# How do you value a business?



## patch (May 28, 2009)

Hi there,

I'm working my way through The Intelligent Investor, reading a lot of blogs and websites, on how to value a business. Primarily I've been reading the FWallStreet site here: http://www.fwallstreet.com/blog/25.htm.

Am I on the right track? What do some of the people here to do analyze the value of a business? 

Thanks!


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## Andrew (May 22, 2009)

Here is how I approach it. 

1) Forecast free cash flow (FCF) for x years (known as the explicit forecast period)

How to calculate FCF

EBIT = Revenues - COGS - SG&A - Depreciation - Amortization for Goodwill + Adjustment for Operating Leases 

NOPLATPA (Net Operating Profit Less Adjusted Taxes Plus Amortization For Goodwill) = EBIT - Taxes on EBIT +/- Increase in Accumulated Deferred Taxes + Amortization For Goodwill

FCF = NOPLATPA + Depreciation +/- Increase/Decrease in Working Capital - Captial Expenditures - Increase in Capitalized Operating Leases - Investment In Goodwill - Net Increase in "Other" Assets +/- Non Operating Cash Flows +/- Increase/Decrease in foreign currency translation adjustments

2) Once you have FCF forecasted for x years (x depends on predictability of FCF) discount the FCF by WACC (Weighted Average Cost of Capital). 

You can estimate WACC using the Capital Asset Pricing Model (CAPM) or use Cost of Debt + Equity Premium (which I prefer).

3) Calculate a Terminal Value which essentially is a perpetuity of FCF from year x onwards.

TV = NOPLATPA * (1 + g) / WACC

NOPLATPA for year x
g = long term growth rate of NOPLATPA

4) Present value the Terminal Value (TV) and add the PV of the FCFs forecasted earlier for the explicit forecast period.

5) To the sum above add...

+ ECMS (excess cash and marketable securities) 
+ Non Operating Assets 
+ Excess Real Estate (after tax)
+ Pension Fund Over/Under funding (after tax)

= Value of the company

6) From the above total subtract...

- Short Term Debt
- Long Term Debt 
- Capital Leases
- Capitalized Operating Leases
- Preferred Stock
- Minority Interest
- Warrants / Options (use black scholes to calculate value of the options)

= Value of the equity of in the company

7) Divide the value of the equity / Number of common shares outstanding = Value Per Share

Hope I didn't leave anything out. I typically demand a 33% margin of safety on my calculated intrinsic value per share before I buy.


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## Brad911 (Apr 19, 2009)

patch said:


> What do some of the people here to do analyze the value of a business?


I've outlined in detail *here* how I approach a fundamental analysis of any stock I purchase.


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## Robillard (Apr 11, 2009)

Patch,

Andrew has outlined the valuation methodology for a discounted cash flow analysis using free cash flow to the firm. There are other valuation methodologies though, such as ones using free cash flow to equity, dividends and residual income. What makes valuation more of an art than a science is projecting the future cash flows (regardless of which basis is used) and determining the correct discount rate. 

Some analysts also do valuation by multiples, but in my opinion, this is better done as a sanity check. The use of valuation multiples is also a bit of art rather than a science, since rarely, if ever, does one ever encounter two companies with almost identical operations. In my work I often review companies for comparability (for profitability benchmarking rather than for the application of valuation multiples). Let me just say, there are almost always reasons to reject a potential comparable. Determining appropriate adjustments can be just as tortuous than projecting future cash flows.

Are you sure that you need to do valuations? As someone who has studied valuation methods formally, I don't really think it's something I would want to do in my spare time unless I had a lot of money at stake or someone was paying me. There are significant fudge factors introduced by the assumptions that the analyst makes, particularly as they relate to the projection of future cash flows. A bad valuation may be worse than no valuation at all.


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## Andrew (May 22, 2009)

Thanks Robillard for clarifying that my method was a discounted cash flow analysis.

I wrote that post in haste last night and intended to add the DCF detail at the top .


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## patch (May 28, 2009)

Thanks for all the responses, it's very helpful! 

Do I need to do valuations? Nope, mostly an indexer but I figure this is one of those things that's good for you.


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## leslie (May 25, 2009)

It is only necessary to 'value' a stock if your strategy is to pick stocks using absolute valuations. There are a few different ways to come up with that value.

But I think most retail investors use relative valuations. Before you move beyond ETFs you need to learn what your strategy options are. Pick the one that suits you.


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## OntFA (May 19, 2009)

Robillard said:


> There are significant fudge factors introduced by the assumptions that the analyst makes, particularly as they relate to the projection of future cash flows. A bad valuation may be worse than no valuation at all.


Pay close attention to this part of Robillard's response. I think it's the most important part. Andrew laid out a detailed explanation and set of formulas that, as far as I can tell, is all technically accurate. But he forgot the most important part - how on earth do you forecast all of the variables necessary (i.e. revenues, profit margins, capital expenses, etc.) to arrive at even a ball park cash flow number.

In other words, Andrew's post - while interesting - amounts to saying: _forecast the future and I'll show you how to value a stock_. But if you can forecast the future, you don't need anybody's help.


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## Rickson9 (Apr 9, 2009)

I've written about how I pick a company on my web site at http://www.ticonline.com


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## Andrew (May 22, 2009)

OntFA said:


> Pay close attention to this part of Robillard's response. I think it's the most important part. Andrew laid out a detailed explanation and set of formulas that, as far as I can tell, is all technically accurate. But he forgot the most important part - how on earth do you forecast all of the variables necessary (i.e. revenues, profit margins, capital expenses, etc.) to arrive at even a ball park cash flow number.
> 
> In other words, Andrew's post - while interesting - amounts to saying: _forecast the future and I'll show you how to value a stock_. But if you can forecast the future, you don't need anybody's help.


The value of forecasting FCF and the DCF model is that you can measure sensitivity based on different scenarios. 

When doing a valuation I usually ask myself...

What is the best case scenario?
What is the worst case scenario?
What is the expected scenario?

This will give you a range of value and give you an idea of what the market in pricing into the stock. 

As well you can apply best guess probabilities to each scenario and come out with kind of an "expected value".

Someone said it best in a post above though. Valuation is sometimes more of an art than a science .


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## Rickson9 (Apr 9, 2009)

If you can't tell it's a deal in 5 seconds, then it isn't.


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## Andrew (May 22, 2009)

Rickson9 said:


> If you can't tell it's a deal in 5 seconds, then it isn't.


I disagree.... I have done a deep dive on a few securities that I initially thought were an amazing deal on first glance that turned out to have hidden skeletons. 

- Off balance sheet financing 
- Pension liabilities
- Dilutive option/warrant compensation
- High probability of impairment charges (future write downs)
- Other accounting wizardry

On the other side of the coin I have also found a few great buys on securities that I initially thought were overvalued on first glance. Some deep dives have revealed..

- Tax loss carry forwards that added value 
- Assets on the balance sheet at book value did not represent fair market value

In conclusion I don't like that quote at all. I think the quote should be.. "If it looks like a good deal in a 5 second glance do the du-diligence and make absolutely sure."


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