for $500,000. Further, let’s assume that the gas station can be sold for $400,000 after 10 years.

Free Cashflow- Money that can be pulled out of the business – is expected to be $100,000 a year for 10 years. let’s say that we have an alternative low-risk investment that would give us a 10% annualized return on the money.

Are we better off buying the gas station or taking our virtually assured 10% return? I used a Texas Instruments BA-35 calculator to do these discounted Cash Flow ( DCF) Calculations.

Alternatively, you could use excel. astable 7.1 demonstrate, the gas station has an intrinsic value of about %775,000

Table 7.1 Discounted Cash Flow (DCF) Analysis of the gas station

Year	Free Cash Flow ($)	Present Value ($) of Future Cash Flow ( 10%)
2007	100,000	90,909
2008	100,000	82,645
2009	100,000	75,131
2010	100,000	68,301
2011	100,000	62,092
2012	100,000	56,447
2013	100,000	51,315
2014	100,000	46,650
2015	100,000	42,410
2016	100,000	38,554
2017	Sale Price  400,000	154,217
Total		768,671

We would be buying it for $500,000 so we’d be buying it for roughly two-thirds of its intrinsic value. If we did the DCF Analysis it looks like Table 7.2

Table 7.2 Discounted Cash Flow ( DCF) Analysis of the 10 percent yielding low-risk alternative.

Year	Free Cash Flow ($)	Present Value ($) of Future Cash Flow ( 10%)
2007	50,000	45,454
2008	50,000	41,332
2009	50,000	37,566
2010	50,000	34,151
2011	50,000	31,046
2012	50,000	28,224
2013	50,000	25,658
2014	50,000	23,325
2015	50,000	21,205
2016	50,000	17,277
2017	Capital returned  500,000	192,772
Total		500,000

Not surprisingly the $500,000 invested in our low-risk alternative has a present value of exactly that – $500,000

Investing in the gas station is a better deal than putting the cash in a 10% yielding bond- assuming that the expected cash flows and sale price are all but assured.”

so above calculation, you see that buying the $500,000 is below the intrinsic value of a Gas Station. then the author gives the same example, in the stock market also.

the author says, ” The stock market gives us the price at which thousands of businesses can be purchased. We also have the formula to figure out what these businesses are worth, it is simple

When we see a huge gap between the price and intrinsic value of a given business – and that gap is in our favor – we can act and buy that business- and let’s take the of a well-known retail business, Bet, Bath, Beyond (BBBY).

I have to admit that I have never analyzed BBBY before. I have been to its stores a few times over the years, and it has been a pleasant experience.

As I write this, BBBY has a quoted stock price of $36 per share and a market cap of $10.7 billion.”

then the author calculates the intrinsic value of BBB Y’s company

the author says, ” What is BBBy’s intrinsic Value? let’s take a look at a few BBBY statistics a Yahoo finance, BBBY had $505 million in net income for the year ended February 28, 2005

Capital Expenditures for the year were $191 million and depreciation was $99 million. the ” Back of the Envelope.” net Free cash was about $413 million.

It looks like BBBY is growing revenues by 15% to 20% and net income by 25% to 30% a year. it also takes like it stepped up Capital expenditure (Opex) spending in 2005, let’s assume that free cash flow grows by 30% a year for the next three years and then grows 15 % a year for the following three years

then 10% a year after where. further, let’s assume that the business is sold at the end of that year for 10 to 15 times free Cash flow plus any excess capital in the business.

BBBY has about $850 million in cash in the business presently ( see table 7.3)

Table 7.3 Aggressive Discounted Cash Flow ( DCF) Analysis of Bed Bath and Beyond

Year	Free Cash Flow ($MM)	Present Value ($MM) of Future Cash Flow ( 10%)
Excess CASH		850
2006	523	475
2007	679	561
2008	883	663
2009	1016	693
2010	1168	725
2011	1340	758
2012	1478	758
2013	1625	758
2014	1787	758
2015	1967	758
2016	Sale Price 29,500	11,373
Total		19,130

so, the intrinsic value of BBBY is about $19 billion, and it can be bought at $10.7 billion. I’d say that’s a pretty good deal, but look at my assumptions – they appear to be pretty aggressive.

I’m Assuming no hiccups in its execution no changes in consumer behavior, and the ability to grow revenues and cash flows pretty dramatically over the years, what if we made some conservative assumptions?

We can run the numbers with any assumptions. the company has not yet released numbers for the year ended February 28, 2006, but we do have nine months of Data ( through November 2005)

We can compare November 2005 data to November 2004 data. Nine-month revenues increased from $3.7 billion to $4.1 billion from November 2004 to November 2005 and earnings increased from $324 million to $375 million. It looks like the top line is growing by 1% a year- going from 15% to 5% and its the final sale price is 10 times 2015 free cash flow the BBBY’s intrinsic Value looks like Table 7.4

Table 7.4 Conservative Discounted Cash Flow ( DCF) Analysis of Bed Bath and Beyond

Year	Free Cash Flow ($MM)	Present Value ($MM) of Future Cash Flow ( 10%)
Excess CASH		850
2006	469	426
2007	535	442
2008	604	454
2009	680	464
2010	751	466
2011	827	467
2012	901	462
2013	973	454
2014	1041	442
2015	1103	425
2016	Sale Price 11,030	4252
Total		9,604

Now, we end up with an intrinsic value of $9.6 billion.

BBBY’s Current Markt Cap is $10.7  billion. if we made the investment, we would end up with an annualized return of a little under 10%.

if we have good, low-risk, alternatives where we can earn 10%, then BBBY does not look like a good investment at all. so what is BBBY’s real intrinsic value?

My best guess is that it lies somewhere between $8 to $18 billion. And in these calculations, I’ve assumed no dilution of stock via option grants, which might reduce intrinsic value further.

With a present price tag of around $11 billion and an intrinsic value range of $8 to $18 billion. I’d not be especially enthused about this investment. there isn’t that much upside and a fairly decent chance of delivery under 10% a year. for me, it’s an easy pass.”

then the author comes the lesson of these examples,

the author says, ” We’re getting off track, the objective of this exercise is not to figure out whether to invest in BBBY stock. it is simply to demonstrate that while John Burr William’s definition of Intrinsic value is painfully simple, calculating it for a given business may not be so simple.

I think of BBBY as a fairly straightforward, low-tech, and simple business to understand. Even with its simplicity, we end up with a pretty wide range of its intrinsic value.

If we were to look at a business like Google. it starts getting very complicated. Google has undergone spectacular growth in revenues and cash flow over the past few years If we extrapolate that into the future, the business appears to be tracking at a big discount to its underlying and intrinsic value.

if we assume that not only is its growth rate likely to topper off, but that its core search business monopoly may be successfully challenged – by Microsoft, Yahoo, or some upstart – the picture is quite different. In that scenario, the current valuation of google might well be. many times it’s under intrinsic value.

The Dhandho way to deal with this dilemma is painfully simple: only invest in businesses that are simple- ones where conservative assumptions about future cash flows are easy to figure out.

What businesses are simple? well, simplicity lies in the eye of the beholder. Papa Patel bought a business that’s very easy to understand. the motel had a long history of revenues, cash flows, and profitability available for analysis.

From that data, it is not too hard to get a ballpark range of estimated cash flow that the motel is likely to generate in the future. Papa Patel also has a good handle on potential repairs and capital expenses that were likely to be required in the future based on the historical data and the condition of the property.”

then author explains the power of simplicity

the author says, ” simplicity is a very powerful construct. Henry Thoreau recognized this when he said, ” Our life Is frittered away by detail… simplify, simplify,” Einstein also recognized the power of simplicity, and it was the key to his breakthroughs in physics. he noted that the five ascending levels of intellect were, ” Smart, Intelligent, Brilliant, Genius, simple,”

for Einstein, simplicity was simply the highest level of intellect. Everything about, Warren Buffett’s investment style is simple. it is the thinkers like Einstein and Buffett, who fixate on simplicity who triumph. the genius behind E=mc2 is its simple elegance.

Everything about the Dhandho is simple, and therein lies its power. As we see in Chapter 15, the psychological warfare with our brains really gets heated after we buy stock.

The most potent weapon in your arsenal to fight these powerfully simple. there’s for why you’re to make a great, deal of money and unlikely to lose much. I always write the there down. if it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up excel, it is a big red flag that strongly suggests that I ought to take a pass.”

If you want to learn more about value investing, and finding great business, then buy this book from the following link

so this is all about the Intrinsic Value, from the book ” The Dhandho Investor” Chapter 7 written by author Mohnish Pabrai.

Read more Investing Articles

• The Intelligent Investor book
• Common Stocks and Uncommon profits Book
• One Up On Wall Street Book
• Stocks to riches
• Security analysis
• rich dad poor dad
• Money Game
• Financial Literacy