Calculating The Value Of A Business - Part I

By Joe Ponzio on July 19, 2007  |  16 comments

The Greater Fool Theory is a belief that you can buy a stock at any price and sell it to some other, bigger fool for a profit. In times of ever-increasing markets, this theory often shows itself to be true. Still, reality must come crashing down at some point. It always does. And that is precisely when great fools lose tons of money, and great investors come to life.

There is definitely no shortage of fools in the market. In their ongoing quest for short-term profits, fools will, with absolute disregard for value, drive prices up and down wildly. And they will invariably screw up—to the ultimate profit of smart business investors.

Let's take some investing advice from Warren Buffett, and use it to determine how to value a business.

Understanding Market Mania

The key to investment success is to identify which companies will rise in price—faster and longer than the others. Over the long term, the price of an investment follows its value. To know whether or not an investment's price will rise in the coming years, you need to purchase that investment at a discount to its value and then hope that value will rise.

Buffett says,

In the short run, the market is a voting machine but in the long run it is a weighing machine.

On a day-to-day basis, the fools will fly bad companies high and drive wonderful companies down—and vice versa. Over time, however, the markets will drive the price of great companies up—and that of bad companies down.

Understanding Value Vs. Price

One of the most misused terms on Wall Street is "value". Stocks are commonly referred to as "undervalued" or "overvalued" in reference to whether or not they are attractively priced. The reality is such that a stock can never be under- or overvalued—merely under- or overpriced. The value of a company at a given point in time is fixed, the price moves rapidly above or below that value as the fools play with the stock.

As Warren Buffett tells us:

Price is what you pay, value is what you get.

In other words, no matter what price you pay for a stock, you end up with the same amount of value.

Putting Them Together

What is the world's greatest investor telling us? Simply this—if you buy $1 worth of a growing business, and you spend less than $1 to get it, you will make money in the long term. Is that a guarantee? No—but it is as close as you can get, and certainly more of a sure thing than Wall Street is offering.

What Is The Value Of A Business?

When determining the value of a company—and hence, the price you should pay for its stock—you need to know the company's intrinsic value—its value as an ongoing business. The intrinsic value is the value of a company's operations if it had to rely on operations alone to grow and pay its bills. Though at first glance that may seem obvious, it is not always so. Too many companies rely on taking on debt, selling assets, or issuing stock to fuel their growth or sustain operations. These actions all serve to reduce the company's value.

Mr. Buffett?

The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.

Intrinsic value is comprised of two things—the Shareholder Equity of the company today and the discounted value of the cash that can be taken out of the business. Let me put that into Plain English.

Shareholder Equity

Shareholder Equity is a company's net worth. It is essentially the sum of money investors would be entitled to if the company stopped operations, sold off all of its assets, paid off its debts, and distributed cash to owners.

When you buy a company, you are entitled to your fair share of its net worth if the company closed up shop. A quick way to understand this is to think in terms of a small business. If two business partners decided to close down and go their separate ways, they would each take half of the equipment, signs, etc.

When you buy a stock, you are becoming a partner in the business—along with thousands of other investors. Should your company close down, you would be entitled to your share of the desks, signs, etc.

Why Shareholder Equity Matters

Most investors do not concern themselves with Shareholder Equity because they do no believe that their company will ever go out of business. Maybe they're right. Still, Shareholder Equity is a base that protects you from years of slow growth, from competitors tapping into your company's markets, and from a "worst case scenario" of your company closing down or being forced to liquidate.

Shareholder Equity is easily found on any balance sheet of any company. For example, take a look at Berkshire Hathaway's Shareholder Equity. In 2000, an investor in Berkshire would have been entitled to his or her share of $61.7 billion if the company was liquidated. In 2006, that same investor would have been entitled to share in $108.4 billion if Berkshire closed down.

Moving On

Take a look at Part II of Calculating A Business' Value—the discounted value of the cash that can be taken out of the business. Don't worry—technology has made it pretty easy to figure out.

Other Posts In This Series

Calculating The Value Of A Business - Part II
Calculating The Value Of A Business - Part III
Calculating The Value Of A Business - Part IV

Also Filed Under "How to Value a Business"

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• Calculating The Value Of A Business - Part III
• What's Happening with Research and Development?
• Calculating The Value Of A Business - Part II