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Calculating The Value Of A Business - Part IV

By Joe Ponzio on July 24, 2007

By now, you have determined what your desired rate of return is. Personally, I like to use 15%. At that rate, my money will double approximately every 5 years. Why 15%? Considering that I have to find the companies, analyze them, say "no" to most of them, and patiently wait on the sidelines until an opportunity comes along, 15% is the minimum annual return I want to justify the work that I have put in.

Let's say that, like me, you want a 15% average annual return on your money. Let's also assume that you would ideally like to hold your company for at least twenty years—assuming you could continue to earn 15% for all twenty years. If that's the case, then we need to know what to pay today to earn 15% on tomorrow's cash.

The Future Cash

The key to valuing a business is projecting, with a degree of accuracy, the future cash that a business can produce. Difficult? Yes. Most companies do not have steady, consistent operations that lend themselves to accurate, or comfortable, valuations. If the company's operations are a roller coaster ride—up and down in an unpredictable cycle—it is nearly impossible to predict the future cash because there is no reason or data supporting your valuation.

If, however, a business has consistently and steadily grown its owner earnings for a decade or more, and assuming the business has not recently undergone a radical change, then it is possible to have confidence in your predictions and value calculation. The more consistent the numbers have been, the more confidence you can have.

What Is Consistency?

Consistency is not a firm, annual yardstick by which we measure the success of a company. When we look for consistency, we should look less at the actual numbers, and more at a chart of that consistency. It is easy to look at a set of data and quickly deduce that there is no consistency. However, a chart will allow you to better visualize your company in a long-term timeframe without focusing on a single year's performance.

One need not look further than Buffett's legendary purchase of Coca-Cola in 1988. At first glance, the owner earnings from 1978 through 1987 looked as inconsistent as they come, first dropping 14% from '78 to '79, then growing 100%, then 2%, 9%, 31%, 29%, -2%, 68%, and finally up 3% in 1987 from 1986's level. Where's the consistency? Look at the graph below to find it:

Coca-Cola Owner Earnings Graph

The green line is the actual owner earnings. The black line is a trend line. Coca-Cola's owner earnings were practically married to the straight trend line. Sure, they strayed a bit, but no company will be spot on. This is about as consistent as they come. What's inconsistent you ask? Take a look at Campbell Soup below:

Campbell Soup Owner Earnings Graph

Need I say more? Perhaps you can value and own this company. I don't want to work that hard.

Projecting Cash

Okay—you know your company's cash has been steady and predictable. Let's say it has grown about 14% a year. To find that, of course, you've looked at multiple timeframes throughout the ten years. Let's also say that your company had $10,000 of owner earnings in 2007. Based on its consistent past and operations, you may reasonably expect it to generate $11,400 (14% more) in 2008.

Why can you say that? Though business is very fast paced, businesses move like snails. They usually do not grow consistently for ten years—and then change course on a dime. Nor do they often swing up and down, and then turn into "old reliable" in a year. If your business has been consistent, you can reasonably expect it to stay that way. As you check in on it in the future, if you find things to be otherwise, you can take the appropriate action (buy more, sell, or hold).

Buying The Cash

At the beginning of this discussion, we assumed a 15% growth rate. That means we can not buy the company's $11,400 in excess cash for $11,400. We have to figure out what price we can pay today to earn 15% for one year and end up with $11,400. Fortunately, Excel® can do the leg work for us. To buy 2008's $11,400, we can pay $9,913.04 today and earn 15%.

Do the same thing for 2009 through 2015, growing the cash at 14% and then "discounting" it back to today at 15%. Then, for years 2016 through 2025, use a 5% growth rate in cash, and then discount it back at 15%. Add up all of your "discounted cash flows" and you'll have the price at which you can buy the projected cash and earn 15% a year for 20 years.

Add It Up

You know the net worth. You have a reasonable expectation of the cash flows and you have a purchase price. Add them up. Now, you have a company value. Three questions remain:

  1. Is it a wonderful company?
  2. How confident am I in my valuation?
  3. How much money should I invest?

Only you can answer those. And that, my friend, is how you value a business.

Other Posts In This Series

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

45 comments. Read them below or add yours!

 
 

The Discussion on Calculating The Value Of A Business - Part IV

Georgia said,
Hi Joe,

When we are looking to value a company in the financial services area, which meterics would we utilize to determine cash flow? I am thinking specifically of a brokerage firm and or a credit card company.

Thanks for your time!

Georgia
 
Joe Ponzio said,
Hello Georgia,

I know - Morningstar doesn't cover the financial sector yet. Probably because it is a little more difficult to get to the root of free cash flow/owner earnings.

Start your research at DowJones' Market Watch. They provide four years' worth of cash flow data—a good indication as to whether or not you need to continue your research.

If you want to investigate further, you'll need to head over to the SEC's EDGAR database (it's free) to look up the numbers from each year's annual report (Form 10-k).

In the financial sector, you'll want to remove any investment gains and realized investment gains from the stated Cash Flow From Operations. Then, don't forget to subtract the Purchase of Plant, Property, & Equipment—a business can't survive without them!

Hope that helps.
 
Georgia said,
Thanks so much!!
 
Josh said,
Joe,

I was referred to your website by a friend. I am new to investing, and currently have positions in 10 companies. I am not sure that I'm 100% confident in everyone of them.

I have read through the information on your website, and was curious to see how you'd go about valuing a company in an industry sector that isn't always rich in free cash flow as a result of capital expenditure. One example is UNT.

In your opinion, is a company like this too difficult to perform a reasonable valuation on (i.e. the rock analogy)?

Any thoughts you or anyone else can share would be greatly appreciated.

Thank you for the wonderful site!

-Josh
 
Joe Ponzio said,
Hi Josh,

The problem with companies that have consistently high capital expenditures is that they struggle through slow times and have a hard time generating cash through good times. This, of course, assumes the capital expenditures are fixed rather than tied to revenue. (An auto manufacturer or airline generally has fixed capital expenditures.)

Here's my thing: I don't fall in love with a company. With the thousands of available investment options, I look for "ideal" investing conditions. For me, an ideal company generates a ton of excess cash (relative to its size and above and beyond capital expenditures) - and does so with relatively little capital.

If I don't find that in a company, I move on.

Remember: All businesses have a value. But, also remember that a business that is eating more cash than it is generating is shrinking your investment rather than growing it. Every time it borrows money, sells stock, or otherwise raises funds, you end up with a smaller piece of the pie.

I'm not a gambler, so I'd pass on UNT and look for ATM-type businesses where the cash is always flowing.
 
Sanjay Shetty said,
In an interview available at http://bankstocks.com/print.asp?id=9881373 Buffet and Charlie M, mention that "When we try to determine a companyâ??s intrinsic value or its stockâ??s margin of safety, thereâ??s no one easy method. We use multiple techniques and models..."

Besides using the model which you mention on your blog, what other models are you aware that Buffet and Charlie might be using?

Thanks in advance :-)

Regards,

Sanjay Shetty
I blog at: http://indiainvestor.wordpress.com
 
mm said,
I use p/e model.
Here is the excel -
http://rapidshare.com/files/65316532/BUFFET_EXCELL_VALUATION.xls
 
Robert Crawford said,
MM,

Would you mind sending this to me directly at rcrawford@starlight.unc.edu? The download process at the referenced site presents a problem with my browser.

I'll share any upgrades I create from it with you.

Robert
 
mm said,
Robert Crawford

Check your mail.
 
Robert Crawford said,
MM,

My mistake. I left out a portion of the email address. It should be:

rcrawford@starlight.sph.unc.edu

Thanks for being patient with an old academic.

Robert
 
kfh227 said,
Wow,

All these years, and that is all there is to DCF and FCF?

Joe. I think you should get a pat on the back as that was the most well written discussion on investing I have ever read on the internet. I know hter e is more to learn, but talk about leading a horse to water.

All that is left is to go over your JNJ Excel spreadsheet and "reverse engineer" it to make sure I understand everything to DCF/FCF based valuation.

I want you to know the following. In all my years of investing (about 7 now), I think this past hour was the best single hour I have ever spent reading about investing.

I feel like an idiot thinking about how I valued stocks in the past (I relied heavily on PE). And now, I even think I understand the problem with valuing financial companies more so now than ever.
 
kfh227 said,
I think I have a good question.

Does one need to consider dividend or yield at all? It sems like DCF/FCF might already implicate yield into the equation but I'm not sure.

My thoughts are as follows. Let us assume that you get a 2.5% yield from JNJ which is 2% after taxes (for simplicity) and you want a 15% annual return. Should you actually use a discount rate of 13% (15%-2%)? This way, you would guarantee (hopefully) a 13% return via capital appreciation and 2% via dividends.

Or should the yield just be considered icing on the cake?
 
Dave Miller said,
KFH227,

The day a stock goes ex-dividend, the value of the dividend is removed from the price of the stock (the stock decreases by the amount of the dividend) and will eventually be deposited into your brokerage account. There is no change in the value of your stock position. In theory you haven't been made any better or worse off because of this dividend, and all it amounts to is a cash flow transaction in your brokerage account. Therefore you should not decrease your discount rate by the dividend yield of a stock.

Most people think of a dividend as free money as you wait for the stock price to appreciate. They forget that they are "robbing Peter to pay Paul" and there is not any change in their stock position value when they receive a dividend.

Dave Miller
 
Edward said,
I have read this series and everything was clear until the last few paragraphs. I understand what Shareholder Equity is ( Part 1 ). I don't see how that is used in determining value ( parts 2, 3 and 4 ). I understand completely the math behind projecting the cash forward and then discounting backwards. However, these calculations don't use the Shareholder Equity, so how should I gauge what a "good" value is for Shareholder Equity?
 
Tommy V said,
I just went trough your example above...I understand that to buy 2008's $11,400, we can pay $9,913.04 today and earn 15%. That is 13% less...how did you get to 13%? how did you come up with a number of 2% less? Di I invest $11,400 in 2007 then another $9918 in 2008 to maintain 15%.

What is tha actual formula....

Thanks,

Tom
 
Hari said,
Excellent work! Very, very helpful.

One question... after calculating net present value of futue cash-flows + shareholders' equity, you divide it by # of shares outstanding and that gives you intrinsic value per share. I understand it so far...

But, how would you do that in case of Berkshire - it has class A and class B shares. It doesn't make sense to add # of shares outstanding for both classes and use such total in above division. So how do I get intrinsic value per share of class B only?

Thanks.

Hari
 
Joe Ponzio said,
Edward: There is no "good" or "bad" value for shareholder equity. It just is. If a company is asset-heavy, you will likely pay more than a company that is asset-light. In the event of a break-up or closure, the asset-heavy business can sell the assets and distribute the cash to shareholders. The asset-light business relies more on cash flow and leaves little left for shareholders in a break-up. Then again, you'll generally pay more for the asset-heavy business because of that. Make sense?

Tommy V: The formula is the discounted cash flow over a time period using a certain rate. I know: It sounds greek. Excel can do it quickly using the NPV or PV formula. If you want to understand the advanced math behind it, check out this Wikipedia article on the discounted cash flow formula.

Hari: You need to divide the total value by the pieces to figure out the value per share. In the case of Berkshire, you would divide by the total outstanding shares by using the total outstanding "A" shares + the total outstanding "B" shares x 30. That "30" is because 30 B shares are equal to 1 A share.
 
Jason said,
Hey Joe, great site at first glance. The name alone appeals to me. I've really been wanting to delve into value investing but I'm having a hard time with the calculations. I have an awesome bank that has a pretty detailed screener on it. However, I'm having trouble figuring out what numbers to plug in where and what info I need to be screening for. Is there anywhere I can go to find out how to employ somewhat of a "Buffett Method" so I can create a custom screener to figure out the value of a company and whether or not I should be buying it?

thanks
 
Joe Ponzio said,
Jason,

My advice would be to look at as many companies as you can. If you limit your search to companies with rapidly growing earnings, high returns on capital, and low debt, you'll wind up with a few real gems. You'll also miss out on some companies that may be generating tons of cash and just about ready to explode.

If your bank allows you to screen by free cash flow, that's probably the best place to start - companies with positive and growing FCF. Once you've exhausted that screen, broaden your results. Keep going until you're crosseyed or you found some opportunities.

Hope that helps!
 
Jason said,
Thanks Joe. Could you help a little with my choices please? For "rapidly growing earnings" my choices are these:
LTM Revenue
LTM Income from Total Operations
LTM Income from Continuing Operations
Last Twelve Months EPS Continuing Operations
Last Twelve Months EPS Total Operations

For "high returns on capital" I have these:
Return on Assets
Return on Equity
Return on Invested Capital
Return on Assets: 5 Year Average
Return on Equity: 5 Year Average
Return on Invested Capital: 5 Year Average

For "low debt" I have these:
Long Term Debt
Debt/Equity Ratio
Long Term Debt/Equity Ratio

Which of those would you use in the screener? It does allow me to choose FCF and I will use that for the screen.

Thanks for an awesome sight and great info!
 
Tim2 said,
Joe,

I have a question about valuations...

I am very careful about looking at what the company does with it's free cash flows. Does it buy back stock? Pay dividends? Increase equity? Pay off debt? etc...

There is somethings that's not making sense to me about how the cash flow sheet and balance sheet correlate.

I was looking into a company called Patterson-UTI Energy Inc (PTEN). And what I noticed was this... The net issuance of debt in the cash flow sheet is greater than the increase in total liabilities on the balance sheet. Why is this? Logic tells me that an increase in issuance of debt should be reflected in an equal or greater increase in total liabilities.

I've been looking for answers on the net but am having trouble finding the answer I'm looking for.

TIM
 
mm said,
Tim
check this link:
http://pages.stern.nyu.edu/~adamodar/
 
Joe Ponzio said,
Tim,

When a company assumes, say, $1 million worth of debt, the majority of that will head to the long-term liabilities category. Interest and the principal payments due in the next twelve months goes on the short-term liabilities side of things. So, if $1 million was borrowed and a total of $50,000 in interest and $30,000 of principal were due in the first twelve months, it would look something like this:

ST Liabilities: $80,000
LT Liabilities: $970,000
Cash flow from financing: $1 million

Make sense?
 
Tim2 said,
Joe,

Yes that does make sense, thanks...

I have another question! This is also in the financing section of the Cash Flow sheet.

When I am trying to establish wether management is being rational with the free cash flow they make, what I am doing is this....

I try to make sure that when I add the following:

1. Shareholder equity increase from previous year
2. Share buybacks
3. Repayment of debt
4. Dividends Paid out

that the total of these 4 things is at least equal to the Free Cash flow for that year...

Are there any other areas that a company can spend money in a 'good' way that I should be aware of?

Tim
 
Joe Ponzio said,
Absolutely! Companies can (and often do) spent their cash on "assets" to increase revenue and profit margins, ultimately hoping to generate more cash. Those "assets" can be on-the-balance-sheet assets like physical plants, techonology, etc. or human assets such as sales people.

You won't be able to track every penny of cash for that exact reason. If I want to increase our cash flow at the company, I'm going to hire another adviser and burn cash initially while training and supporting him or her, with the ultimate hopes of watching that adviser grow, provide additional revenue, and ultimately generate excess cash for the firm.

You'll never see that on our balance sheet (save maybe a desk, computer, etc.) but it is the absolute best way for us to increase future cash flow, and ultimately the value of my business.
 
edward said,
This is a great start thank-you Joe. If you were Graham and didn't rely as much on future projections how would you go about finding the intrinsic value of a company?

Thanks for your help!
 
miguel.s said,
Joe-

I've been using your method now for two weeks or so (ever since I found this great site) and have picked out a great company that seem very strongly underpriced (i.e., intrinsic value >> than market capitalization).

How do I know how confident I am in the valuation?

My findings disagree strongly with the analyst research I've dug up (they mostly say, hold or market perform, and some even claim to be using a discounted cash flow method). Since I've just started, I was hoping that other research would confirm what I found. What to do?

At the same time, I also saw that analysts aren't all agreeing on JNJ or AEO, two companies you've mentioned as undervalued...

Don't know if you'd need to know, but the company is BDK.

It seems like each company is so different that even though the model seems great, it's hard to figure out what to do when rubber hits road. I know that some more examples (even historical ones or with identities removed) would help me.
 
(MikeR) said,
Miguel,

FWIW, I have come to the same conclusion as you regarding BDK and have bought some at 80, then 70, and I have recently sold March 65-strike puts to maybe get some more BDK, or pocket a little cash.

Mike
 
Howard said,
You're right, BDK valuation looks really good. I'm getting about 74% MOS, and CROIC looks nice. The brand name is a kind of moat I suppose, although I'm kind of weak on determining moat. I would say that perhaps the moat isn't very strong given that other brands like Dewalt are known for high quality giving the others stronger pricing power. Another possible flag for BDK is the high debt to equity (about TD/E is about 1).
 
Joe Ponzio said,
If the analysts knew what the heck they were talking about, they wouldn't be analysts - they'd be billionaire private money managers crushing the markets! Analysts tend to be very short-sighted - What's this stock going to do for the next three to twelve months?

Analysts generally equate "risk" with short-term price volatility when the two are completely unrelated if you are looking at and valuing a business.

Retail is getting clobbered right now, and that may continue for the next 6-months, year, 5 years. Of course they will hate AEO and other retailers - their stock prices are falling! Six months ago, they hated Wal-Mart. Then, WMT ran up almost 20% and they loved it. Now, they hate it again because it's retail.

JNJ - is there any fundamental business risk? Not that I'm aware of. Maybe the stock won't move for a year; maybe it will rise or fall 20% in six months. The real question: Will JNJ be making more money five years from now than it is today? If the answer is a resounding yes!, who cares what the analysts say?

Don't ask: Am I confident? Ask yourself, Why am I not confident?

What is holding you back from jumping on Black & Decker? What are the risks to its business - not this year, but five years from now?

If you are unsure of your strategy, go back in time and make yourself confident by running analyses on various companies in various timeframes. If you are confident in your strategy, but unsure of your valuation, you should probably skip it.

Before you put any money to work, you need to believe you are stealing a business because you are confident that you know about where that business will be in five or ten years. If you don't see that in BDK, move on.
 
Carson said,
If you look at the company information on Black and Decker's web site, you will see that Dewalt is actually one of Black & Decker's companies. They also list Porter-Cable and Delta there as well. If they own all these "competitors", it seems they have a corner on the power tool market. That was a big boost to my confidence when looking at BDK.
 
Howard said,
Carson,

Wow, that's very useful info. To me that is pretty big moat. And with the valuation this does look very attractive. I'm going to try and investigate any other risks from the SEC reports and independent news and go from there.
 
Alex said,
I'm a finance major graduating this semester....and I can honestly say I have learned more about valuation through this series of articles than I have in four years of undergrad. A classmate of mine told me about the site and he also felt the same way. Please keep up the amazing work. Thanks!
 
miguel.s said,
@ Joe: Thanks, as always. I have jumped on BDK, and I feel like I'm stealing the company, and that is exactly what is making me nervous. (My doubting voice is asking: How am I more right than a lot of people who do this for a living?) Your site is helpful in instilling confidence, but I still don't feel the force running through me.

"If you are unsure of your strategy, go back in time and make yourself confident by running analyses on various companies in various timeframes."

I think I previously asked about this. How are you generating those "price follows value" charts that you've put up in several places? Using forecast data, or something else. Once you truly believe price follows value, then you can be a worry-free investor.

Re BDK: My intention wasn't to make this thread about one particular company, so maybe I shouldn't have mentioned it, but I do like the company's products, mainly because of DeWalt. In fact, I basically started 'filtering' companies by going through my day with awareness tuned to products I use and really like. BDK was the first company like that where the valuation model gave a "buy signal", and a pretty strong one to boot. But I could come up with reasons that in five years things might be worse (e.g., maybe the housing crisis puts so many home builders out of work that the second hand market is flooded with DeWalt tools...).
 
Manish said,
Hi Joe,

Yes article is indeed looks very good for learners. It has simplified many things said and mentioned so far but never elaborated.

One simple question - Just wondering if the world now knows the investing art of legendary W Buffet then why still we have only one Buffet? There has to be something which is yet not revealed or its always less or more context specific which can never be formulated.

Rgds
Manish
 
Joe Ponzio said,
Manish -- there is only one Buffett, but plenty of others have made millions and billions doing the same thing. I know Beethoven's Fur Elise when I hear it; I can play it on the piano too. Though we may never see another "Beethoven", we can certainly enjoy the copycats who produce beautiful music.

Will there ever be another "Buffett"? I can almost guarantee it, though it took him fifty years to become the world's richest man and he's still going. We'll see another, but probably only after Buffett is long gone and others can crawl out of his shadow.
 
Manish said,
Joe,

Yeah! you are right in your explanation.

I am trying to use your valuable excel for FCF based evaluation. While trying to determine the FCF definition i come across this article (http://seekingalpha.com/a...) which says that FCF definition is different for different people.

Whats your difnition of FCF among following?

1) As per Buffett - net income from "operations" plus depreciation and amortization minus capital expenditures.
Net income from operation - Is it cash flow from operation or Net Profit?

2) Investopedia and Wikipedia definition
-Cash provided by operations less capital expenditures
-Cash provided by operations less capital expenditures and dividends paid
-Net income plus depreciation less capital expenditures EBITDA less capital expenditures

As usual thanking you in anticipation of your answer to above.

-Manish

 
Ethan Bloch said,
Just discovered your site today and took the liberty of reading through a few posts, including all the posts Calculating The Value Of A Business.

I believe you do quite a good job of explaining difficult ideas and methods in easy to follow steps. And really enjoyed your method of how you deicde your discount rate, as the conventional way is to discount the cash flows in regards to the riskiness of those cash flows, and as Buffett has said in the past if you've done your homework the cash flows can become pretty much riskless, and therefore he had recommended using the 30 year gov't bond rate, or risk free rate. Being that rates are so low today this just doesn't work and I had been using a hybrid to determine my discount rate. But your logic, at first glance, appears to definitely work, in a sense you are building your margin of safety into your discount rate... very intriguing.

I am slightly concerned you didn't mention that depending on the kind of business you are evaluating, the way to evaluate the cash flows and equity could be tremendously different. In the most obvious example valuing Shareholder Equity $1 for $1 is a scary assumption. As if most companies were forced to liquidate it is very unlikely their assets would be sold $1 for $1. In reality $.20 on the $1 is a very real possibility.

Furthermore to assume a company which has a huge chunk Goodwill or Intangibles could pay out all of it's shareholder equity is another extremely risky assumption, as in most cases these kinds of Asset's don't easily liquidate into Cash and again when they do are usually worth less then $1 for $1. In the good cases large amounts of goodwill and intangibles mean this company will continue to grow it's owners earnings at a nice clip while maintaining high profit margins and returns on equity, because they have some valuable competitive advantages represented in their high Goodwill and Intangibles estimates. However you get paid for this competitive advantage when you calculate your discount model i.e. through the growth rate. So in many senses adding shareholders equity in to your discounted cash flow estimate in many cases will make you think you are getting a better deal then you really are.

I know this is a massive comment, I'd love to chat more with you on the topic, so feel free to shoot me an email.

I think what you are doing for the little guys... that's US! is awesome. Keep it up.

Cheers.
Ethan
 
Edward said,
I have read this series several times and I always get stuck at the last 2 sections.
To quote Joe ...

"To buy 2008's $11,400, we can pay $9,913.04 today and earn 15%."

I understand that completely. What I need to do is calulate the value of a share though, not the discounted owner earnings.

"You know the net worth. You have a reasonable expectation of the cash flows and you have a purchase price."

I agree, I can find the first two. I do not know what the "purchase price" is. I know it must be a simple formula, but how do I calculate a price-per-share from my discounted owner earnings and net worth?
 
Eric said,
Edward,

You said: "I understand that completely. What I need to do is calulate the value of a share though, not the discounted owner earnings."

Apparently you didn't. The value of a business ARE the discounted cumulated owner earnings. It's basically what the owner will get from the business from now until the day it closes.

If you know the discounted cumulated owner earnings you just have to divide it by the numbers of outstanding shares to get your price-per-share.
Of course there is a level of uncertainty in the future owner earnings. To make sure that a mistake in the estimation is not hitting you too heavily you should buy the business with a margin of safety. The bigger your uncertainty is, the bigger should be your margin of safety.

Therefore your purchase price should not only depend on a "simple formula". It should depend on your level of confidence in estimating the future owner earnings.

Cheers,
Eric
 
Edward said,
Eric,

Thank you for responding, I am getting closer to an answer. Please understand, I am not looking for a formula to tell me whether to buy a stock or not, I am purely seeking knowledge here. I understand that once I have a "value" for the entire business, I divide by the # of shares and get a "value per share". That is what I am ultimately seeking so I can compare to the current "price per share" on Wall Street.

As you stated ...

"If you know the discounted cumulated owner earnings you just have to divide it by the number of outstanding shares to get your price-per-share."

So, the net worth ( shareholder equity ) from part 1 of this series doesn't enter into the equation at all?

Part 1 says "value per share" = shareholder equity / # shares. This is current "net worth".

Parts 2-4 show how to discount the owner earnings.
Now, "value per share" = discounted owner earnings / # of shares.

The Excel spreadsheet formula is (shareholder equity discounted owner earnings) / # shares.
It seems to me that shareholder equity should already include the owner earnings, which are therefore being counted twice.

This is where I'm getting confused. Does shareholder equity include the current cumulated owner earnings or not ? If not, then the spreadsheet formula makes sense and part 1 should be changed to net present value = (shareholder equity current cumulated owner earnings).
 
Eric said,
Edward,

Don't confuse yourself too much. You're obviously on the right way when you say, that you're purely seeking knowledge.

Joe said in his part 1 "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."
He then goes on with: "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."

Therefore according Joe's definition Shareholder Equity doesn't include the discounted cumulated cash. The intrinsic value of the company includes both.

Personally I don't include shareholder equity in my valuation as I like to make my valuations as easy as possible and I also like to be a bit more conservative in finding the right price. But I know that it would be more accurate to consider it as well.

Cheers,
Eric
 
billy said,
Good question Manish I have the same one!

Whats your difnition of FCF among following?

1) As per Buffett - net income from "operations" plus depreciation and amortization minus capital expenditures.
Net income from operation - Is it cash flow from operation or Net Profit?

Buffett seems to use adjusted net income as opposed to cash from operations, is this correct Joe?
 
Joe Ponzio said,
Free Cash Flow=Net Cash From Operations - Capital Expenditures

Owner Earnings = Net Income Non-Cash Charges (Depreciation, etc.) - Capital Expenditures

Free Cash Flow is a proxy for Owner Earnings for certain companies. For others, the two can be greatly different.

Buffett uses Owner Earnings.
 
Siddharth Shukla said,
Hi joe,
Excellent site for value investors... i am glad i discovered your site in the beginning of my investing career.
I have read a couple of books and certain articles on DCF Valuation and most of them seemed to add the terminal/residual value(value of the company at a small growth rate of 1-3 % to perpetuity) at the end to the discounted cash flows. Does the Shareholder's equity roughly equal terminal value of the company??? please help me this is the only doubt i have about your methodology
 

Join the Discussion on Calculating The Value Of A Business - Part IV

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