Chapter 2: Introducing Intrinsic Valuation and Business Valuation


We are in a world where we don't know the fundamental value of any asset

Raghuram Rajan
In 2011,Prannoy Roy, a TV presenter conducted an Interview with Warren Buffett—known as the Oracle of Omaha—who addressed the students at a business school in India. Prannoy Roy asked Buffett “What do the Business Schools need to teach?” and Warren said, "If you are going to be in the business of Investing one should learn how to Value a Business".

Who are Investors ?


Some people look at Companies such as Apple, Facebook, Google, Tesla, Microsoft, etc., and are fascinated by them, working day in and day out in hopes of building a company like that of their own. These people are called Entrepreneurs. The underlying message of their work is to Change the World.

Then there is a set of people - the likes of Warren Buffett, Carl Icon, George Soros, Peter Lynch, and of course, some of you who study companies and ideas, and strive to understand their worth. These are the Investors. The quintessence of their ideology is to understand what the market is ignoring.

What is Intrinsic Value ?


Intrinsic Valuation is about Forecasting Cash Flows from today to infinity and discounting back with the cost of capital one may expect, to obtain the Present Value. The Discounted Cash Flow (DCF) Model is used as a tool to compute intrinsic value. These cash flows consists of two parts :

  • Cash Flows during the forecast period
  • Cash Flows post the forecast period (Terminal Period)

The value augmentation of a company occurs primarily during the forecast period. During the post forecast period - also referred to as the Terminal Period - the assumption is that the company could be

  • The Free Cash flows will grow at the Terminal Growth Rate.
  • The Free Cash Flows will grow at the Inflation Rate.
  • The Free Cash Flows will remain constant.

The cash flows generated during these periods belong to Lenders (Debt) and Shareholders. The present value of these cash flows is called the Enterprise Value. The Enterprise Value less Debt will be called Shareholder Value of the Company / Business. Therefore:

  1. Enterprise Value = Shareholder Value + Debt Value (includes all interest bearingobligations)

  2. ShareholderValue = Enterprise Value - Debt (Further the Company's Statement Of Affairs may also contain Non-Operating Balance Sheet elements such as cash, securities, investments & other assets and minority interest & other liabilities that are not utilized for generating operating cash flows which may need to be added or subtracted to arrive at the Shareholder Value).

  3. IntrinsicValue/Shareholder Value /Business Value therefore is:
    • The Present Value (PV) of Operating Cash Flows After Tax (operating profit less investments less tax) during the forecast period, plus
    • Present Value of Terminal Value of the company's business. (The value of cash flows generated post the forecast period), plus
    • Cash & Marketable Securities and other investments (The income from these investments should not be included in cash flows from operations), minus
    • Minority Interest and Other Liabilities, minus
    • Debt and Long-Term Obligations

Cash flow from operations is operating cash inflows less operating cash outflows. Cash inflows is operating profit and cash outflows is fixed assets investments, net working capital (NWC) investments and income tax.

The cash flow from operations is estimated for each year in the forecast period, which is then discounted back to the present. The cost of capital or the Weighted Average of the Cost of Debt Capital and Cost of Equity Capital (WACC) is used to discount the cash flows. The Present Value of Terminal Value is the cash flow post the forecast period to perpetuity, discounted back to the present.

Discounted Cash flows (DCF) is the only method where one may truly understand How to Value a Business or How to Value a Company. The DCF process takes into account all value drivers including growth, margins, investments, cost of capital etc. to arrive at an estimated value of a company or business.

A Simple Example of Computing Intrinsic Valuation


Table 1 demonstrates the computation of the Present Value of Cash Flows for a forecast period of 5 years with a discount rate of 11% and the present value of terminal value.

Table 1

Year 1 2 3 4 5
Cash Flow 1000 1500 2000 2500 3000
11% Discount Factor 0.901 0.812 0.731 0.659 0.593
Present Value of Cash Flow 900.9 1217.4 1462.4 1646.8 1780.4
Cumulative PV of Cash Flow 900.9 2118.3 3580.7 5227.5 7007.9
Inflation 2%
WACC 11%
Discount Factor 1 / (1.11) n
Cumulative PV of Cash Flow 7007
PV of Terminal Value 20178
Debt & Obligations 1000
Intrinsic / Shareholder / Business Value 26185

Notes:

  1. The computation of terminal values assumes there will be only inflationary growth in cash flows.
  2. The computation of terminal value will be explained in Chapter 18 of the book.
  3. Readers should read Chapter 4 - Time Value of Money and Discount Factor for better understanding of discounting and terminal value.

Intrinsic Valuation is about forecasting cash flows from today to infinity and discounting back with the cost of capital one may expect to obtain the Present Value