So, the intrinsic value of BBBY is about $19 billion, and it can be bought at $10.7 billion. BBBY has about $850 million in cash in the business presently (see Table 7.3).
Further, let’s assume that the business is sold at the end of that year for 10 to 15 times free cash flow plus any excess capital in the business. Let’s assume that free cash flow grows by 30 percent a year for the next three years then grows 15 percent a year for the following three years, and then 10 percent a year thereafter. It also looks like it stepped up capital expenditure (capex) spending in 2005. It looks like BBBY is growing revenues 15 percent to 20 percent and net income by 25 percent to 30 percent a year. (FCF = Net Income plus Depreciation, which is a non-cash expense minus Capital Expenditure) The “back of the envelope” net free cash flow was about $408 million.
Capital expenditures for the year were $191 million and depreciation was $99 million. What is BBBY’s intrinsic value?īBBY had $505 million in net income for the year ended February 28, 2005. We know BBBY is being offered on sale for $10.7 billion. Here is how his explanation goes –Īs I write this, BBBY has a quoted stock price of $36 per share and a market cap of $10.7 billion. Mohnish then uses this concept to a real-life retail business that is Bed Bath and Beyond (BBBY). We also have the formula to figure out what these businesses are worth. The stock market gives us the price at which thousands of businesses can be purchased. Investing in the gas station is a better deal than putting the cash in a 10 percent yielding bond-assuming that the expected cash flows and sale price are all but assured.
Not surprisingly, the $500,000 invested in our low-risk alternative has a present value of exactly that-$500,000. If we did the DCF analysis on the 10 percent yielding low-risk investment, it looks like Table 7.2. We would be buying it for $500,000, so we’d be buying it for roughly two-thirds of its intrinsic value. As Table 7.1 demonstrates, the gas station has an intrinsic value of about $775,000. I used a Texas Instruments BA-35 calculator to do these discounted cash flow (DCF) calculations.
Are we better off buying the gas station or taking our virtually assured 10 percent return? Let’s say that we have an alternative low-risk investment that would give us a 10 percent annualized return on the money. Free cash flow-money that can be pulled out of the business-is expected to be $100,000 a year for the next 10 years. Further, let’s assume that the gas station can be sold for $400,000 after 10 years. To illustrate let’s imagine that toward the end of 2006, a neighborhood gas station is put up for sale, and the owner offers it for $500,000.
He then goes on to explain this concept using the example of a gas station – Per Williams, the intrinsic value of any business is determined by the cash inflows and outflows-discounted at an appropriate interest rate-that can be expected to occur during the remaining life of the business. Else, Confucius wouldn’t have said that life is really simple, but we insist on making it complicated.Īnyways, coming back to this chapter from Mohnish’s book, he expands on John Burr Williams’ concept of calculating intrinsic values by discounting future cash flows. Though I am sure a lot of readers would not like such a simplistic approach to calculating values, for our minds generally don’t accept things that are simple and rather search for things that are complex (which make us look and feel smart). I would recommend you read this book in its entirety, and especially this chapter for it explains one of the most critical aspects of the investment process i.e., intrinsic value calculation, in its simplest sense. One of my favourite chapters from the book is “Dhandho 102: Invest in Simple Businesses.” Here, Mohnish explains the concept of intrinsic value and also why, for most investors, it pays to identify simple businesses and then buy them at prices that provide sufficient margin of safety. The premise of Dhandho investing is, as is repeated time and time again in the book is simple – Heads, I win tails, I don’t lose much. Dhan-dho, literally translated, means “endeavors that create wealth.” The street translation of Dhandho is simply “business.” What is business if not an endeavor to create wealth? Dhan comes from the Sanskrit root word Dhana meaning wealth. One of the best books I’ve ever read on investing, and one written in a simple language, is Mohnish Pabrai’s The Dhandho Investor.ĭhandho (pronounced dhun-doe) is a Gujarati word.