A couple of years ago a good friend of mine bought me a subscription to the Rothery Report, a value investing newsletter. The newsletter is published quarterly and contains a model portfolio of value stock picks. It features a list of stocks along with value oriented price ratios such as price to earnings (P/E), price to book value (P/B), price to sales (P/S), price to cash flow (P/C) and dividend yield.

From this report I came across Book A Million (Nasdaq: BAMM) which I purchased in October of last year for $3.00 per share. It looked quite cheap based on its P/E ratio (3 times 2008 earnings) and dividend yield (12%). But was it really cheap?

**Ratios**

Ratios are the lazy man’s way of investing. They serve as a great starting point to identify potentially undervalued companies. However, they do not have a strong theoretical footing when it comes to valuation. A retailer that sells for 0.8x sales versus another similar business that sells for 1.8x is not necessarily a better deal. You need to understand a lot more about certain key aspects of the business: the annual free cash flows, relevant growth rate, and capital structure (how much debt versus equity). Ratios also don’t convey by how much a company is over or undervalued.

**Discounted free cash flow**

So how do you value a business? In my opinion there is only one way that holds water. That method is to discount the free cash flows from the businesses. Free cash flows are the cash that the business generates in excess of all costs and what it needs to reinvest. Theoretically, the business should be able to pay out these funds in the form of dividends.

In fact, this valuation methodology has not changed much from when it was formally put forward by John Burr Williams in 1938. This is the approach that Warren Buffett uses:

*In The Theory of Investment Value, written over 50 years ago,**John Burr Williams set forth the equation for value, which we**condense here: “The value of any stock, bond or business today 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 asset.” Note that the formula is the same for stocks as for bonds…*

* *

*The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.*

– 1992 Berkshire Hathaway Chairman’s letter

Clearly any investor worth his salt needs to be able value a business using a discounted cash flow approach. So let’s work through a simple example. Once we have mastered the basic case we can move on to looking at larger and more complicated businesses. Please bear in mind that this is a very simplified example.

**An example valuation **

The business: a profitable, private, one location coin laundromat business.

Revenue – $100,000

Costs – staff, rent, electricity, taxes – $80,000

Net income $20,000

We will assume that in this business there are no accounts receivable, accounts payable, inventory or other working capital items. Some more assumptions:

- Depreciation (included in earnings) – $2800
- Capital expenditures (capex) – $2000
- Growth rate – 2% (to match inflation)
- Required rate of return – 15%

**Step 1**

The first step in our example is to determine the annual free cash flow:

Net income $20,000

Plus: depreciation $2,800

Less: capex ($2000)

Total $20,800

**Step 2**

The next step is to take the $20,800 of net annual cash flow and determine how much it is worth as an ongoing income stream. We will use the growing perpetuity formula to do this. This formula takes the annual cash flow and says that it will grow by a fixed percentage amount every year. Then it discounts the future values for each year back to today using the required rate of return. We are assuming a growth rate of 2% and a required rate of return of 15%.

Here is our formula

Value =

FCF (1+g)

r – g

Where “FCF” is the free cash flow in the base year, “g” is the growth rate and “r” is the required rate of return.

$20,800 (1 + .02)

(.15 – .02)

= $163,200

**Step 3**

Let’s review the results. So our business that generates $20,800 of free cash flow will be worth $163,200.

This could be realistic for a public company but unlikely for the coin laundromat in our example. A small private business requires owner involvement that could result in a higher required rate of return. Also this investment in not easily tradeable in pieces like common stock so requires a higher return. Plus there are no barriers to entry (easy for new competitors to open up next door) so it might not be realistic to expect that the cash flow will growth at the rate of inflation forever.

So let’s move onto a real public company and use the skills we just learned. Again we will keep our analysis simple.

To be continued…