Calculating The Value Of A Business – Part IV

July 24, 2007 by Joe Ponzio

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:

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:

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.

A Note From Joe Ponzio

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