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GROWTH WITH VALUE

How to Value a Business

Steps to finding Intrinsic Value
Alistair Cowley

Through this eBook I hope to simplify the valuation process for the novice investor by
deciphering the sometimes confusing and complex information offered in many
investment publications and setting out an easy to follow, step by step process in
how to value a business.

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 Table of Contents
1 About ................................................................................................................... 1
1.1 Growth with Value ......................................................................................... 1
1.2 The Author .................................................................................................... 2
1.3 Disclaimer ..................................................................................................... 3
2 Overview .............................................................................................................. 5
2.1 Why I wrote this eBook ................................................................................. 5
2.2 Overview of Value Investing .......................................................................... 5
3 Market Overview .................................................................................................. 7
3.1 Market Sentiment .......................................................................................... 7
3.2 ‘Mr Market’ .................................................................................................... 7
4 Stock Filter ........................................................................................................... 8
4.1 Stock Screeners ............................................................................................ 8
4.2 Filters ............................................................................................................ 8
5 Checklist ............................................................................................................ 11
5.1 Overview ..................................................................................................... 11
5.2 Values and Principles .................................................................................. 11
5.3 Business Characteristics ............................................................................. 11
5.4 Financial Characteristics ............................................................................. 13
5.5 Management Characteristics....................................................................... 20
5.6 Ethical Characteristics ................................................................................. 22
6 Margin of Safety................................................................................................. 23
6.1 Overview ..................................................................................................... 23
6.2 Another Approach ....................................................................................... 25
7 Calculating the Investor’s Required Return / Discount Rate .............................. 26
7.1 Overview ..................................................................................................... 26
7.2 Inflation ....................................................................................................... 27
7.3 Equity Risk Premium ................................................................................... 27
7.4 Risk Free Rate ............................................................................................ 28
7.5 Other Methods ............................................................................................ 28
7.6 Summary ..................................................................................................... 28
8 Determine the Intrinsic Value ............................................................................. 30

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 8.1 Overview ..................................................................................................... 30
8.2 Obtaining the Data ...................................................................................... 30
8.3 Calculating the Projected Growth of a Company......................................... 39
8.4 High Growth vs. Terminal / Stable Growth Period of a Company................ 40
8.5 The different Methods of Calculating Intrinsic Value ................................... 42
8.5.1 The Benjamin Graham Formula .................................................................................... 42
8.5.2 Discount Cash-Flow Method (DCF) ............................................................................... 47
8.5.2.1 Comments on Cash Flow and Earnings Data ................................... 55
8.5.3 Dividend Discount Method (DDM) ............................................................................... 57
8.5.4 Residual Income Method (RIV) ..................................................................................... 63
8.5.5 Balance Sheet Methods ................................................................................................ 72
8.5.5.1 Book Value ........................................................................................ 72
8.5.5.2 Liquidation Value ............................................................................... 75
8.5.5.3 Net Current Assets Value .................................................................. 79
8.6 Comparing each Intrinsic Value .................................................................. 81
9 Summary ........................................................................................................... 83
9.1 A quick recap .............................................................................................. 83
9.2 Thank you ................................................................................................... 84
10 Glossary ............................................................................................................ 85
11 Resources ......................................................................................................... 91

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How to Value a Business Chapter 1 - About

1 About
1.1 Growth with Value

Growth with Value, along with this eBook, has been created for the Value (or
aspiring to be!) Investors out there. Growth with Value’s primary goal is to break
down the complexity behind stock valuation as well as investing in general. We hope
this eBook provides you with an easy to read guide which you can refer to when
determining in which businesses you would like to invest.

We aim to invest in what we deem to be well principled businesses. For each

individual it is important to understand your own values and principles and
incorporate these into your investment decisions. For example, I would like to grow
my wealth by investing in businesses which endeavour to; serve their
community/customer bases, have minimal negative impact on our planet, take
measures to mitigate their footprints by using green technology where possible, do
not exploit their workforce, people or animals, do not produce any harmful,
dangerous or addictive products and finally, businesses whose products and/or
services are based on helping improve the lives of their customers.

I believe that having a list of life principles and morals on which to base daily
decisions and help guide our investment choices is very important. My aim is to help
you develop your own life principles (if you haven’t done so already), as well as
recommend some great investment resources and publications to help you achieve
this. Everything starts with that first step, which is usually the hardest of the whole
journey, and hopefully we can help guide you and greatly reduce your investment
risk along the way.

All the information and valuation techniques in this eBook and on our website,
www.growthwithvalue.com, have been derived from researching a mass of
information about Value Investing. On the Resources Page there is a list of books
and other resources which have been used to obtain this information, some of which
I highly recommend. I don’t claim to be a stock picking expert or guarantee your
results if you choose to use some of my methods. Growth with Value should be seen
as a site to aid you in establishing Intrinsic Valuations of businesses and to share
knowledge on Value Investing and investing in general.

Value books to grow your knowledge.

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How to Value a Business Chapter 1 - About

1.2 The Author

If you have stumbled across this eBook, chances are that you are on the same
journey as me, trying to understand Value Investing and how to calculate the Intrinsic
Value of a business. Since discovering Value Investing, I now realise that the share
market provides investors the opportunity to buy shares in real businesses, not just a
platform to speculate and hope for the best. It made sense to me that by buying
quality businesses at fair value greatly increased my chances of success.

Since this discovery, I have made it my goal to be the best investor that I can be. To
achieve this goal, I first needed to understand exactly what Value Investing is, so I
have been soaking up as much information as possible by studying books, articles,
websites and online forums, as well as listening to podcasts and watching numerous
documentaries. I soon realised there is a lot of valuable information available to the
novice investor provided by highly acclaimed investment professionals. The only
problem was it took me a long time to understand what it all meant.

Straight after school, at the age of 18, I started work as an apprentice industrial
electrician. After my four-year apprenticeship I moved into a different business group
within the same corporation where I was employed. My new role was to manage,
operate and maintain water treatment plants. Looking back on my work, I now realise
that it has many correlations with Value Investing. My work requires me to follow
strict procedures to ensure the continuity of safe and clean drinking water for the
public. You could say it is similar to an investment checklist, using it to ensure that
nothing has been overlooked. Also, I have to analyse data from the various
treatment plants to determine any abnormalities, which is similar to reading a
business’s financial report and looking for any warning signs. I also have strict
parameters to follow to maintain water quality, with key indicators I use to monitor
the potential for any water quality incidents. This is similar to using a stock screener,
where I incorporate filters to monitor the market for any potential investment
opportunities. Trends and historical graphs are also used and monitored to ensure
that water quality is not drifting outside certain parameters, similar to analysing the
financial history of a company, looking for growing earnings or falling debt as a
positive sign that the company is headed in the right direction.

Given my background isn’t in the financial sector, I found it somewhat difficult at first
to understand many of the publications and investment theories that I came across.
Eventually things started making more sense, and I came to realise that for me to
satisfy what had become a passion for finance and investment, I would have to learn
how to become a Value Investor. It became clear to me that the principles of Intrinsic
Value and Value Investing aligned with my views of what true investing (as opposed
to speculation) is all about.

By the time I was nineteen I had already been investing for a few months. I was a
novice investor at the time but was lucky enough to start my investing career in 2009

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How to Value a Business Chapter 1 - About

after the Global Financial Crisis had made its impact, so as luck would have it, most
of my investments were made at a large discount to their Intrinsic Values, without me
even realising. I had a mixed bag of mainly Blue-Chip shares as well as a few
speculative stocks. I soon realised that my greatest investment at the time was
saving my money. As I was on a small wage, I managed a tight budget which
allowed me some free cash flow which I could then allocate to my investments.
Budgeting and managing my spending is still the most important financial decision I
have made. It helped me understand the importance of maintaining a positive cash
flow.

I experienced reasonable returns in my first 6 years, slightly outperforming the

Australian Stock Exchange ASX 200 Accumulation Index (largest 200 companies
listed on the ASX, which includes dividends paid out by the companies) by about 25
to 30%. This period was a learning process for me and since mid-2015 to mid-2019
my portfolio has outpaced the ASX 200 Accumulation Index by 95%. Since its
inception (early 2009), my portfolio has returned about 330%, at an annual
compound rate of 15%, compared to the ASX 200 Accumulation Index which
returned about 200% or 11.3% compounded annually.

In those first few years I realised that I had too many holdings, making it impossible
to monitor them all. I also didn’t realise the benefits of investing in businesses that
had a strong financial history, zero or little debt, good profit margins and positive
indicators of future growth. I also had no understanding of the principle of
ascertaining the Intrinsic Value of a business which has now become fundamental to
all my investment decisions.

I hope that you enjoy this eBook and the website www.growthwithvalue.com and that
they are of some value to you.

1.3 Disclaimer

The information contained on www.growthwithvalue.com website (the "Service") or

from this eBook “How to Value a Business” is for general information purposes only.

Growth with Value assumes no responsibility for errors or omissions in the contents
on the Service.

In no event shall Growth with Value be liable for any special, direct, indirect,
consequential, or incidental damages or any damages whatsoever, whether in an
action of contract, negligence or other tort, arising out of or in connection with the
use of the Service or the contents of the Service. Growth with Value reserves the
right to make additions, deletions, or modification to the contents of the Service at
any time without prior notice.

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How to Value a Business Chapter 1 - About

www.growthwithvalue.com website and its products may contain links to external

websites that are not provided or maintained by or in any way affiliated with Growth
with Value

Please note that Growth with Value does not guarantee the accuracy, relevance,
timeliness, or completeness of any information on these external websites.

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How to Value a Business Chapter 2 - Overview

2 Overview
2.1 Why I wrote this eBook

Establishing the Intrinsic Value of a business is just one of the important steps that
Value Investors will take before investing in a business. As the great man Warren
Buffett says, “Price is what you pay, value is what you get”.

There are many different approaches to calculating the Intrinsic Value of a business.
You will find that some methods are more suited to certain companies than others.

As you will see, each approach can give you a very different result; even the same
method can give large differences in a business’s value. This is mainly due to the
fact that future predictions of growth or earnings etc. are required to achieve a
valuation. Different investors will have a greater emphasis on certain fundamentals,
e.g. Growth Rates, Return on Equity, Earnings per Share, Free Cash Flow, Debt, the
list goes on.

Through this eBook I hope to simplify the valuation process for the novice investor by
deciphering the sometimes confusing and complex information offered in many
investment publications and setting out an easy to follow, step by step process in
how to value a business. You will discover that understanding the Intrinsic Value of a
business is one of the best ways to reduce risk, achieved simply by not overpaying
for a stock. If a business is trading below its Intrinsic Value, chances are the market
will eventually realise its error and come to its senses and the share price will
increase accordingly. In the meantime, the market’s undervaluation might be your
chance to snap up “a wonderful company at a fair price” – Warren Buffett.

A great business is not a great investment if you pay too much for it.

2.2 Overview of Value Investing

I. Stock Screener – applying a stock screener to help find the businesses that
may fit into your valuation criteria is very beneficial. As there can be
thousands of businesses listed on a stock exchange, it can be very difficult to
find those that are worthy of your time to investigate further
II. Create a Checklist – this will be used to analyse a potential investment. The
benefits of this include; ensuring that consistent valuations are performed
across all your investments, help mitigate against business failure, prevent
you from overlooking vital points of analysis, gives you the ability to analyse
the business on numerous qualitative and quantitative levels, ability to learn
from and prevent previous mistakes from recurring by including them into your
checklist and finally, it will give you the peace of mind that you have
completed a thorough investigation of the business being considered

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How to Value a Business Chapter 2 - Overview

III. Margin of Safety – this is perhaps the most important step in valuing a
company. Using a Margin of Safety will help reduce the affects which may
come from any incorrect forecast of future growth and any unforeseen events
which may negatively impact the business
IV. Determine the risk – decide what your required minimum return will be to
compensate you for the risk inherent in your investment. Known as the
Discount Rate or the Investor’s Required Return, this will be used to calculate
the Intrinsic Value of a business by discounting future returns back to a
present-day value
V. Determine the Intrinsic Value – how much is the business really worth? By
using tested methods of determining Intrinsic Value, you can give yourself a
chance to find those wonderful businesses that are undervalued by the
market
VI. Back yourself – having applied the above steps in the evaluation process and
decided upon a business that matches your criteria, you should then back
your hard work and make the investment knowing that you have done
everything in your power to mitigate the risk and to establish the value

The most difficult part in investing is remaining disciplined.

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How to Value a Business Chapter 3 - Market Overview

3 Market Overview
3.1 Market Sentiment

What makes Value Investing so great is that it removes the stress of trying to predict
the market and in which direction it may be headed. Having said that, it does still pay
to keep an eye on where the market and the domestic/global economy is at. You can
ask yourself questions like; are we in a Bull or Bear Market, what returns can I
expect, when was the last market correction or crash and in turn what are the
chances of one recurring, at what level are interest rates, bond yields and inflation
and in which direction do they look to be heading? Some of these indicators like
inflation and bond yields are used in the valuation process of a company as well as
calculating your expected returns.

When it comes to Value Investing, economic indicators are not imperative, but it still
pays to give them some attention. The reason the Value Investor doesn’t need to
worry or predict where the market is at is because the investor is buying a quality
business below its Intrinsic Value. The investor is confident in the fundamental
qualities of their investment and is just as confident that the price paid for the
company will see good returns in the long haul, regardless of any market fluctuations
in the interim.

By only investing in quality businesses at discounted prices, you will guard

against the rollercoaster ride that is the global economy.

3.2 ‘Mr Market’

Benjamin Graham best describes the stock market, and the chaos that comes with it,
in his book ‘The Intelligent Investor’ with his ‘Mr Market’ analogy.

He describes ‘Mr Market’ as having similar characteristics to a manic-depressive

person, who is very emotional, temperamental and often irrational. Basically ‘Mr
Market’’ is offering you, each day, the opportunity to purchase shares in a business.
Some days he is very optimistic and asking inflated prices for his shares of the
business, and other days he is very pessimistic about the business he is selling, and
this is reflected in the discounted price he is asking for his shares.

It also is important to note that Benjamin Graham states that ‘Mr Market’ is there to
serve you, and will never be offended, even if you keep refusing his offers day after
day. Instead, you wait patiently for him to be in one of his pessimistic moods and
present you with the opportunity to buy shares in a business at discounted prices.
After all, the market in the short term is a voting machine and in the long run, a
weighing machine. Meaning that in the short term the market can be quite inefficient
however in the long term the market will eventually reflect the true value of a
business.

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How to Value a Business Chapter 4 - Stock Filter

4 Stock Filter
4.1 Stock Screeners

Using a stock screener is a great way to help filter out stocks that are not worth your
time investigating. By including certain criteria in your screening process like low
amounts of debt, consistent growth, certain industry sectors, high returns on equity
and market capitalisation, you can quickly limit the number of companies that
warrant further investigation. There are many different criteria that you could use to
help identify the company in which you would like to invest.

Here is a list of some sites with a free global stock screener:

• https://finance.yahoo.com/screener/new (probably has the widest range of

criteria that is available for free and for the global market)
• www.investing.com/stock-screener (has a reasonable selection of criteria
available free, not quite as comprehensive as yahoo)
• www.morningstar.com (you will be required to create a free account to use
their service, and their range of criteria is not as comprehensive as the others)

Have a play around with these stock screeners and chose one that you find simple,
easy to use and understand. There are many others out there; this is just a select
few that I have found useful. Also, if you currently have a brokerage account it will
generally have some sort of stock screener available for your use.

4.2 Filters

Listed below are a few filters that I personally use to help me find the businesses that
I would like to further investigate. These aren’t supposed to be hard set rules and
criteria; you may find that you will need to adjust some filters to find a reasonable
amount of stocks for your further investigation. I usually like to filter the number of
stocks down to about 15 – 20 if possible. From there I have a quick look at what
each company does and if it is a business that I understand, and which meets my
values.

1. The first criterion that you can use to filter stocks is simply to filter out the
industry sector or sectors that don’t match your ethical values. If you are
happy to consider all sectors, then just skip this first filter.
2. Next apply filters that represent the competency of management, profitability
of the business in relation to its investments, equity and assets and how
efficient the business is at generating profits. These ratios are best used to
compare like for like businesses. For example:
a. Return on Equity (ROE) > 10% - 15% – Measures the profitability of the
business against the shareholders’ equity employed in generating
those profits

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How to Value a Business Chapter 4 - Stock Filter

b. Return on Capital (ROC) > 5% - 10% – Measures the profitability of the

business against shareholders’ equity plus long term debt, to ensure
management is using debt wisely
c. Return on Assets (ROA) > 5% - 10% – Measures profitability against
the business’s total assets. If the company has no debt this should be
the same as ROE
d. Net Profit Margin > 5% - 15%1 – Measures the efficiency of the
company’s operations. It is the amount of money retained from each
dollar of revenue after all expenses have been paid, including interest
3. Now we can look at the debt of the company. This will help mitigate risk and
filter out those companies that are highly leveraged and vulnerable to failure if
they were to experience any downturn in their business. Different sectors tend
to have different levels of debt, but as a blanket rule excessive debt is never
good.
a. Debt to Equity Ratio < 0.5 - 0.82 – Measures the amount of debt in
relation to the company’s equity. If this number is above 1 then that
means the company has more debt than it does equity (property,
buildings, equipment, inventory etc.)
b. Interest Coverage Ratio > 5 – Measures the company’s ability to keep
paying its interest expenses. Having a ratio of 5 will mean that the
interest expense could increase 5 times and still be covered by the
company’s pre-tax income
c. Current Ratio > 1 – Measures the company’s ability to pay its current
liabilities from its current assets (the Quick Ratio is more conservative
as it excludes things like inventory as they generally are more difficult
to convert into cash)
4. Next is to filter out those companies that aren’t able to increase their earnings
and are not profitable. Depending on the functionality of the stock screener
that you use, you can hopefully choose a time frame for the growth
calculations. The longer the period the better, 10 years is ideal.
a. Free Cash Flow Growth > 5% - 10% – Measures how much cash the
company has left after all expenses are paid and that this amount of

1 It is best to compare Profit Margins between businesses within the same industry. This is due to the
fact that some industries have higher Profit Margins in comparison to others because of lower
operational costs and the ability to charge more for goods and services. Due to these factors,
industries like Financial Services and Technology (Software and IT Services) will have better Profit
Margins when compared to other industries like Airlines and low-end Retail and Supermarkets.
2 Some industries may require a higher Debt to Equity Ratio than others. Industries which have a

greater demand for capital (to maintain or build new property, plant and/or equipment) will most likely
see an increase in the need for Debt. These industries include businesses that manufacture, produce
or refine their products. Telecommunications and Transportation industries can also have a greater
requirement for debt to maintain infrastructure, e.g. railroads, airplanes, telecommunication cables
etc. For these industries we would not want to see Debt to Equity levels of greater than 1.0. The
Financial Sector, in particular banking, will have even greater levels of debt which is generally
acceptable. This is because debt is a bank’s main business. They borrow large amounts of money
and then loan this money to their customers, generally at a higher interest rate. For banking, a Debt to
Equity of no greater than 2.5 to 3.5 is acceptable.

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How to Value a Business Chapter 4 - Stock Filter

free cash is continuing to grow (this can be substituted for EPS Growth
> 5% - 15%)
b. Revenue Growth > 5% - 10% – Measures how much the company is
receiving from its products and services; basically, the money coming
into the business. If it is steadily growing it’s a positive sign that the
company will continue to prosper
c. PEG < 1 – Measures the Price / Earnings Ratio (P/E Ratio) compared
with the forecast earnings growth of the company. If this number is
greater than 1it indicates the company may be overpriced

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How to Value a Business Chapter 5 - Checklist

5 Checklist
5.1 Overview

This will be one of your most important tools when investing in a business. Having a
checklist will ensure that you have all bases covered and have not forgotten
anything. A checklist can also grow as you grow as an investor. If you make a
mistake or one of your investments fail, you can perform an analysis of this
investment to find any points that you may have missed in your original evaluation
which you can now include in your checklist for the next time, ensuring not to make
the same mistake again.

The components of my preferred checklist are outlined below.

5.2 Values and Principles

As far as possible I like to invest in a business that reflects my personal values and
principles. We will only quickly cover this topic here, but if you are interested in
finding out more, I would suggest looking in the Resources section of this eBook for
relevant books on personal development.

Having your values and principles written down can be of great benefit, not just for
making investment decisions but also for general life choices. Your values and
principles can be referred to whenever a decision needs to be made. By doing this
you will hopefully avoid any rash decisions and you can be confident that, as far as
possible, the outcomes will be in line with your principles.

It can be as simple as not investing in companies that manufacture, promote or sell a

certain product that goes against your values. You will just need to decide what is
important to you and implement that into you daily decisions as well as your
investments.

5.3 Business Characteristics

If there is anything that you should take away from this section, it’s that you
understand the business you are investing in. Understanding a business is essential
when valuing that business, as it will help you in making forecasts of growth and
earnings as well as establishing the business’s long-term viability.

Common checklist items to help determine the quality of a business are:

1. How well do I understand the business – as mentioned earlier, it is vital for

you to understand what it is the business does and be able to clearly explain
it.
2. How strong is the economic moat of the business – this is a measure of
the business’s competitive advantage and ability to increase prices without
fear of losing customers. A strong moat comes from strong brands or a high

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How to Value a Business Chapter 5 - Checklist

threshold of entry, meaning for another company to compete would require it

to undertake a major capital expense to start up a similar business. Some
other ways a company can create a strong moat is to build the business
across great locations that are highly populated like how McDonalds and
major supermarkets like Coles and Woolworths choose to locate their stores,
or if the business controls a large area that can be hard to penetrate like a
shopping mall or when a mining company has control over a large area that is
rich in resources. Also, companies like Apple ensure its products are
extremely compatible with other Apple products but not so with different
brands or operating systems like Android. A huge network or client base can
help create a strong moat; for instance, Google is now a household name and
its search engine has a massive user base which would be hard to penetrate.
3. How recession proof is the business – does the company sell essentials
rather than discretionary items. This will be important in times of economic
uncertainty or during a recession as people will be more likely to limit their
spending on discretionary items but will continue to buy those items which are
essential for their daily living.
4. Does the business have multiple income streams – this is in relation to its
customers where ideally you would like a business that doesn’t rely heavily on
a single contract or where the majority of its earnings come from a handful of
large contracts.
5. The business doesn’t rely on a single product – be wary if the company is
only selling one specific item, if there is a chance for that particular item to
become redundant or go out of fashion this would be detrimental to the
business.
6. Has the business successfully expanded its business or product
offering into multiple locations – this is akin to a franchise. This may
indicate the product or business can be further expanded into new locations
whilst continuing to grow its profits.
7. Is the business free from governmental influences – does the business
along with its products receive any government rebates or subsidies or is
required to pay any levies; if so, be aware of the impact on its sales if these
subsidies were removed or levies increased and if there was a change of
government.
8. What phase is the business in; Start-up, Expansion or Mature Phase –
the start-up phase is the riskiest time for a business, but it can come with high
rewards. In the expansion phase, a business is growing both its brand and
products whilst growing its revenues through expanding those products into
new locations and markets; this is generally the safest stage for the investor.
Finally, we have the mature phase; this is where the company has no more
easy options for expansion and is at most risk of losing market share to new
competitors.
9. Is the business operating in a popular sector or field – if the business is in
a popular sector it could result in the share price trading well above its

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How to Value a Business Chapter 5 - Checklist

Intrinsic Value. It may well be a stable and strong company, but if there is a lot
of media attention and high expectations surrounding it then this should be of
some concern. An example of this is the tech bubble in the late 1990’s that
greatly impacted tech industry businesses in the USA or likewise the mining
boom which Australia experienced between 2003 and 2008.

Beware of bubbles

5.4 Financial Characteristics

Financial characteristics are considered when conducting a Quantitative or

Fundamental Analysis of the business. To analyse the financial strength of a
company you will be using the annual or bi-annual financial statements of a
company. You will be analysing the company’s balance sheet, income statement and
cash flow statements in particular. It is helpful to calculate your results on a per
share basis; this will avoid any surprises in a company’s earnings due to changes in
the number of shares it has on issue.

1. Does the company consistently grow its earnings or earnings per share
(EPS) – EPS that are consistently growing is usually a good sign that the
company is operating well.
2. Does the company consistently generate positive operating cash flow –
a history of positive operating cash flow suggests that the company is able to
maintain and expand its operations, as it is the measure of the amount of
cash that is generated from the normal operations of the business.
3. Free Cash Flow is increasingly growing at a consistent rate – Free Cash
Flow is similar to Warren Buffett’s Owner Earnings. This is the net earnings
remaining after expenditure outlaid on expanding or maintaining the business.
Free Cash Flow is generally a better measure of a company’s financial health
as it is funds that can be taken out of the business without disrupting normal
operations.
4. Is the company using shareholders’ money wisely – is the company
creating at least one dollar of market value for each dollar of retained
earnings? Ideally, we are looking for a ratio greater than 1. It is best to
calculate this ratio over a longer timeframe to avoid any short-term
fluctuations in price. For example, over a 10-year period we calculate the
change in share price and divide that by the total retained earnings over the
same period to give us our answer. To calculate the retained earnings per
share you simply take the dividends per share (DPS) from the earnings per
share (EPS)

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = 𝐸𝑃𝑆 – 𝐷𝑃𝑆

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How to Value a Business Chapter 5 - Checklist

A worked example using ASX Listed Company CSL Limited (CSL):

Fiscal Year Ends in June

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Share Price ($)3 35.0 30.0 32.0 33.5 38.5 60.5 68.0 90.0 113 135
Earnings ($) 1.27 1.92 1.85 1.74 1.89 2.62 2.86 3.81 3.61 3.81
Dividends ($) 0.41 0.53 0.75 0.80 0.81 0.96 1.16 1.39 1.72 1.72
Retained Earnings ($) 0.86 1.39 1.1 0.94 1.08 1.66 1.7 2.42 1.89 2.09

First calculate the change in share price over the 10 years. This is achieved
by taking the average share price for June 2008 ($35) from the average price
in June 2017 ($135) which equates to $100. Now add each year’s retained
earnings over the ten-year period which gives a total of $15.13. Finally,
calculate the Retained Earnings vs Market Value Ratio (RE/MV) which is:

𝑅𝐸 /𝑀𝑉 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒/𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠

= $100 / $15.13

= 6.61

(This means for every dollar retained and reinvested by the company there has been
a $6.61 increase in share price.)

5. Can the company maintain earnings growth after acquisitions – if the

company is one which makes numerous acquisitions, it may need to raise
capital, which in turn can end up diluting the existing shareholders’ value by
negatively impacting the Earnings per Share (EPS). But if the company is able
to continue to grow its EPS whilst raising capital it is a good sign that the
merger or take-over has added value to the shareholders. When a company
announces a take-over bid, there are a few points that may help to determine
if it will be a successful acquisition:
a. Does it have previous successful experience with acquisitions
b. Is it a similar business with a similar or complimentary culture
c. Is the acquirer a larger business than the targeted business
d. A public company acquiring a private company may attract less media
hype which in turn may result in a lower price to be paid (price is what
you pay, value is what you get – Warren Buffett)
6. Is the PEG Ratio less than 1 – the PEG ratio is the P/E (Price/Earnings) ratio
divided by the earnings growth rate of the company. A ratio of less than one
generally means that the current P/E ratio is acceptable. Generally, the
earnings growth used for this calculation is either EPS or Net Profit after Tax
(NPAT). You can either calculate growth rates yourself by using the

3 I have used a yearly average which will help eliminate any share price fluctuations.

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Compound Annual Growth Rate (CAGR) formula (see section 8.3 Calculating
the Projected Growth of a Company) or it can be found at websites such as
Yahoo Finance, MSN Money or Morningstar.

𝑃𝐸𝐺 = 𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 / 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐺𝑟𝑜𝑤𝑡ℎ

For example, if a company has a P/E Ratio of 25 and the EPS are growing at
a compounded rate of 30% then:

𝑃𝐸𝐺 = 25 / 30
= 0.83

If we were to just look at the P/E Ratio of 25, we may think that this company
would be overpriced, but by including the growth rate of the business (30%),
we can see that a P/E Ratio of 25 may be acceptable.
7. Abnormal items are not consistently affecting the earnings – it is
important to look for any abnormal or non-recurring items that may have
affected the company’s earnings. These can either have a positive or negative
impact of the final earnings the company reports. If this is the case and there
has been a significant abnormal item reported in the company’s financial
statements it is prudent to remove these from your analysis of the company to
get a more accurate picture of the normal (operating) earnings of the
company. But beware of ‘recurring’ non-recurring items, meaning a company
can report something as being abnormal on a regular basis, which would
make it not that abnormal and maybe should be included when calculating its
earnings.
8. Is the company able to maintain or improve its profit margins – profit
margins are an indication of how much the company keeps after expenses
and is expressed as a percentage. It is calculated as Profit / Sales (Revenue).
It is measurable using different earnings figures such as Gross Profit,
Operating Profit and Net Profit. Each can give a similar result and together will
provide an overall picture of how well the company is able to reduce costs or
maintain price increases.

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A worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue (M) 245.24 258.61 267.45 321.11 368.65 385.35 413.01 436.37 450.66 456.92
Gross Profit (M) 172.13 183.1 191.2 225.72 261.35 272.13 291.4 310.93 323.63 332.51
Operating Profit (M) 38.6 39.1 41.9 46.8 52.4 52.3 56.1 54.9 59.9 68.6
Net Profit (M) 28.03 33.2 27.37 27.01 44.48 48.87 54.52 54.84 70.95 97.44
Gross Margin (%) 70.2 70.8 71.5 70.3 70.9 70.6 70.6 71.3 71.8 72.8
Operating Margin (%) 15.7 15.1 15.7 14.6 14.2 13.6 13.6 12.6 13.3 15.0
Net Profit Margin (%) 11.4 12.8 10.2 8.4 12.1 12.7 13.2 12.6 15.7 21.3

𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 / 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 / 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 / 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒

To convert into percentages, multiply the above calculations by 100. Take for
example the Operating Margin from 2017:

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 = (𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 / 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 100

= (68.6 / 456.92) × 100
= 15.0%

As you can see from this example, InvoCare has been able to maintain the
Profit Margins across the board which is good. If a company is able to keep
growing or at least maintain Profit Margins this is a good sign that the
company is able to control costs or increase prices.
9. The company is consistently achieving high Returns on Equity (ROE),
Invested Capital (ROIC) and its Assets (ROA) – these three ratios are of
great importance as they give you a more representative breakdown on a
company’s performance as well as providing an insight to management’s use
of shareholders’ funds. Basically, ROE measures how profitable the company
is, expressed as a percentage of shareholders equity (which does not include
any debt). Something to note is if you find any big spikes when measuring a
company’s ROE this may be due to equity right-downs or share buy-backs.
ROIC (or ROC) is a measure of a company’s profitability compared to its
invested capital including debt. By maintaining a high ROIC suggests that
management is investing the businesses capital wisely. ROA measures how
effectively the company’s assets are being used in generating a profit. It is
important to note that ROE and ROA should only be used for comparisons
between similar companies from the same industry sector as these ratios can
vary depending on the industry.

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10. Is the shareholders’ equity rising on a regular basis – shareholders’ equity

is the company’s assets minus its total liabilities. If shareholders’ equity is
rising, it indicates that management is working effectively at growing a
shareholder’s value in the business. It will usually also equate to greater
earnings and perhaps a larger dividend being paid.
11. Has the number of shares outstanding remained steady or decreased
over time – generally speaking if a company is issuing more shares to raise
capital and not able to increase its earnings at least at the same rate, if not
more, this will mean there is less value for the shareholder as the company’s
earnings are now being spread across more shares.
12. Is the inventory turnover remaining constant or increasing – if you see
that the inventory turnover is decreasing over the years, this is usually a sign
that the company is unable to sell its stock as quickly as it has done
previously. This could be due to things such as; less demand for its products,
an increase in prices or increased competition. If this does occur, it will
generally result in less revenue for the company. To calculate the inventory
turnover ratio, you first find the average inventory over the last two years, this
is done by adding the last two years inventory and then divide by two (the
number of years). From here you divide the company’s annual revenue by its
average inventory. This will give you how many times a year the company
turns over its stock. To translate that into days you divide 365 (days in a year)
by the yearly stock turnover. This will give you an answer in days for how long
inventory is on hand before it is sold. In this instance the lower the number the
better.
A worked example using ASX Listed Company JB Hi-Fi Limited (JBH):

Fiscal Year Ends in June

2013 2014 2015 2016 2017

Revenue (M) 3,308.4 3,483.9 3,652.1 3,954.5 5,628.0
Inventory (M) 426 459 479 546 860
Inventory Two Yearly Ave. (M) 442.5 469 512.5 703
Yearly Stock Turnover 7.9 7.8 7.7 8.0
Ave. Days Inventory is Held 46.0 46.5 46.9 45.2

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑤𝑜 𝑌𝑒𝑎𝑟𝑙𝑦 𝐴𝑣𝑒. = (𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑌𝑒𝑎𝑟 1 + 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑌𝑒𝑎𝑟 2) / 2

𝑌𝑒𝑎𝑟𝑙𝑦 𝑆𝑡𝑜𝑐𝑘 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 / 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑤𝑜 𝑌𝑒𝑎𝑟𝑙𝑦 𝐴𝑣𝑒.
𝐴𝑣𝑒. 𝐷𝑎𝑦𝑠 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑖𝑠 𝐻𝑒𝑙𝑑 = 365 (𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟) / 𝑌𝑒𝑎𝑟𝑙𝑦 𝑆𝑡𝑜𝑐𝑘 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

13. Goodwill4 is not excessive and requiring numerous write downs – if a

company is carrying excessive amounts of goodwill on its Balance Sheet
causing it to write down the value of this asset, it indicates that management
4Goodwill is basically the price paid for intangible assets like brands and patents etc. during a take-
over

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may have overpaid for a previous acquisition. If a write down does occur, it is
recorded as an expense on the Income Statement.
14. Does the company have a current ratio of greater than 1 – the current
ratio measures the company’s ability to pay its short term (current) liabilities
from its short term (current) assets. Current Assets are those that can be sold
within twelve months and include; cash, inventory, accounts receivable etc.
Short term liabilities are amounts that are due within twelve months and can
include interest payable, long term debts falling due, accounts payable etc. A
current ratio of one indicates the business has the ability to pay its current
liabilities from its current assets. A current ratio of two would mean that there
is twice the current assets available compared to the current liabilities; a ratio
of 0.5 would mean that the company only has the ability to pay half of its
current liabilities when required, which is obviously not ideal. To calculate the
current ratio, you divide Total Current Assets by Total Current Liabilities.
A worked example using ASX Listed Company JB Hi-Fi Limited (JBH):

Fiscal Year Ends in June

2015 2016 2017

Cash Assets 49,131 51,884 72,800
Receivables ($) 81,480 98,073 196,600
Inventory ($) 478,871 546,437 859,900
Others ($) 7,416 6,124 41,400
Total Current Assets ($) 616,898 702,518 1,170,700
Account Payable ($) 325,604 384,928 647,800
Debt Due ($) 0.00 0.00 0.00
Others ($) 54,732 61,905 238,000
Total Current Liabilities ($) 380,336 446,833 885,800
Current Ratio 1.62 1.57 1.32

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 / 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

15. Does the company have a low debt to equity ratio5 – the debt to equity
ratio measures the company’s financial leverage. A lower ratio is preferred as
it indicates the company could still manage their debts even during a
downturn. A ratio of less than 0.5 – 0.8 is generally considered of lower risk. It

5 Some industries may need a higher Debt to Equity Ratio than others. Industries which have a
greater demand for capital (to maintain or build new property, plant and/or equipment) will most likely
see an increase in the need for Debt. These industries include businesses that manufacture, produce
or refine their products. Telecommunications and Transportation industries can also have a greater
requirement for debt to maintain infrastructure, e.g. railroads, airplanes, telecommunication cables
etc. For these industries we would not want to see Debt to Equity levels of greater than 1.0. The
Financial Sector, in particular banking, will have even greater levels of debt which is generally
acceptable. This is because debt is a bank’s main business. They borrow large amounts of money
and then loan this money to their customers, generally at a higher interest rate. For banking, a Debt to
Equity of no greater than 2.5 to 3.5 is acceptable.

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is measured by dividing the company’s total borrowings by the shareholders

equity. If the debt/equity ratio is 0.5 then the company has twice the equity as
it does debt. If you consider the purchase of a house for $100,000 and you
have $20,000 as a deposit, you would have debt totalling $80,000 and equity
of $20,000 (the deposit). Given you have $20,000 of equity (deposit) and total
debt of $80,000 you would personally have a debt to equity ratio of 4,
calculated by total debt ($80,000) divided by equity ($20,000)
A worked example using ASX Listed Company JB Hi-Fi Limited (JBH):

Fiscal Year Ends in June

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Total Debt (M) 123.0 89.4 34.6 232.6 149.8 124.3 179.7 139.5 109.7 558.8
Shareholders’ Equity (M) 163.9 229.3 293.3 152.3 184.5 243.3 294.6 343.5 404.7 853.5
Debt to Equity 0.75 0.39 0.12 1.53 0.81 0.51 0.61 0.41 0.27 0.66

𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 / 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝐸𝑞𝑢𝑖𝑡𝑦

16. Does the company have an increasing or high interest coverage ratio –
the interest coverage ratio measures the company’s ability to pay the interest
charge on its debts from its profits. A ratio of one would mean that the
company’s earnings can only just cover its interest payments, with no money
to spare for further expansion and maintenance of the business, which is
obviously not ideal. Generally, a ratio of 2 – 2.5 is seen as a bare minimum,
with Benjamin Graham looking for a ratio of five or higher. Having a higher
ratio will allow the company to still function in down times and avoid the need
to borrow funds or sell assets just to pay its interest. To calculate the interest
coverage ratio, you divide the EBIT (earnings before interest and tax) by the
company’s interest expense.
A worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
EBIT (M) 51.8 54.2 58.5 53.5 78.1 84.9 93.2 93.1 113.2 165.3
Interest Expense (M) 13.7 8.8 11.0 15.1 16.3 16.8 15.5 14.8 13.6 12.4
Interest Coverage Ratio 3.8 6.2 5.3 3.5 4.8 5.1 6.0 6.3 8.3 13.3

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐸𝐵𝐼𝑇 / 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

17. The company is not required to expend great amounts of capital just to
remain competitive – high amounts of Capital Expenditure (CAPEX) could
mean that the company is needing to invest heavily in things like plant,
property, equipment and other assets just to remain competitive. Dividing the
Capital Expenditure with the company’s Revenue indicates how much of each
dollar is being invested into Capital Expenses. If this number is increasing or

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consistently high in comparison to its competitors, it could be a warning sign

that the company is struggling to remain competitive.
A worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue (M) 245.2 258.6 267.4 321.1 368.7 385.4 413.0 436.4 450.7 456.9
Capital Expense (M) 16.4 13.8 14.3 16.7 18.4 19.3 26.7 22.0 30.3 47.5
CAPEX to Revenue (%) 6.7 5.3 5.3 5.2 5.0 5.0 6.5 5.0 6.7 10.4

𝐶𝐴𝑃𝐸𝑋 𝑡𝑜 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (%) = (𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 100

InvoCare has had consistent Capital Expense (CAPEX) to Revenue of

between 5.0% and 6.7% for nine years from 2008 until 2016 after which it had
a large increase in CAPEX of over 50% in 2017. Although this is cause for
concern, a CAPEX to Revenue of 10.4% is still relatively low for its industry. It
does however call for further investigation, which most times can be found by
reading the company’s Annual Report. InvoCare has implemented a ‘Protect
and Grow’ strategy which has required greater Capital Expense. This has
been implemented to help further increase the future earnings of the business
by upgrading existing facilities to better serve the changing needs of its
customers and to be able to offer more services which will increase its
revenue. InvoCare is also opening across new locations to increase market
share. All of these strategic moves are what caused the increase in Capital
Expenditure. This indicates that you should not just rely on the numbers to tell
the full story but more as an indication that further investigation may be
required.
18. Are receivables decreasing as a percentage of revenue – receivables are
basically debts or unpaid invoices owed to the company. If receivables are
growing faster than revenue this could be a sign that the company is
struggling to recoup what is owed or there has been changes or complications
with the payment (receivables) process.

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑜 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 (%) = (𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 / 𝑅𝑒𝑣𝑒𝑛𝑢𝑒) × 100

5.5 Management Characteristics

Having great management may not be as important to a business as having great

financials and an ability to generate cash. However, it still pays to assess how well
the company is run and the competence of management. Also, to understand where
management sees the business heading and if they have foreshadowed any major
changes to operations which could have a big impact on the value of a company is
very important to be across. Some of these points may be hard to find or research

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however, that shouldn’t prevent you in trying to gain an insight into the way
management is thinking about the future of the business. You may find it helpful to
read some of the CEO’s previous letters to the shareholders for any relevant
information.

1. Has management made any announcements about growing the

business – if the company is still in its expansion phase this may well be
obvious however, if it is a well-established business, its growth may have
plateaued. By understanding whether management intends to make any
changes or investments to further grow the business will help you make
forecasts of future growth rates6. If there is no mention of intentions to grow
the business, be sure to include lower growth rates in your valuation process.
2. Does management deliver on its promises – if management has made
previous bold promises and delivered on them, this is a good sign they have
the ability and determination to deliver what they promise. This can be
revealed by reading previous letters to shareholders and annual reports.
3. Are dividends consistent and not excessive – if the board elects to pay a
dividend, is it being paid at a consistent rate which is not adversely affecting
the overall future earnings ability of your investment. For example, if the
company is producing well over one dollar of market value for each dollar of
retained earnings then you would prefer the dividend payout ratio to be lower
than if the reverse was the case.
4. Is the sum of Free Cash Flow close to the sum of EPS - Over time, when
comparing the sum of the Free Cash Flow to the sum of Earnings per Share
(EPS), you would like to see both figures are within a similar range. If the sum
of the EPS are largely greater than the sum of the Free Cash Flow, this could
indicate that management may have overstated the company's reported
earnings.
5. Is management being fairly paid – Warren Buffett is famous for being paid a
salary of $100,000 as the CEO of Berkshire Hathaway and not receiving any
bonuses or any other compensations. This, in comparison to many other
CEO’s, is very low. It is not uncommon to see the salary of a CEO to be in the
millions and even tens of millions. If management is receiving high salaries,
you would expect they have been producing consistently high returns for the
company. Warren Buffett does however have a large holding in his company,
which makes up the majority of his wealth. This brings us to our next item.
6. Do directors own shares in the company – if directors have a large
shareholding in the company, you can be sure their decisions will be made in
the best interest of the shareholders.
7. Are directors buying shares – if you are running a company you would have
the best seat in the house to see which direction the business is heading and
how well the company is currently situated. If you see that directors are
6Understanding a business’s potential to grow will become important when we look to calculate the Intrinsic
Value of the business.

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buying shares this could be a sign that the company is in a good position. If
you find that directors are selling, further investigation may be required but
this may not be cause for alarm, for there could be a number of valid personal
reasons for a director needing to sell shares.

5.6 Ethical Characteristics

If your only concern is to receive high returns, then the ethical standards of a
business will not be of great concern and will have little impact on your final
investment decision. I do believe however that it doesn’t hurt to still include some
sort of ethical checklist in your final decision. Just like changes in technology,
changes in community ethical beliefs can have a major impact on a particular sector
and its possible future returns. Below are some checklist items that I personally use;
you can adapt these to suit your own situation.

1. The company does not exploit its workforce – is the company known to
pay fair wages and not exploit cheap third world labour. Pay attention to any
media reports about the company to see if it has been involved in any legal
battles in relation to workers’ rights or wage disputes.
2. Animals are not used as a commodity or profited from in any way – does
the company use or exploit animals in its operations. Again, this will depend
upon individual interpretations and standards about what is or is not
acceptable.
3. The environment is not negatively impacted by the company and its
operations – does the company use any materials that have a negative
impact on our environment or are exploiting the earth’s resources at an
unsustainable rate. How much pollution is generated from its products and
general operations; is this being appropriately managed or being offset in
some way.
4. The products which the company produce does not take advantage of
its customers – are the products that the company produce of an addictive
nature or contain addictive substances. If they have a patent or are one of a
few companies to produce the product, e.g. medical treatments, physical aids
or a service for the community, does the company overprice these products
and take advantage of its customers.
5. The company and its products do not negatively impact the health of the
public or its customers – does the business promote healthy food and
exercise as well as other healthy lifestyle choices to its customers. Are the
products known to cause sickness or have a negative impact on its
consumer’s general health.

No wise pilot, no matter how great his talent and experience, fails to use his
checklist. ~ Charlie Munger

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How to Value a Business Chapter 6 - Margin of Safety

6 Margin of Safety
6.1 Overview

Basically, the Margin of Safety is the difference between the value of a business
(Intrinsic Value) and the price which you pay for that business (market price). It is
different from the Investor’s Required Return / Discount Rate (See Section 7) and
can vary, depending on the perceived risk of the investment. The Margin of Safety is
there to; absorb the impact of any unforeseen events that may adversely affect the
business or the market in general, minimise the impact of any miscalculations made
during the valuation process, allow for small declines in the company’s future
earnings power, as well as taking into account your own risk tolerance. It is
imperative not to use the Margin of Safety to justify the purchase of undervalued
stocks if their fundamentals aren’t sound.

Time

As a general observation of the market, investors are happy to buy when prices are
high, and they see less perceived risk in the market. Then in turn, when the market
crashes and prices plummet, they perceive this situation as high risk and sell.
Logically, the margin of risk has now greatly reduced as prices are much lower than
they were. If you were to purchase quality businesses at this time, your Margin of
Safety has greatly increased.

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒
𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 (%) = {1 – ( )} × 100
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒

To further increase your Margin of Safety (but not just by purchasing at a lower price)
you should stick to businesses that you know and understand. By doing this your
evaluations and future earnings predictions will have more meaning and certainty
behind them. After all this, have confidence in your knowledge of the business and in
your valuation and act on it.

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How to Value a Business Chapter 6 - Margin of Safety

To know what Margin of Safety to apply can be difficult. Generally, the riskier the
investment the higher the Margin of Safety required. I like to set my desired Margin
of Safety after first completing my checklist. I will give each checklist item a rating
from 0 to 5, with 5 being excellent, 3 being average, 1 substandard and 0 being non-
existent. From here I sum my checklist results to give me an overall rating and then
divide that rating by the sum of the total points. For example, say we have 30
checklist items; each item can achieve a maximum score of 5 points, which would
give a total of 150 points (30 checklist items x 5 points for each item). If, after
conducting my analysis of the business and giving each checklist item a rating, I
arrive at a total of 110 points, I would divide my score of 125 by 150, which equates
to 83.3% and by inverting that number I get a Margin of Safety of 16.7%. I will then
discount my calculated Intrinsic Value of a company by 16.7%7 which will equate to
my preferred purchase price for that company. For example, if I have calculated the
Intrinsic Value of a company to be about $10 per share, I will then discount this price
by 16.7% to give me my purchase price for that company, which is now $8.33.

𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒 = 𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 − (𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒 × 𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑡𝑒𝑦)

= $10 − ($10 × 16.7%)

= $8.33

I believe this approach is a simple and relatively accurate way to asses a company’s
risk and thus allowing me to incorporate a Margin of Safety into my Intrinsic Value
calculation. To further express how applying a Margin of Safety works please see the
graph below. It is a repeat of the graph above but this time I have included the
Purchase Price (Intrinsic Value – Margin of Safety).

7My minimum required Margin of Safety is set to 20%, so in this circumstance I would apply a 20% Margin of
Safety.

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How to Value a Business Chapter 6 - Margin of Safety

6.2 Another Approach

The most common approach to applying a Margin of Safety is as described above,

effectively requiring a discount to the calculated Intrinsic Value before investing in
the company. However, if you were to apply a Margin of Safety to each input used to
calculate the Intrinsic Value instead, it could make more sense, as small changes in
forecasts can have big implications on the final Intrinsic Value. As an example, say
you have projected Company XYZ to increase its Free Cash Flow at a rate of 10% a
year, rather than applying that 10% straight into your Intrinsic Value calculation, you
could instead apply a Margin of Safety at this point to allow for any errors in
calculation or unforeseen events that could affect the future Free Cash Flow. Then
continue this for each individual input that you use to calculate Intrinsic Value.

The margin of safety is there to act as a buffer for any unforeseen

circumstances and events.

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How to Value a Business Chapter 7 - Calculating the Investor’s
Required Return / Discount Rate

7 Calculating the Investor’s Required Return / Discount Rate

7.1 Overview

By including an Investor’s Required Return (also known as a Discount Rate) in your

Intrinsic Value calculation, you provide yourself with a buffer against things like
inflation. By purchasing a company at its Intrinsic Value, you should expect to
receive a minimum return which includes an offset against inflation and allowing for
the inherent risk associated with the purchase of equities. It could be a good idea to
have a minimum Required Return of at least 8 – 10%, depending on the fundamental
health of the company, e.g. low debt and ability to repay its loans. Warren Buffett
suggests a minimum required return should be at least 10%, whereas I apply a
minimum required return of 12%.

One of the components of your Required Return should reflect the return that is
available from a risk-free investment. Investors will generally think of a risk-free
return as being the return available from investing in long term government bonds
(usually 10-year duration). These days there is an alternative to investing directly into
government bonds which is afforded by low cost broad market index funds (ETF’s)
which are listed on the stock exchange. This too could be seen as a good basis to
decide what your discount rate will be, however at a higher risk than a government
bond due to the fact that your return is not guaranteed.

Personally, I like to include a mix of inflation costs, long term government bond
yields, and an equity risk premium. I will explain further in this chapter what each of
these are and where you can find the data.

I would also like to note that the Discount Rate (Investors Required Return) is what
we will be using to calculate a company’s Intrinsic Value. A Discount Rate is used to
discount the projected future cash flow of the business to a present value. Basically,
one way to calculate the Intrinsic Value of a company is to forecast future earnings
for each year for the life of the business, then add these together to give us the
Intrinsic Value of the business. But if we don’t discount those future earnings into the
present value, the valuation will be grossly overpriced. As we know, due to inflation
and other factors one dollar today does not buy you as much as it did 20 years ago.

For an example, let’s use a hypothetical company called ‘Leo’s Lemonade’. After the
first year in business Leo produced $100 of free cash flow from selling his lemonade.
Remember that free cash flow is the money that is left in the business after all
expenses have been paid like taxes, wages, interest expenses, maintenance etc.
Leo expects to grow his business and expand his free cash flow at a rate of 10% a
year for the next 10 years when finally, the company will be sold as Leo has to move
away to attend University. We will use a Discount Rate of 12% (you will see how to
calculate the Discount Rate later in this chapter). Running these figures using a

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How to Value a Business Chapter 7 - Calculating the Investor’s
Required Return / Discount Rate
Discount Cash Flow (DCF) valuation method8, we believe that when Leo sells his
business in ten years’ time his business will be worth about $1,750. But that is the
value of the business in 10 years’ time, so to express that into today’s dollars we will
need to discount that valuation using the 12% Discount Rate. This gives the
business a current Intrinsic Value of about $900. I will show you how to calculate the
Intrinsic Value in more depth in a later chapter titled Determine the Intrinsic Value.

Summarised below is an overview of the three main components used in

establishing the Investor’s Required Return (Discount Rate).

7.2 Inflation

Inflation is basically the rate at which the value of your cash is decreasing each year
due to the costs of goods rising (loss of purchasing power). The Investor’s Required
Return should take into account expectations of inflation, which has averaged 3%
per annum over several hundred years. At the conservative end an inflation rate of
5% would be appropriate. It is important to include inflation in your discount rate as
not to do so would mean that the calculated future returns would be overstated when
expressed in today’s dollars.

This link will take you to the International Monetary Fund website which has historical
inflation data for each country. Click Here

In case the link didn’t work copy the site address below.

http://www.imf.org/en/countries

Children are getting stronger these days; my son can carry $10 worth of
groceries in one hand. When I was a boy, I had to make three trips!

7.3 Equity Risk Premium

The Investors Required Return (Discount Rate) should also take into account a
compensation for risk, or an ‘Equity Risk Premium’. The Equity Risk Premium is the
difference between what you expect to receive on your investment compared to a
long term ‘no risk’ government bond. To obtain the equity risk premium you simply
calculate the expected return on an investment, minus the risk-free rate, usually a
government bond. This figure is included in your Discount Rate to ensure that the
price you pay can be expected to exceed the returns you would have otherwise
achieved from a risk-free bond. The market’s Equity Risk Premium over the last few
decades has ranged between 4% and 6% per annum.

8 See section 8.5.2

Discount Cash-Flow Method (DCF) for further information on calculating Intrinsic Value using the DCF
Method.

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How to Value a Business Chapter 7 - Calculating the Investor’s
Required Return / Discount Rate
You can calculate it for each individual company, as not all companies carry the
same level of risk. Otherwise this site (click here) is a helpful tool to use when
deciding on an appropriate Equity Risk Premium. The site uses the current stock
market return as a whole and deducts the current risk-free rate from that. This is the
site that I use to establish the current Equity Risk Premium for my calculations.

In case the link didn’t work copy the site address below.

http://www.market-risk-premia.com/market-risk-premia.html

7.4 Risk Free Rate

The risk-free rate is accepted as being the current yield of a long-term government
bond, generally of 10 years or longer duration. Value Investors deem this as the
highest risk-free return that you could receive from an investment. That is why it is
used in calculating your Discount Rate, for it wouldn’t make any sense to invest in a
high-risk investment like the stock market, if you didn’t take into consideration other
returns that are available to you that have next to no risk. The reason it is deemed
‘Risk Free’ is because it is backed by government, so the chances of the government
defaulting and not repaying your investment is slight, although not unheard of.

This rate can be found at the same link you used to find your Equity Risk Premium
click here

In case the link didn’t work copy the site address below.

http://www.market-risk-premia.com/market-risk-premia.html

7.5 Other Methods

There are other methods used to calculate an Investor’s Required Return / Discount
Rate. Two commonly used methods are listed below. I will not be giving an
explanation here but if you are interested I have added links to
www.investopedia.com which contain detailed explanations of the methods:

1. Weighted Average Cost of Capital – WACC Click Here

2. Capital Asset Pricing Model – CAPM Click Here

I find these add unnecessary complications to what should be a simple calculation.

What we are really after in relation to discount rates is opportunity costs – what is the
next best available investment return I can get that is relatively risk free.

7.6 Summary

We now understand the importance of calculating the Investor’s Required Return, to

help mitigate the risk of equity investing. By including Inflation we cover the losses
inevitably incurred by the continuing rise in the price of goods (loss of purchasing
power); having an Equity Risk Premium insures that we will only take on those

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How to Value a Business Chapter 7 - Calculating the Investor’s
Required Return / Discount Rate
investments that can achieve high enough returns to compensate for the risk of
equity investments and finally, the Risk Free Rate will ensure that we include, as a
component of the Investor’s Required Return, a return that is available from a ‘risk
free’ investment which is usually represented by the yield from a 10 year government
bond.

Basically, our Discount Rate is the sum of these three figures, Inflation, Equity Risk
Premium, and the Risk-Free Rate. So, let’s take the long-term average Inflation of
3%, and say an Equity Risk Premium of 6% plus the current 3% yield on the
government bond and we get a Discount Rate of 12%.

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 + 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒

= 3% + 6% + 3%

= 12%

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

8 Determine the Intrinsic Value

8.1 Overview

Now that you have found a great company which you understand and one which is
consistently growing its profits as well as having a strong outlook, you will next need
to calculate if this company is trading at fair value. If you were to invest in the
company at an over inflated price, you run the risk of greatly diminishing your
potential profits or even losing money in the future. This is due to the short term,
unpredictable nature of the stock market, as Benjamin Graham describes in his ‘Mr
Market’ analogy. In the short term the market fluctuates with the 24/7 news cycle,
market hype and any other short-term impacts on price, that in the long run may
have little impact on a company’s performance. The share market has consistently
proved over time that it can be a great way to increase your wealth. By only
purchasing great companies at a discount to their Intrinsic Value, you not only have
a greater chance of achieving above average market returns, but you will also
greatly reduce your risk of overpaying when investing in a company. Remember
‘price is what you pay, value is what you get’ – Warren Buffett.

As you will see there are many different valuation methods and each method may
have more relevance when valuing some companies compared to others. They will
also give different Intrinsic Values and sometimes the difference can be quite large.

Two people looking at the same set of facts, moreover – and this would apply
to Charlie and me – will almost inevitably come up with slightly different
Intrinsic Value figures ~ Warren Buffett

8.2 Obtaining the Data

To perform an Intrinsic Valuation of a company you will first need to have access to
historical financials of the company, preferably over the last ten years. In most cases
your brokerage firm should be able to supply you with company analyses as well as
historical financials of the company’s Income Statement, Balance Sheet and Cash
Flow Statement. If this isn’t the case you can obtain this data a few different ways,
either through paid subscriptions or for free. The company will issue an annual
Financial Report that is free to access from the company’s website, usually under
Investor Relations or Shareholder Relations. From here you can download the
historical annual Financial Reports of the company, preferably from the last 10 years
(if the company has been in business that long) and extract the financial data
required to perform an Intrinsic Value calculation of that company. This can be an
arduous task, however your brokerage firm or a websites like The Wall Street
Journal and Yahoo Finance may provide you with historical data in a simple, easy to
view table. I have found it to be rather difficult to obtain historical financial data via
free sites for companies listed on the Australian Stock Exchange (ASX). The free

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

sites that I just mentioned will supply between 4 to 6 years of historical financials.
Otherwise you may choose to open a brokerage account with your bank or an online
broker who may provide you with a selection of historical data. Most cases this will
be up to the previous 10 years’ financial reports, but as mentioned, it may only be a
selection of the data that is normally suppled on a company’s Income Statement,
Balance Sheet and Cash Flow Statements and you may find that some information
that is needed to analyse a business may not be available.

There are also many paid sites; one in particular that I find very beneficial and use
myself is www.gurufocus.com. This site primarily targets the Value Investor.
Gurufocus provide up to thirty year’s financials of a company which also includes
many different ratios and per share data e.g. Price to Book, Return on Equity,
Current Ratio, Debt/Equity, Profit Margins, and PEG Ratio, which saves you
calculating them yourself. You may find some of these ratios available on other free
sites, but not to the extent and with as much detail as www.gurufocus.com.

The data tables displayed below are the preceding 10 years Income Statement,
Balance Sheet and Cash Flow Statements of ASX Listed Companies Perpetual
Limited (PPT) and InvoCare Limited (IVC). This data was obtained via
www.gurufocus.com. From tables such as these you will be able to conduct
valuations of a company as well as forecasting projected growth rates. These are the
tables that I have referred to when calculating Perpetual Limited (PPT) and InvoCare
Limited’s (IVC) Intrinsic Values in the examples later in this chapter. But as
mentioned earlier, it is imperative to also read the letters to the shareholders or the
CEO’s report to get an idea of the direction the company may be headed and if
management consider the best interest of shareholders when making decisions.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

PERPETUAL LTD (PPT) INCOME

Fiscal year ends in July.
STATEMENT
AUD in millions except per share data. 08 09 10 11 12 13 14 15 16 17
Revenue 594 473 492 500 391 389 443 495 488 504
Cost of Goods Sold
Gross Profit 594 473 492 500 391 389 443 495 488 504
Selling, General, & Admin. Expense 305 279 323 359 303 286 342 318 304 309
Research & Development
Other Operating Expense 10 141 66 67 50 38 23 21 17 19
Operating Income 279 54 103 74 37 66 77 156 167 175
Interest Income 13 6 13 12 7 7 7 10 10 10
Interest Expense -3 -3 -3 -4 -2 -2 -3 -3 -3 -3
Net Interest Income 10 3 10 9 5 5 4 6 7 8
Other Income (Expense) -101 2 20 13 -8 11 31 12 9 7
Other Income (Minority Interest) 0 0 0 4 1 -1 -1
Pre-Tax Income 188 59 134 96 35 82 113 174 183 189
Tax Provision -59 -21 -43 -33 -14 -25 -33 -50 -51 -52
Tax Rate % 31 36 32 35 40 30 30 29 28 27
Net Income (Continuing Operations) 129 38 91 62 21 58 79 124 132 137
Net Income (Discontinued Operations) 2 3 3
Net Income 129 38 91 62 27 61 82 122 132 137
Preferred Dividends
EPS (Basic) 3.30 0.96 2.27 1.53 0.69 1.58 1.96 2.74 2.91 3.00
EPS (Diluted) 3.09 0.89 2.11 1.41 0.64 1.49 1.86 2.65 2.84 2.94
Shares Outstanding (Diluted Average) 42 42 43 44 42 41 44 46 46 47
Depreciation, Depletion and Amort. 10 13 15 16 14 9 12 15 17 19
EBITDA 201 75 151 115 51 93 128 193 203 211

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

PERPETUAL LTD (PPT) BALANCE SHEET Fiscal year ends in July.

AUD in millions except per share data 08 09 10 11 12 13 14 15 16 17
Assets
Current Assets
Cash and Cash Equivalents 183 146 188 220 153 217 283 289 278 323
Marketable Securities 1507 1605 1217 920 695 462 310 295 300 278
Cash, Cash Equivalents, Securities 1691 1751 1405 1140 848 679 592 584 578 601
Accounts Receivable 73 65 71 70 56 58 82 85 87 90
Notes Receivable
Other Current Receivables 15 13 16 3 27 4 3 6 2 6
Total Receivables 89 78 87 73 82 62 85 91 88 96
Inventories, Raw Materials
Inventories, Work in Process
Inventories, Inventories Adj.
Inventories, Finished Goods
Inventories, Other
Total Inventories
Other Current Assets 23 12 7 7 24 8 9 11 12 19
Total Current Assets 1802 1841 1499 1220 954 749 686 686 678 717
Non-Current Assets
Investments and Advances 77 44 50 184 39 77 45 52 75 63
Land and Improvements
Buildings and Improvements
Machinery, Furniture, Equipment 16 46 51 50 16 9 8 8 9 9
Construction in Progress 1 0 1 8 0
Other Gross PPE 27 32 31 29 31 36 48
Gross Property, Plant, Equipment 44 46 51 50 48 40 37 40 53 57
Accumulated Depreciation -13 -18 -23 -24 -28 -22 -21 -25 -28 -33
Property, Plant and Equipment 31 28 28 26 20 18 16 15 25 24
Intangible Assets 88 113 164 148 123 129 322 333 339 331
Goodwill 62 77 114 103 97 97 257 267 277 277
Other Long Term Assets 372 245 201 35 116 31 38 37 35 37
Total Assets 2370 2270 1941 1614 1253 1004 1107 1123 1153 1172
Liabilities
Current Liabilities
Accounts Payable 37 32 29 31 26 34 39 37 39 52
Total Tax Payable
Other Current Payables 129 3 12 10 5 4 4
Current Accrued Expense
Accounts Payable & Accrued Exp. 166 35 41 40 31 38 43 37 39 52
Current Portion of Long-Term Debt 108 25 17 23 36 305
Current Deferred Revenue 21 7 5 3
Current Deferred Taxes Liabilities 25 0 17 15 13 15 27 22 23
Deferred Tax and Revenue 47 0 17 15 7 19 17 27 22 23
Other Current Liabilities 1546 1549 1248 951 744 469 53 346 351 328
Total Current Liabilities 1758 1692 1331 1024 806 562 419 411 412 402

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Non-Current Liabilities
Long-Term Debt 261 256 210 179 133 87 87 87 87 87
Capital Lease Obligation
Long-Term Debt & Capital Lease 261 256 210 179 133 87 87 87 87 87
Pension and Retirement Benefit 2 3 2 4 5 7 12
Non-Current Deferred Liabilities 2 2 7 8 8 8 21 20 20 14
Other Long-Term Liabilities 33 30 32 27 21 21 20 17 22 21
Total Liabilities 2056 1980 1580 1238 972 681 550 540 548 537
Shareholders’ Equity
Common Stock 164 174 206 245 237 240 461 482 493 502
Preferred Stock
Retained Earnings 106 72 96 77 7 37 52 78 95 112
Acc. other comprehensive income 44 43 57 44 24 37 32 23 17 20
Additional Paid-In Capital
Treasury Stock
Other Stockholders Equity 0 0 0 0 0
Total Stockholders’ Equity 314 290 359 366 268 314 545 584 606 634
Minority Interest 1 0 2 10 12 9 12
Total Equity 314 290 361 376 280 324 556 584 606 634

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

PERPETUAL LTD (PPT) CASH FLOW

STATEMENT Fiscal year ends in July.
AUD in millions except per share data. 08 09 10 11 12 13 14 15 16 17
Receipts from Customers 480 407 484 503 444 396 472 569 547 546
Receipts from Government Grants
Other Cash Receipts from Op. Activities
Cash Receipts from Operating Activities 480 407 484 503 444 396 472 569 547 546
Payments to Suppliers for Goods and
-311 -313 -311 -362 -359 -285 -355 -409 -346 -331
Services
Payments on Behalf of Employees
Other Cash Payments
Cash Payments -311 -313 -311 -362 -359 -285 -355 -409 -346 -331
Dividends Paid
Dividends Received 2 1 1 1 1 1 1 0 0 0
Interest Paid -3 -3 -3 -4 -2 -2 -3 -3 -3 -3
Interest Received 13 6 12 12 9 7 6 9 6 6
Taxes Refund Paid -73 -36 -31 -37 -26 -11 -27 -36 -55 -60
Cash Flow from Others 0 0 0 0 0 0 0
Cash Flow from Operations 109 63 153 114 66 106 95 129 150 158
Purchase of Property, Plant, Equipment -18 -14 -12 -14 -10 -14 -7 -16 -17 -12
Sale of Property, Plant, Equipment 2 0
Purchase of Business -5 -19 -35 -10 -1 -1 -62 -6 -1
Sale of Business 8 60 2 0 0
Purchase of Investment -103 -43 -38 -74 -50 -34 -39 -58 -37 -20
Sale of Investment 152 60 37 75 54 39 55 53 16 41
Net Intangibles Purchase and Sale
Cash from Discount. Investing Activity
Cash from Other Investing Activities -15 -8 0 7 0 0 0 0 0
Cash Flow from Investing 11 -24 -48 -16 -7 1 8 -19 -44 8
Issuance of Stock 5 1 9 14 3
Repurchase of Stock 0 -1 -71
Net Issuance of Preferred Stock
Net Issuance of Debt 32
Cash Flow for Dividends -156 -76 -71 -88 -61 -38 -71 -98 -116 -121
Other Financing 8 6 -4 -1 -6
Cash Flow from Financing -151 -75 -63 -66 -126 -42 -37 -104 -116 -121
Net Change in Cash -31 -37 41 33 -67 64 65 7 -11 45
Capital Expenditure -18 -14 -12 -14 -10 -14 -7 -16 -17 -12
Free Cash Flow 91 49 141 101 56 91 88 113 133 146

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

INVOCARE LTD (IVC)

INCOME STATEMENT Fiscal year ends in December.
AUD in millions except per share data. 08 09 10 11 12 13 14 15 16 17
Revenue 245 259 267 321 369 385 413 436 451 457
Cost of Goods Sold 73 76 76 95 107 113 122 125 127 124
Gross Profit 172 183 191 226 261 272 291 311 324 333
Selling, General, & Admin. Expense 106 114 119 144 166 177 190 207 216 218
Research & Development
Other Operating Expense 27 30 30 35 43 43 45 49 48 46
Operating Income 39 39 42 47 52 52 56 55 60 69
Interest Income 1 1 1 1 1 1 1 1 1 1
Interest Expense -14 -9 -11 -15 -16 -17 -15 -15 -14 -12
Net Interest Income -13 -8 -10 -14 -15 -16 -15 -14 -13 -11
Other Income (Expense) 13 15 6 7 26 32 36 41 53 84
Other Income (Minority Interest) 0 0 0 0 0 0 0 0 0 0
Pre-Tax Income 39 46 38 39 63 68 77 82 100 141
Tax Provision -11 -13 -10 -12 -18 -19 -23 -27 -29 -43
Tax Rate % 28 28 27 31 29 28 29 33 29 31
Net Income (Continuing Operations) 28 33 27 27 45 49 55 55 71 98
Net Income (Discontinued Operations)
Net Income 28 33 27 27 44 49 55 55 71 97
Preferred Dividends
EPS (Basic) 0.28 0.33 0.27 0.26 0.41 0.45 0.51 0.48 0.65 0.89
EPS (Diluted) 0.28 0.33 0.27 0.26 0.41 0.45 0.50 0.50 0.65 0.88
Shares Outstanding (Diluted Average) 100 101 102 105 109 109 109 110 110 111
Depreciation, Depletion and Amortization 10 11 11 14 16 18 19 20 21 21
EBITDA 62 66 60 68 95 103 112 117 135 175

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

INVOCARE LTD (IVC) BALANCE SHEET Fiscal year ends in December.

AUD in millions except per share data 08 09 10 11 12 13 14 15 16 17
Assets
Current Assets
Cash and Cash Equivalents 6 6 5 6 6 9 10 9 12 16
Marketable Securities
Cash and Cash Equivalents, Securities 6 6 5 6 6 9 10 9 12 16
Accounts Receivable 17 18 20 29 31 34 34 36 44 46
Notes Receivable
Other Current Receivables -1 0 0 0 -1 -1 -1 -1 -1 -1
Total Receivables 17 18 20 29 30 33 33 35 43 45
Inventories, Work in Process 3 2 1 1 2 1 2 1 2
Inventories, Inventories Adjustments
Inventories, Finished Goods 14 12 15 19 21 20 22 22 25 27
Inventories, Other 0 0 0
Total Inventories 14 15 17 20 21 22 22 24 26 29
Other Current Assets 2 2 277 316 359 37 43 46 49 53
Total Current Assets 39 41 319 371 416 100 109 114 129 142
Non-Current Assets
Investments and Advances 0 0 5 2 0 0 0
Land and Improvements 226 227 236 290 289 303 314 330 336 363
Buildings and Improvements
Machinery, Furniture, Equipment 64 67 71 92 100 109 119 129 144 155
Construction in Progress
Other Gross PPE 6 7 7 4 9 10 11 12 13 20
Gross Property, Plant and Equipment 296 301 314 386 398 422 444 471 493 538
Accumulated Depreciation -74 -77 -82 -103 -113 -126 -136 -149 -161 -183
Property, Plant and Equipment 222 223 232 283 285 297 308 322 332 355
Intangible Assets 62 58 62 131 137 149 152 153 152 147
Goodwill 59 56 60 123 129 141 145 147 148 144
Other Long-Term Assets 17 19 22 22 23 366 393 419 471 540
Total Assets 340 342 635 806 862 917 965 1009 1085 1185
Liabilities
Current Liabilities
Accounts Payable 17 16 19 21 17 25 26 26 33 42
Total Tax Payable
Other Current Payables 4 5 6 8 8 10 12 13 12 12
Current Accrued Expense
Accounts Payable & Accrued Expense 21 21 26 28 25 35 37 39 45 54
Current Portion of Long-Term Debt 0 2 0 0 0
Current Deferred Revenue 3 3 268 3 3 7 8 9 10 12
Current Deferred Taxes Liabilities 5 3 7 8 5 10 9 10 10 12
Deferred Tax and Revenue 8 6 274 11 8 17 17 19 20 24
Other Current Liabilities 9 11 9 329 369 45 48 50 53 55
Total Current Liabilities 37 38 309 371 402 96 102 108 118 132
Non-Current Liabilities
Long-Term Debt 159 154 152 214 223 224 229 231 234 243
Capital Lease Obligation 2 0 0
Long-Term Debt & Capital Lease 159 154 153 214 223 224 229 231 234 243
Pension and Retirement Benefit 1 1 1 2 2 2 2 2 3 4
Non-Current Deferred Liabilities 67 71 74 70 73 72 78 87 93 109
Other Long-Term Liabilities 13 0 0 7 10 352 366 377 402 415
Total Liabilities 277 264 538 664 710 746 777 805 851 902
Shareholders’ Equity
Common Stock 72 77 80 133 133 132 132 134 135 136
Preferred Stock

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Retained Earnings -9 -1 14 11 21 33 48 63 91 140

Acc. other comprehensive income -1 0 2 -3 -3 4 7 6 7 5
Additional Paid-In Capital
Treasury Stock
Other Stockholders Equity 0 0 0 0 0
Total Stockholders’ Equity 62 76 96 141 151 169 187 202 233 281
Minority Interest 1 1 1 1 1 1 1 1 1 1
Total Equity 63 77 97 143 152 171 188 203 234 282

INVOCARE LTD (IVC) CASH FLOW

STATEMENT Fiscal year ends in December.
AUD in millions except per share data. 08 09 10 11 12 13 14 15 16 17
Receipts from Customers 267 283 293 351 409 434 466 490 508 509
Receipts from Government Grants
Other Cash Receipts from Op. Activities 4 5 5 6 7 7 8 8 9 8
Cash Receipts from Operating Activities 271 288 298 358 416 441 474 498 518 517
Payments to Suppliers for Goods and - - - - - - - - - -
Services 211 225 229 282 328 337 367 395 401 403
Payments on Behalf of Employees
Other Cash Payments from Op. Activities
Cash Payments -211 -225 -229 -282 -328 -337 -367 -395 -401 -403
Dividends Paid
Dividends Received
Interest Paid -11 -11 -11 -14 -16 -16 -15 -14 -13 -12
Interest Received 0 0 0 0 0 0 0 0 0 0
Taxes Refund Paid -13 -14 -12 -17 -20 -16 -20 -24 -25 -27
Cash Flow from Others 0 0 0 0 0 0 0 0
Cash Flow from Operations 36 38 46 44 53 72 72 65 78 76
Purchase of Property, Plant, Equipment -16 -14 -14 -17 -18 -19 -27 -22 -30 -47
Sale of Property, Plant, Equipment 1 0 2 1 3 8 1 1 5 8
Purchase of Business -6 0 -9 -44 -9 -8 -7 -7 -1 0
Sale of Business 7 2
Purchase of Investment -5
Sale of Investment
Net Intangibles Purchase and Sale
Cash from Discontinued Investing Activity
Cash from Other Investing Activities 0 0 0 0 0 0 2 -7 5
Cash Flow from Investing -22 -14 -21 -53 -24 -24 -32 -26 -34 -34
Issuance of Stock 11
Repurchase of Stock -1 -1 -1
Net Issuance of Preferred Stock
Net Issuance of Debt 4 -5 0 25 7 -7 2 0 2 11
Cash Flow for Dividends -20 -19 -24 -25 -34 -37 -39 -40 -43 -48
Other Financing -1 -1 -1 -1 0 0
Cash Flow from Financing -17 -25 -26 10 -29 -45 -38 -40 -41 -38
Net Change in Cash -3 0 0 1 0 3 1 -2 3 4
Capital Expenditure -16 -14 -14 -17 -18 -19 -27 -22 -30 -47
Free Cash Flow 20 25 32 27 35 53 45 43 48 28

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

8.3 Calculating the Projected Growth of a Company

Some things to consider when forecasting the growth of a business is to first take a
step back and look at how well the economic environment has suited the business
that you are analysing. For example, in times of low interest rates, which tend to
encourage higher consumer spending, there will usually be better returns and
greater revenue for retail businesses for example and alternatively, if interest rates
are relatively high or climbing, people will tend to limit their discretionary spending.
Another influence on the growth of a business could be if it was in a rapid expansion
phase, e.g. opening many new stores and growing market share. This too would be
reflected in high growth in earnings of the business and you would need to consider
how long the business could continue to grow at this rate. Other things like changing
commodity prices such as oil, can have either a positive or negative impact on the
bottom line (profit) and in turn the growth of a business, depending if it is a producer
or consumer of the commodity. Also, movements in currencies can affect the
businesses growth. For example, if a large proportion of the business revenue is
dependent on international sales, or if it exports most of its produce, then any rise in
the local currency could negatively impact its sales. Similarly, the business may have
previously had a strong economic moat9 and this can be affected by changes in
technology or an increase in competition which could greatly reduce the growth of a
business.

Having a detailed checklist can insure you consider the numerous issues which may
influence the future growth of a business. These issues could be easily overlooked
and not taken into consideration when calculating the company’s growth. It is always
better to be conservative when forecasting the growth of a business and if you
decide to invest in the business, incorporating a larger Margin of Safety to help
protect your investment in the event there are circumstances in the future that
negatively impact on the value of that investment.

I use the Compound Annual Growth Rate (CAGR) formula when projecting the future
likely growth rates of a company. This basically means using the growth rates from
previous years and then projecting them forward. There are obvious flaws with this
method, as just mentioned in the points above, because the economic
conditions/environment in which a business operates can easily change. As Warren
Buffett has said “The investor of today does not profit from yesterday’s growth”.
Having said that, regardless of its flaws, using the Compound Annual Growth Rate
(CAGR) of a company to project its future growth rate provides us with a simple
method that is not easily manipulated. That is why it is very important to know and
understand what exactly the business does. You also need to be comfortable in
recognising how the business operates and then use this knowledge to help you
project the future growth of a business. By using the Compound Annual Growth Rate

9 An economic moat is the ability of a business to maintain a competitive advantage over its
competitors in order to protect profits and market share.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

(CAGR) of a business’s free cash flow for example, you can see how the business
has performed over the last few years and then relate that to the economic
conditions the business was operating under at the time. If you believe these
conditions can continue or even improve over time, then it is safe to assume similar
growth rates. If, however, the conditions that were previously present seem unlikely
to continue, you will need to take this into consideration when analysing the CAGR
(growth) of the company.

The CAGR formula is used to calculate average future returns or growth rates of a
business. The CAGR formula is versatile and simple to use and suits just about any
scenario which requires a growth figure. By averaging the growth rate over a period,
the formula helps adjust for any distortions that could be caused by the occurrence
of abnormal annual results from the business. However, it can be limiting to screen
out completely any volatility in a company’s financials. In particular, when calculating
a company’s growth rate, it pays to be aware of how consistent the company is
growing its earnings, as this will give you confidence in the company’s ability to keep
growing at that particular rate.

The Compound Annual Growth Rate (CAGR) formula is as follows:

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

Where:

Ending Value = Last published EPS, Dividend, Free Cash Flow etc.
Beginning Value = First EPS, Dividend, Free Cash Flow etc. for the chosen period.
Number of = Number of years between the Beginning Value and the Ending
years10 Value.

8.4 High Growth vs. Terminal / Stable Growth Period of a Company

The projected growth of a company (CAGR) is sometimes used in Intrinsic Value

calculations. In most scenarios, when a company is still expanding and increasing its
market share it will be growing its business and thus increasing its profits at a greater
rate than that of a well-established company. It is up to the investor to decide if a
company still has the capacity to grow market share, or whether it has reached
maturity and will continue to grow its revenues at a more subdued rate.

There are two types of growth periods mentioned above; the first relates to a
company that still has the capacity to grow revenues rapidly and this is referred to as
the High Growth Period. It is up to the investor to decide the number of years they
believe the business can maintain these higher rates of growth. It is often the case

10 Please note that when counting the years of growth, it is actually the change in years that you are
counting, not the actual years of data. For example, if we have data from 2009 to 2017, this equates
to 9 years’ data, but only 8 years of change or growth.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

investors assume the Higher Growth Period will last for no more than 10 years. It is
important to reiterate, the High Growth Period is just a forecast which has the high
probability of being impacted (both negatively and positively) by many unforeseen
scenarios, which in turn, would impact a business’s growth rate. For this reason,
forecasting past a 10-year period would also come with a much greater risk of being
affected by any unforeseen events, no matter how great the business may appear to
be.

Once it is anticipated that the business has reached the end of its High Growth
Period, the investor will then adopt a Terminal or Stable Growth Period for the
business where the Growth Rate will be more modest. Mature businesses are easier
to value as they are more predictable than a younger expanding company. This can
be obvious when reviewing a mature company’s Financial Statements, as the
reportable figures such as Revenue, Net Profit, Assets and Liabilities will generally
be more consistent with fewer fluctuations and with steadier growth than that of a
younger business. This doesn’t mean that they don’t come with less risk, as mature
businesses, if not properly managed, could be left behind in an ever-changing
market. Once a business reaches maturity it is generally accepted that a growth rate
just above inflation is appropriate; therefore, a Stable Growth Rate of between 3% –
6% is often used when calculating Intrinsic Value.

For many mature businesses that have been operating for decades, I will usually still
include a High Growth Rate/Period in my formula which will ensure that I include
those companies that have continued to produce above average returns (greater
than the Stable Growth Rate of 3% – 6%). By including a High Growth Rate in my
Intrinsic Value calculation, I will avoid undervaluing a great business with a proven
ability to achieve above average returns by including a High Growth Period and not
just calculating the business’s Intrinsic Value using the Stable Growth Rate of 3% –
6%. I will also avoid any overvaluations or increased investment risk (as described in
the previous paragraphs) that would occur by using the company’s current high
growth rate in place of the Terminal/Stable Growth Rate which is normally be
between 3% - 6%11. This would give us an unrealistic Intrinsic Value of the business.

As it is not feasible to continue calculating the High Growth period too far into the
future due to the increasing challenge of accounting for changes in the market and
economy, we therefore revert to the Terminal/Stable Growth Rate as mentioned
above, using 3% – 6% growth per annum from thereafter. This is an attempt to value
the future cash flows of the business into perpetuity, notwithstanding it is not
possible to know how long the business will continue its operations into the future.

11By using a high growth rate of say 10% for the terminal/stable period growth rate, which assumes
the company will continue to grow at this rate forever, would result in the company eventually
becoming larger than the entire country’s economy, assuming GDP growth of that country is less than
10%.

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8.5 The different Methods of Calculating Intrinsic Value

I will now provide you with an analysis of the different methods which I use to help
me establish the Intrinsic Value of a company. The results of these methods stem
from my own opinions of a company and may not be entirely correct or may differ
from your opinion. For this reason, it can be difficult to arrive at an Intrinsic Value for
a company which will be accepted universally. The methods which I use include:

1. The Benjamin Graham Formula

2. The Discount Cash-Flow Method (DCF)
3. The Dividend Discount Method (DDM)
4. The Residual Income Method (RIV)
5. Balance Sheet Methods
a. Book Value
b. Tangible Book Value
c. The Graham Number
d. Liquidation Value
e. Net Current Assets

8.5.1 The Benjamin Graham Formula

Benjamin Graham, who is known as the “Father of Value Investing”, distinguished

the difference between “Investing” and “Speculating”. He created an approach to
valuing companies and in particular calculating their Intrinsic Values, as well as
performing a ‘Fundamental Analysis’ of the Balance Sheet to determine the financial
health of the company. He used a quantitative methodology in his company
valuations, mainly focusing on the numbers and not so much the quality of the
company. He realised that the market wasn’t always correct and he best described
this in his “Mr Market” analogy (See Section 3.2 ‘Mr Market’). One of his students
and a long-time advocate is Warren Buffett, Chairman and CEO of Berkshire
Hathaway and one of the wealthiest investors in the world.

The key indicators that Graham used to calculate the Intrinsic Value of a company
were its earnings and earnings growth.

Shown below is the Intrinsic Valuation formula that Graham mentioned in his book,
The Intelligent Investor:

𝐸𝑃𝑆 × (8.5 + 2𝑔) × 4.4

𝑉=
𝑌

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Where:

V = Intrinsic Value
EPS = Trailing 12-month Earnings per Share12
8.5 = Graham’s assumption of the P/E Ratio for a mature (stagnant growth)
business13
2g = 2 x the company’s projected earnings growth rate14 for the next 7-10
years
4.4 = Graham’s estimate of a risk-free rate
Y = Today’s AAA Corporate Bond Rate15

Here is a worked example using ASX Listed Company Perpetual Limited (PPT):

Fiscal Year Ends in June

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Earnings (EPS) ($) 3.09 0.89 2.11 1.41 0.59 1.42 1.80 2.65 2.84 2.94

First, we need to estimate the growth rate of the future earnings of the company. We
can do this by using the Compound Annual Growth Rate formula (CAGR) which is:
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

Looking at the table you can see that in 2008 the company’s earnings were over
three times the value of the earnings in 2009, this was due to the impact of the
Global Financial Crisis (GFC) on the 2009 earnings. So, to find an appropriate
growth rate it may pay to average the EPS of 2008 and 2009, as this will help reduce
the impact of a period of abnormal growth caused by the Global Financial Crisis. We
can also average the last two year’s EPS which will give us a more conservative
growth result. If we put the data into the formula, the Beginning Value is average
EPS from 2008 and 2009, ($3.09+0.89)/2=$1.99, with the Ending Value being the
average of the last two year’s EPS ($2.84+2.94)/2=$2.89.
1
2.89 (9)
𝐶𝐴𝐺𝑅 = ( ) −1
1.99

𝐶𝐴𝐺𝑅 = 4.2% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑒𝑎𝑐ℎ 𝑦𝑒𝑎𝑟 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑎𝑠𝑡 𝑛𝑖𝑛𝑒 𝑦𝑒𝑎𝑟𝑠.

12 For a more conservative valuation or to avoid abnormal numbers that could occur in the trailing 12
months EPS, you can instead use an average of the Earnings over a 2-3 Year period.
13 Investors may wish to modify this number to better reflect the current economic situation. Lowering

it will result in a more conservative valuation. Between 7 and 8.5 is a good range to maintain.
14 See Section 8.3 Calculating the Projected Growth of a Company.
15 You can use the Discount Rate (see Section 7 Calculating the Investor’s Required Return /

Discount Rate) that you calculated earlier in place of the AAA Corporate Bond, for a more
conservative result

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Please note that when counting the years of growth, it is actually the change in years
that you are counting, not the actual years of data. For instance, in the example
above we have used data from 2008 to 2017, which is 10 years’ data, but 9 years of
change.

We can round this down to 4% or even lower depending on your appetite for risk. We
can also apply a Margin of Safety to this figure as well to account for any changes in
projected growth. But for this exercise we will leave it at 4.2%.

Next we need to find the EPS figure in the Benjamin Graham Formula calculation,
which Graham says is the trailing 12 months EPS. We can also use the more
conservative result of the last two year’s average of the EPS of $2.89 which we just
used to calculate the growth.16 To do this we add the last two years EPS, e.g. 2016
EPS + 2017 EPS, then divide that by the number of years, which in this case are
two.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝐸𝑃𝑆 = (𝑌𝑒𝑎𝑟 1 + 𝑌𝑒𝑎𝑟 2) / 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

= (2.84 + 2.94)/2

= $ 2.89

Next we need to find Y. I prefer to use the Discount Rate (12%) that we worked out
earlier in the chapter ‘Calculating the Investor’s Required Return / Discount Rate’
opposed to the AAA Corporate Bond Rate as preferred by Benjamin Graham.

Now we have all the figures required to populate Benjamin Graham’s formula:

𝑉 = (𝐸𝑃𝑆 × (8.5 + 2𝑔) × 4.4)/𝑌

= (2.89 × (8.5 + 2 × 4.2) × 4.4)/12

= $ 17.93 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $40)

According to Benjamin Graham’s formula the fair value of Perpetual (PPT) is around
$18. At the time of writing the Perpetual share price was around $40, so this would
suggest that it is currently overpriced. To achieve a valuation of $40 using this
formula, the company would need to have an earnings growth rate of about 15%, or
we would have to decrease our Investors Required Return or Discount Rate from
12% to around 5.3%.

If we were instead to use the Australian AAA Corporate Bond Rate17 as preferred by
Benjamin Graham (as opposed to the calculated 12% Discount Rate) we would

16 This can be between 2 – 3 years of EPS data.

17 Australian AAA Corporate Bond Rate at time of writing is around 2.9%

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arrive at an Intrinsic Value of close to $75. This is why I prefer to use the more
conservative Discount Rate figure than the AAA Corporate Bond Rate.

Here is another worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Earnings (EPS) ($) 0.28 0.33 0.27 0.26 0.41 0.45 0.50 0.50 0.65 0.88

Again, we will need to calculate the growth rate of InvoCare’s EPS, but due to the big
jump in earnings in 2016 and 2017 it would be better to use a three-year average of
the EPS rather than taking the single 2017 value.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝐸𝑃𝑆 = (𝑌𝑒𝑎𝑟 1 + 𝑌𝑒𝑎𝑟 2 + 𝑌𝑒𝑎𝑟 3) / 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

= (0.50 + 0.65 + 0.88) / 3

= $0.68

Now we can plug these values18 into the CAGR formula to find the projected growth
rate of the company. You can always look at other websites’ forecast earnings as a
comparison to see if the analysts believe the earnings are expected to keep growing.
For example, here are the analysts’ forecast EPS for InvoCare for the next three
years supplied via CommSec brokerage account.

Fiscal Year Ends in December

Earnings Forecast
2017 2018 2019 2020
Earnings (EPS) ($) 0.89 0.55 0.59 0.61

As you can see there is a big drop in 2018 forecast earnings. This is due to InvoCare
temporarily closing some of its stores for renovations as well as other increases in
Capital Expenditure being forecast by management. This has been communicated
by the board in reports and shareholder letters and I believe the drop in EPS will be
short lived. If you believe there is justification for a drop in earnings (as indicated by
the IVC example above) and such drop would be short lived and shouldn’t affect the
continued earnings growth into the future, then you should be confident to use the
growth rate you have calculated and apply it to the formula.
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒

18 We are using the EPS from 2008 of $0.28 and the calculated Averaged EPS of $0.68 to calculate the CAGR.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

1
0.68 (9)
= ( ) −1
0.28

= 10.3%

We have calculated all the required data to complete the Benjamin Graham Formula.
We are using the three-year average EPS figure of $0.68 and a growth rate of
10.3%. we will also use the same Discount Rate of 12%.

𝐸𝑃𝑆 × (8.5 + 2𝑔) × 4.4

𝑉=
𝑌

0.68 × (8.5 + 2 × 10.3) × 4.4

=
12

= $7.22 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 = ~$13)

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8.5.2 Discount Cash-Flow Method (DCF)

The Discount Cash-Flow Method (DCF) is one of the most popular and widely used
valuation techniques. It is basically the addition of all future free cash flows which
have been discounted annually at the Discount Rate / Investors Required Return,
which we calculated in the earlier chapter titled ‘Calculating the Investor’s Required
Return / Discount Rate’. This will give us the present value of the future free cash
flows. The sum of these free cash flow figures is the company’s Intrinsic Value. As
you will see, it is basically the same formula that we use for the Dividend Discount
Method (DDM) and the Residual Income Valuation Method (RIV) Intrinsic Value
calculations.

The DCF formula comprises two parts; the first part is used to calculate the Intrinsic
Value during what is generally referred to as the High Growth Period, where the
company may have higher but potentially inconsistent free cash flow growth rates.
This period is usually calculated to no more than 10 years (See Section 8.3
Calculating the Projected Growth of a Company). The second part is used for the
Terminal or Stable Growth Period of the company. This is generally a more
conservative estimate of a consistent rate of growth that is expected for the
remaining life of the company. A stable growth rate just above inflation is usually
acceptable, between 3% - 6% (See Section 8.4 High Growth vs. Terminal / Stable
Growth Period of a Company).

The first part of the DCF formula which is used to calculate the Intrinsic Value of a
company’s High Growth Period is as follows:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛

𝑉= 1
+ 2
+ 3
+⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑛
Where:

V = Intrinsic Value
CF1, CF2, CF3 = Cash Flow for years 1, 2 and 319
r = Investor’s Required Return / Discount Rate (See Section 7)
n = Continuing number of years20

To calculate CF1, CF2 and CF3 etc. we will use the formula below which is
calculating the forecasted future free cash flow of the company, which will then be
entered into the DCF formula above.

𝐶𝐹1 = 𝐶𝐹 × (1 + 𝐺)
𝐶𝐹2 = 𝐶𝐹1 × (1 + 𝐺)
𝐶𝐹3 = 𝐶𝐹2 × (1 + 𝐺) 𝑎𝑛𝑑 𝑠𝑜 𝑜𝑛 …

19 You can continue to calculate the Free Cash Flow annually as far into the future you believe higher
growth rates are sustainable. As a general rule, 10 years is accepted as a maximum length of time.
20 For example, if you were to forecast 4 years rather than 3, we would replace the n with 4, and so

on.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Where:

CF1, CF2, CF3 = Cash Flow for years 1, 2 and 321

G = Growth rate (CAGR)22 of High Growth Period

The Terminal Value (the period of consistent growth) is calculated as follows:

𝐶𝐹𝑛
𝑉=
(𝑟 − 𝐺) × (1 + 𝑟)𝑛

Where:

V = Intrinsic Value
r = Investor’s Required Return (Discount Rate) (See Section 7)
G = Constant growth rate for stable period (See Section 8.4)
CFn = Cash Flow from the last year of constant growth
n = Starting year of stable growth

The two formulae are used in combination to give you a final valuation of the
company using the Discount Cash Flow method:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛 𝐶𝐹𝑛

𝑉=[ + + + ⋯ ] + [ ]
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛 (𝑟 − 𝐺) × (1 + 𝑟)𝑛

Here is a worked example using ASX Listed Company Perpetual Limited (PPT):
To calculate the Intrinsic Value using the Free Cash Flow Method, all we need from
the Financial Report is the Free Cash Flow per Share. We have already calculated
our Discount Rate (r) (See Section 7) and we can estimate the future free cash flow
growth rate by using the historical data applied to the Compound Annual Growth
Rate Formula (See Section 8.3 Calculating the Projected Growth of a Company).

Fiscal Year Ends in June

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Free Cash Flow ($) 2.20 1.15 3.27 2.28 1.35 2.23 2.01 2.46 2.85 3.12

As you can see from the table above the free cash flow per share over the last ten
years has been inconsistent. Having a steady increase in free cash flow with
consistent growth is what we would ideally like to see, but to overcome these
fluctuations we can average the free cash flow. Basically, what we can do is
calculate the average free cash flow over two or three years for the Beginning Value
and the Ending Value, as opposed to taking the single value of, in this case, $2.20
from 2008 for the Beginning Value and $3.12 from 2017 for the Ending Value. This
will provide a more accurate and generally more conservative growth rate simply by
minimising any erratic changes in free cash flow from year to year. First, we will find
21 You can continue to calculate the Free Cash Flow annually as far into the future you believe higher
growth rates are sustainable. As a general rule, 10 years is accepted as an appropriate length of time.
22 See Section 8.3 Calculating the Projected Growth of a Company to calculate this rate.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

the Averaged Beginning Free Cash Flow (ABCF) by averaging 2008 and 2009 free
cash flow figures.

Averaged Beginning Free Cash Flow (ABCF) Calculation:

𝑌𝑒𝑎𝑟 1 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (2008) + 𝑌𝑒𝑎𝑟 2 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (2009)
𝐴𝐵𝐶𝐹 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

2.20 + 1.15
=
2

= $1.68

Now we need to find the Averaged Ending Free Cash Flow (AECF) by averaging
2016 and 2017 free cash flow figures.

Averaged Ending Free Cash Flow (AECF) Calculation:

𝑌𝑒𝑎𝑟 1 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (2016) + 𝑌𝑒𝑎𝑟 2 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (2017)
𝐴𝐸𝐶𝐹 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

2.85 + 3.12
=
2

= $2.99

Now we can enter these two figures into our Compound Annual Growth Rate formula
(See Section 8.3 Calculating the Projected Growth of a Company) to calculate the
growth rate of the free cash flow, which we will then use to forecast the future free
cash flows of the company later in the Discount Cash Flow formula.
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
2.99 (9)
= ( ) −1
1.68

= 6.6%

We now have all the required data to calculate the Intrinsic Value using the Discount
Cash Flow Method (DCF). As we have used the Averaged Free Cash Flow in the
CAGR formula to calculate the growth rate we will continue to use this figure of $2.99
as our starting free cash flow per share for the DCF formula. We have calculated the
growth rate of 6.6%, which we can round down to 6.0% to be a little more

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

conservative. This 6.0% is what we anticipate the free cash flow will grow by each
year and what we also call the High Growth Period of the company (See Section 8.4
High Growth vs. Terminal / Stable Growth Period of a Company). The High Growth
Period is commonly calculated between three to ten years. For this situation, as the
previous ten years has been pretty inconsistent, we can use a High Growth Period of
just 4 years.

𝐶𝐹1 = 𝐶𝐹 × (1 + 𝐺)

= 2.99 × (1 + 0.06)

= $3.16

𝐶𝐹2 = 𝐶𝐹1 × (1 + 𝐺)

= 3.16 × (1 + 0.06)

= $3.35

And just keep repeating the formula to calculate the next two years.

𝐶𝐹3 = $3.56

𝐶𝐹4 = $3.77

As we have stated above, the free cash flow will grow at 6.0% for the first four years
during the High Growth Period. From here we will apply a Terminal/Stable Growth
rate of 5%. This will be used to calculate the remaining value of the company post
the 4 year High Growth Period (See Section 8.4 High Growth vs. Terminal / Stable
Growth Period of a Company). So, to calculate the free cash flow for the fifth year we
first must grow the fourth year’s free cash flow by 5%.

𝐶𝐹5 = 𝐶𝐹4 × (1 + 𝐺)

= 3.77 × (1 + 0.05)

= $3.99

Now we can plug these values into the Discount Cash Flow formula. Remember that
‘r’ is the Discount Rate that we calculated to be 12% (See Section 7).

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5

𝑉= 1
+ 2
+ 3
+ 4
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (𝑟 − 𝐺) × (1 + 𝑟)4

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

3.16 3.35 3.56 3.77

= 1
+ 2
+ 3
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)4

3.99
+
(0.12 − 0.05) × (1 + 0.12)4

= 2.83 + 2.67 + 2.53 + 2.39 + 35.98

= $46.40 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $40)

Here is another worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Free Cash Flow ($) 0.20 0.24 0.32 0.26 0.32 0.48 0.41 0.39 0.44 0.25

As you can see, the free cash flow has been pretty consistent over most of the ten-
year period, except for the final year in 2017 when it dropped by about 43% from the
previous year. If you look at the data table below, you can see that there has been a
big increase in Capital Expenditure in the last year which will negatively affect the
free cash flow23. Capital Expenses are generally expenses incurred to maintain or
upgrade property, plant and equipment, which would make sense in this case as
InvoCare has stated that it has implemented a ‘Protect and Grow’ strategy to
upgrade its assets to remain competitive and increase its customer base.

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Capital Expenditure ($) 0.16 0.13 0.14 0.15 0.17 0.17 0.24 0.20 0.28 0.43
YoY Change (%) -18.8 7.7 7.1 13.3 0.0 41.2 -16.7 40.0 53.6

𝑌𝑒𝑎𝑟 𝑂𝑣𝑒𝑟 𝑌𝑒𝑎𝑟 (𝑌𝑜𝑌)% = ((𝑌𝑒𝑎𝑟 2 − 𝑌𝑒𝑎𝑟 1)/𝑌𝑒𝑎𝑟1) × 100

This goes to show how calculating the Intrinsic Value of a company is not a precise
process. Many situations require the investor to make predictions and forecasts of
where they believe the company is heading. As stated previously, this can be
achieved by reviewing past Financial Reports and reading the various
pronouncements made by management about the future direction of the company.
Then it is up to you to judge just how much impact the future strategies announced
by management can actually impact the future growth of the company. For this
example, let’s assume that this drop in free cash flow is just temporary and once the
‘Protect and Grow’ strategy is in full swing the growth rates will increase significantly.
It is anticipated that the strategy will pay for itself in six to seven years as stated in

23 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

their 2017 Annual Report and they are anticipating that earnings will increase by at
least 10 -12% a year by the year 2020. We can use this reported future growth as a
comparison to help us project the High Growth Period of the company.

As we can see,
InvoCare has seen a big
drop in its 2017 free
cash flow figure, but as
explained, this is caused
by the increase in
Capital Expenditure.
Due to this short term
increase in Capital
Expenditure, which
directly affects the free
cash flow, it would be best to calculate the High Growth Period using the CAGR
formula (See Section 8.3 Calculating the Projected Growth of a Company) between
the years 2008 and 2016. As we can see from the Free Cash Flow table and the
corresponding Free Cash Flow graph above, the cash flow for InvoCare has been
relatively consistent and predictable and for this reason we don’t need to perform
any averaging24 of the Beginning and Ending Value figures for the CAGR formula.25
We can now input the free cash flow of $0.20 from 2008 as the Beginning Value and
the free cash flow of $0.44 from 2016 as the ending value, also note that the period
or Number of Years is now 8.
1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
0.44 (8)
= ( ) −1
0.20

= 10.36%

From this we can assume 10% as a reasonable rate of growth for the High Growth
Period of InvoCare. As stated by management, we can expect little growth in
earnings over the next 2-3 years so we can account for this when calculating the
Intrinsic Value using the DCF method.

24 Averaging of data is done to help provide a more consistent result by reducing the impact of any exorbitant
values. This is generally done over a two- or three-year period and is often required for free cash flow in
particular as it is susceptible to changes in Capital Expenditure which can be inconsistent or be at increased
levels for growing companies.
25 You can still use averaged figures if you wish to be more conservative.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

For this scenario we could grow the 2017 free cash flow figure of $0.25 at the rate of
inflation (3%) lasting for the 3-year period until the impact of the ‘Protect and Grow’
strategy and increased Capital Expenditure has subsided. Then, from this point we
can assume business as usual and continue by using the normal/unaffected free
cash flow from 2016 of $0.44 as our starting point from which we will grow that $0.44
free cash flow at a rate of 10% a year for a High Growth Period of 10 years.

Now we have accounted for the changes that will occur in the business over the next
few years we can begin to calculate the Intrinsic Value of InvoCare using the
Discount Cash Flow Method. Starting with the three-year period that will be affected
by the ‘Protect and Grow’ strategy using $0.25 as our free cash flow figure and a
growth rate of 3%.

𝐶𝐹1 = 𝐶𝐹 × (1 + 𝐺)

= 0.25 × (1 + 0.03)

= $0.26

𝐶𝐹2 = 0.26 × (1 + 0.03)

= $0.27

𝐶𝐹3 = 0.27 × (1 + 0.03)

= $0.27

Now we increase the growth rate from 3% to 10% and change the cash flow figure to
$0.44.

𝐶𝐹4 = 𝐶𝐹 × (1 + 𝐺)

= 0.44 × (1 + 0.1)

= $0.48

𝐶𝐹5 = 0.48 × (1 + 0.1)

= $0.53

And just keep repeating the formula to calculate the remainder.

𝐶𝐹6 = $0.59

𝐶𝐹7 = $0.64

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

𝐶𝐹8 = $0.71

𝐶𝐹9 = $0.78

𝐶𝐹10 = $0.86

𝐶𝐹11 = $0.94

𝐶𝐹12 = $1.04

𝐶𝐹13 = $1.14

Now, as we have just calculated the next thirteen years of free cash flow figures, we
just need the free cash flow figure which we will use to calculate the Stable Growth
Period. To do this we will grow the CF13 figure of $1.14 by the Stable Growth Rate,
which in this case we will use 5%26 (See Section 8.4 High Growth vs. Terminal /
Stable Growth Period of a Company).

𝐶𝐹14 = 𝐶𝐹13 × (1 + 𝐺)

= $1.14 × (1 + 0.05)

= $1.20

Now we can use the DCF formula to calculate the Intrinsic Value of the business.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5 𝐶𝐹6 𝐶𝐹7

𝑉= + + + + + +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4 (1 + 𝑟)5 (1 + 𝑟)6 (1 + 𝑟)7

𝐶𝐹8 𝐶𝐹9 𝐶𝐹10 𝐶𝐹11 𝐶𝐹12 𝐶𝐹13

+ 8
+ 9
+ 10
+ 11
+ 12
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)13

𝐶𝐹14
+
(𝑟 − 𝐺) × (1 + 𝑟)13

0.26 0.27 0.27 0.48 0.53 0.59

= 1
+ 2
+ 3
+ 4
+ 5
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)6

0.64 0.71 0.78 0.86 0.94

+ + + + +
(1 + 0.12)7 (1 + 0.12)8 (1 + 0.12)9 (1 + 0.12)10 (1 + 0.12)11

1.04 1.14 1.20

+ + +
(1 + 0.12)12 (1 + 0.12)13 (0.12 − 0.05) × (1 + 0.12)13

26 Once a business reaches maturity it is generally accepted that a growth rate just above inflation is
appropriate; therefore, a Stable Growth Rate of between 3% – 6% is often used when calculating
Intrinsic Value.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

= 0.23 + 0.21 + 0.19 + 0.31 + 0.30 + 0.30 + 0.29 + 0.29 + 0.28 + 0.28 + 0.27 + 0.27

+ 0.26 + 3.92

= $7.40 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 = ~$13)

Examples like this help to illustrate the difficulties that are sometimes encountered
when trying to value a business and highlight the fact that it is near impossible to
assign a definite Intrinsic Value figure to a business as there are many variables to
consider including your own personal assumptions.

8.5.2.1 Comments on Cash Flow and Earnings Data

As a general rule, Free Cash Flow is the statistic used to determine the Intrinsic
Value of a company as demonstrated in the examples above. Other approaches that
I like to use in addition to Free Cash Flow are Earnings per Share and Owner
Earnings.

Earnings per Share (EPS) is the Net Profits of the business divided by Shares
Outstanding. It is one of the key indicators investors look at when analysing a
business and as such, any major changes or missed forecasts on reported Earnings
per Share (EPS) can have a big impact on the price of a stock. Earnings per Share
(EPS) is also more stable than Free Cash Flow as it is not influenced by fluctuations
in Capital Expenditure (To calculate Free Cash Flow, you take Capital Expenditures
from Operating Cash Flow). Earnings per Share (EPS) is perhaps a more stable
measure of the health of a business and indicator of the future price and one that
could be used in calculations of Intrinsic Value. Earnings per Share is also used
extensively by professional investors when attempting to estimate the value of a
business.

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆) =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Owner Earnings (OE) is a calculation that can also be undertaken using data which
can be found in the Financial Statements. It is a term coined by Warren Buffett and is
used to determine the actual cash that can be taken from the business and paid out
to the shareholder (owner), hence the name, Owner Earnings (OE). It is very similar
to the Free Cash Flow figure that has since been developed and can be calculated
from using a company’s Cash Flow Statement. The formula for Owner Earnings (OE)
as outlined by Warren Buffett is:

𝑂𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛 +/−𝑂𝑡ℎ𝑒𝑟 𝑁𝑜𝑛 𝐶𝑎𝑠ℎ 𝐶ℎ𝑎𝑟𝑔𝑒𝑠 −

𝐴𝑛𝑛𝑢𝑎𝑙 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 +/−𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

A more simplified and perhaps more easily acquired version which will provide a
similar value is:

𝑂𝐸 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛

Owner Earnings is not a reportable figure so you will not find it on a Financial Report,
so you will need to calculate it yourself if you wish to use it. You can also find it on
some paid financial sites like www.gurufocus.com where they include many of the
great Value Investors’ formulae within their historical financial data.

I have mentioned three different calculations above which are all derived from the
earnings or profit of a business. When using the Discount Cash Flow method, I like
to calculate the average of all three of these earnings results, namely, Earnings per
Share, Free Cash Flow per Share and Owner Earnings per Share and use this
average in lieu of the Free Cash Flow number. Refer to the example below using
ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Earnings (EPS) ($) 0.28 0.33 0.27 0.26 0.41 0.45 0.50 0.50 0.65 0.88
Free Cash Flow ($) 0.20 0.24 0.32 0.26 0.32 0.48 0.41 0.39 0.44 0.25
Owner Earnings ($) 0.27 0.33 0.28 0.27 0.45 0.52 0.58 0.59 0.74 0.93
Average ($) 0.25 0.30 0.29 0.26 0.39 0.48 0.50 0.49 0.61 0.69

If we use the Average figure in place of the Free Cash Flow figure, as used in the
previous InvoCare example, we reduce the impact changes in Capital Expenditure
has on Free Cash Flow. Also, by using the Average of the three earnings figures we
now incorporate what I believe are the three most widely used figures when valuing
a business, Earnings per Share (used by many institutional investors when preparing
company valuations), Owner Earnings (used by Warren Buffett, one of the world’s
greatest investors of all time) and Free Cash Flow (used more by the more
conservative investor including many Value Investors).

Now, if we were to use this new Average figure and follow the same steps as in the
previous example to calculate the Intrinsic Value of InvoCare, but substitute the Free
Cash Flow figure for 2017 ($0.25) with the new Average from the table above of
$0.69 for the year 2017, maintain the same rates of growth of 3% for the first three
years and then utilise the High Growth rate of 10% for the following ten years, we
would arrive at an Intrinsic Value of $13.34. I believe this is probably closer to the
actual Intrinsic Value of InvoCare than the previously calculated Intrinsic Value of
$6.98. (Current price at time of writing = ~$13)

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

8.5.3 Dividend Discount Method (DDM)

The Dividend Discount Method (DDM) is another method used to calculate the
Intrinsic Value of a company. It takes the forecast dividends and discounts them
back to a present value. It is best used for companies that are forecast to pay a
dividend into the future.

There are two methods we can use to find the Intrinsic Value of a business using the
Dividend Discount Method (DDM). The first method is a simple calculation that is
best suited for companies which pay a dividend that is forecast to grow at a
consistent rate into the future. The second is a variation of the Discount Cash Flow
(DCF) method but instead of using free cash flow, we use a company’s dividend
payments.

The first Dividend Discount Method (DDM) mentioned above which is best used for
companies that have a constant growth rate has three key inputs; next year’s
Forecast Dividends per Share (D1), the Investor’s Required Return or Discount Rate
(r) (See Section 7 Calculating the Investor’s Required Return / Discount Rate) and
Dividend Growth Rate (G) (See Section 8.3 Calculating the Projected Growth of a
Company).

The formula is as follows:

𝐷1
𝑉=
(𝑟 − 𝐺)

This formula assumes however that the Dividend Growth Rate will be constant,
which may not be realistic in some circumstances. You should also note that the
Discount Rate (r) must be larger than the Dividend Growth Rate (G). If not, this
formula will not work.

Where you cannot assume a constant Dividend Growth Rate, a second formula as
detailed below can be used instead.

𝐷1 𝐷2 𝐷3 𝐷𝑛
𝑉= + + + ⋯
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛

Where:
V = Intrinsic Value
D1, D2, D3 = Forecast Dividends for years 1, 2 and 327
r = Investor’s Required Return (Discount Rate) (See Section 7)
n = Continuing number of years28

27 You can continue to calculate the dividends on an individual basis as far into the future as
practicable but forecasting greater than ten years may become difficult given the increase in
economic uncertainty.
28 For example, if you were to forecast 4 years rather than 3, we would replace the n with 4, and so

on.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

This formula, when used on its own, can be limiting as you need to know the
expected life of the company due to the fact the formula calculates each year on an
individual basis and will not account for the perpetuity of a business. Conversely, in
the previous DDM method, which is used for a company with constant growth, it
results in the present value of an infinite series of future dividends at a constant
growth and thus does not account for changes in dividend growth which is often
prevalent in a growing business.

To overcome the problems related to each formula, the first being only for a
company which has constant growth and the second being the need to know the
expected life of the business, both formulae can be combined. The benefit of
combining the two formulae is that you can incorporate both the growth
(expansionary) phase of a business with the long term (mature) constant growth
phase. As seen with most businesses, there can be more prosperous periods where
the company is expanding and increasing its market share. As the company matures
these growth rates generally reduce and become relatively consistent.

To combine these two formulae, you must first modify the original constant growth
formula by discounting the dividend back to a present value as follows:

𝐷𝑛
𝑉=
(𝑟 − 𝐺) × (1 + 𝑟)𝑛

Where:

V = Intrinsic Value
r = Investor’s Required Return (Discount Rate) (See Section 7)
G = Constant growth rate for stable period (Section 8.4)
Dn = Dividend from the first year of constant growth
n = Starting year of stable growth29

Finally, combining the modified Constant Growth formula with the second formula
from above will give us our multistage formula as shown below:

𝐷1 𝐷2 𝐷3 𝐷𝑛 𝐷𝑛
𝑉=[ + + + ⋯ ] + [ ]
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛 (𝑟 − 𝐺) × (1 + 𝑟)𝑛

You should be aware that the Dividend Discount Method (DDM) ignores any retained
earnings, which may not matter, unless the company is able to reinvest these
earnings and generate high returns on them. Therefore, the higher returns generated
on the retained earnings will be ignored in this method and may result in an
underestimation of the Intrinsic Value of the company.

29 This is calculated by counting the number of years (High Growth Years) leading up to the year of
stable growth and is not the actual year e.g. 2025.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Here is a worked example using ASX Listed Company Perpetual Limited (PPT):

To calculate the Intrinsic Value using the Dividend Discount Method (DDM), all we
need from the financial report is the Dividends per Share (DPS). We have already
calculated our Discount Rate (r) (12%) (See Section 7) and we can estimate the
future dividend growth rate by using the historical data applied to the Compound
Annual Growth Rate Formula (See Section 8.3 Calculating the Projected Growth of a
Company).

Fiscal Year Ends in June

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Dividends ($) 3.76 1.81 1.65 2.00 1.40 0.90 1.60 2.10 2.50 2.60
Payout Ratio (%) 121.7 203.4 78.2 141.8 237.3 63.4 88.9 79.2 88.0 88.4

We encounter the same problem we had with the Earnings per Share (EPS) when
we calculated the Intrinsic Value using Benjamin Graham’s formula. As with the
earnings from the Benjamin Graham example, the dividends above are inconsistent
which can create an abnormal Growth Rate and in turn an unrealistic Intrinsic
Valuation of the business.

I have also included the payout ratio, just to illustrate what percentage of the
company’s earnings is being paid to the shareholder. As you can see the Payout
Ratio has been inconsistent but over the last six years has steadily increased to a
ratio of about 90%. A Payout Ratio of 90% is the company’s stated objective for the
foreseeable future. It is also important to note that having a Payout Ratio as high as
90% can result in increased instability in dividends as any drop in a company’s
earnings could result in the dividend needing to be reduced. This is because for a
company to pay a dividend
above its earnings will generally
mean either, the company is
using its own capital reserves
(excess cash) or has raised
capital by way of a loan to ‘top
up’ its dividend payment. This
scenario is obviously not ideal
nor is it sustainable and is
something an investor should
be wary of.

To calculate the payout ratio, you divide the Dividends per Share (DPS) by the
Earnings per Share (EPS):

𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐷𝑃𝑆 / 𝐸𝑃𝑆

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

To start, we can look at this data and see that the company has been consistently
increasing its dividends over the last 5 years. From 2013 to 2017 the dividend has
grown at a compound rate of about 30% a year (see calculation below). It is however
highly unlikely for a company to continue to grow its dividend by 30% a year and it
would be ill-advised to think that this rate of growth could be sustainable. Another
reason for us not to consider 30% as a realistic rate of growth is the fact that the
dividend has been so inconsistent over the longer timeframe of ten years.

2013 – 2017 growth rate:

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
2.60 (4)
= ( ) −1
0.90
= 30.37%

Considering all the information mentioned above, being the fact that the dividend has
been inconsistent and the difficulty in calculating a reliable growth rate, we could
assume a dividend growth just above inflation of 5%, which is what we would
normally use as the Terminal/Stable Growth Rate of a company (See Section 8.4
High Growth vs. Terminal / Stable Growth Period of a Company).

We could simply use the Stable Growth Model to calculate the intrinsic value of this
company, as we have assumed the dividends will continue to grow at a constant rate
of 5%. We now have almost all the data required to calculate the Intrinsic Value. We
have decided upon a dividend growth rate of 5% and can use the Discount Rate
which we calculated earlier at 12% (See Section 7). All we need is next year’s
forecast dividend (D1) which can be easily calculated; also, many stock analysis
sites will provide forecasts of Dividends per Share (DPS) and Earnings per Share
(EPS).

𝐷1 = 𝐷 × (1 + 𝐺)

Where:

D1 = Next year’s dividend

D = Current dividend ($2.60)
G = Dividend Growth Rate (5%)30

𝐷1 = 2.60 × (1 + 0.05)
= $2.73

30 This is the Stable/Terminal growth rate.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

As we now have all the data, let’s calculate the Intrinsic Value using the Dividend
Discount Method for companies with Stable Growth.

𝐷1
𝑉=
(𝑟 − 𝐺)
2.73
=
(0.12 − 0.05)
= $39.00 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $40)

Here is another worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Dividends ($) 0.23 0.25 0.27 0.29 0.31 0.34 0.35 0.37 0.39 0.44
Payout Ratio (%) 82 76 100 112 76 76 70 74 60 50

You can see that

InvoCare has had a
consistent increase in its
dividend over the last 10
years. As a result of this,
it would be safe to use
the actual figures without
them having to be
averaged31. From 2008
until 2017, the dividends
have increased at 7.5% a
year. You can also see
that management place an importance on maintaining a consistent dividend due to
the fact that in 2010 and 2011 the payout ratio was at 100% and 112% respectively.
This indicates that to maintain a consistent dividend, management elected to draw
from its capital reserves, which isn’t ideal. Since then however, the payout ratio has
been at a more sustainable level meaning, InvoCare could experience quite a large
reduction in its earnings before it would affect the dividend payment.

31Averaging data is done to help reduce the impact big changes in data has on calculations and by using
averaged data will return a more conservative and generally more realistic figures.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
0.44 (9)
= ( ) −1
0.23

= 7.5%

As stated in its annual report, InvoCare is implementing a ‘Protect and Grow’

strategy which includes making capital improvements across its business to help
maintain its competitiveness and to keep growing earnings. This gives me
confidence that the dividends can continue to grow at 7.5% for at least the next five
years, and from then on continue with a conservative growth rate of 5%.

To calculate the intrinsic value using the Multistage Dividend Discount Method we
first need to calculate the future dividends, D1, D2 etc.

The 2017 dividend was $0.44 and as we have calculated a growth rate of 7.5% for
the next five years, we now have all the data required to calculate future dividends.

𝐷1 = 𝐷 × (1 + 𝐺)

= 0.44 × (1 + 0.075)

= $0.47

𝐷2 = 𝐷1 × (1 + 𝐺)

= 0.47 × (1 + 0.075)

= $0.51

And just keep repeating the formula to calculate the remainder.

𝐷3 = $0.55

𝐷4 = $0.59

𝐷5 = $0.63

As we have forecast, the dividends will grow at 7.5% for the first five years during the
High Growth Period and 5% from then on during the Stable Growth Period. So, to
calculate the dividend for the sixth year we should grow the fifth year’s dividend by
5%.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

𝐷6 = 𝐷5 × (1 + 𝐺)

= 0.63 × (1 + 0.05)

= $0.66

Now we can plug these values into the multistage DDM. Remember that ‘r’ is the
Discount Rate that we calculated to be 12% (See Section 7).

𝐷1 𝐷2 𝐷3 𝐷4 𝐷5 𝐷6
𝑉= 1
+ 2
+ 3
+ 4
+ 5
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (𝑟 − 𝐺) × (1 + 𝑟)5

0.47 0.51 0.55 0.59 0.63

= + + + +
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

0.66
+
(0.12 − 0.05) × (1 + 0.12)5

= 0.42 + 0.41 + 0.39 + 0.37 + 0.36 + 5.38

= $7.33 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 = ~$13)

8.5.4 Residual Income Method (RIV)

The Residual Income Method (RIV) is very similar to the previous discount methods,
but this time, rather than using estimated future dividends or free cash flows of the
business, we will use what is known as the Residual Income of a business. Residual
Income is basically as it sounds, money that remains in a business after accounting
for the cost of capital or the opportunity cost, which we described in Chapter 7
‘Calculating the Investor’s Required Return / Discount Rate’, and used as the
Discount Rate or the Investor’s Required Return. The Investor’s Required Return or
Discount Rate is applied to the company’s equity, or in this instance we will use Book
Value, which is basically equity per share. This will be the company’s cost of equity
and will then be taken from the earnings of the business where we will be left with
the Residual Income of the business.

The formula to calculate Residual Income is:

𝑅𝐼 = 𝐸𝑃𝑆 − 𝑟 × 𝐵

Where:
RI = Residual Income
EPS = Earnings per Share (EPS)
R = Investor’s Required Return (Discount Rate)
B = Book Value per Share

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Now that we know how to calculate the Residual Income, we can use this formula to
forecast the future growth rate of the business. This can be done by using the
Compound Annual Growth Rate formula, detailed in the table below. I suggest
however that we should compare this rate of growth with the Earnings per Share and
Book Value Compound Annual Growth Rates. Doing this comparison will give us
more confidence in our chosen forecast future growth rate of the business.

Here is a worked example using ASX Listed Company Perpetual Limited (PPT):

Fiscal Year Ends in June

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Earnings EPS ($) 3.09 0.89 2.11 1.41 0.59 1.42 1.80 2.65 2.84 2.94
Earnings CAGR (%) -71.2 -17.4 -23.0 -33.9 -14.4 -8.6 -2.2 -1.0 -0.6
Book Value ($) 7.48 6.82 8.28 8.19 6.39 7.49 11.70 12.94 13.43 13.84
Book Value CAGR (%) -8.8 5.2 3.1 -3.9 0.0 7.7 8.1 7.6 7.1
Discount Rate (%) 16.8 12.2 12.7 13.7 12.0 12.0 12.0 12.0 12.0 12.0
Residual Income RI ($) 1.83 0.06 1.06 0.29 -0.18 0.52 0.40 1.10 1.23 1.28
RI CAGR (%) -96.8 -24.0 -46.0 N/A -22.2 -22.5 -7.1 -4.9 -3.9

Note: Growth Rates have been calculated using the Compound Average Growth Rate (CAGR)
formula (See Section 8.3 Calculating the Projected Growth of a Company).

We have encountered the same problem as before, with the first year of data being a
lot stronger than the subsequent years. To ensure an abnormal year’s number
doesn’t distort our valuation, we can simply ignore those numbers in our equation
and apply a greater Margin of Safety when calculating the growth e.g. be more
conservative with your estimates (See Section 6 Margin of Safety). The two graphs
below will help to illustrate my point.

Full 10 years of data:

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Disregarding the first year:

As you can see, the bottom two graphs show a more constant and steady growth
pattern and give a more representative example of how the company has performed
in the past and are more likely to provide a more accurate forecast of future growth
rates.

Ignoring the first year’s data, the compounding annual growth rates32 of the EPS,
Book Value and Residual Income for the subsequent 9 years are as follows33:

𝐸𝑃𝑆 𝐶𝐴𝐺𝑅 = 8.5%

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝐶𝐴𝐺𝑅 = 7.7%
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 𝐶𝐴𝐺𝑅 = 10.6%

From these three growth rates we can take a conservative assumption that the
Residual Income can continue to grow at about 7.5% a year for the next ten years
from which point the Stable Growth Period should be at a rate of 5% a year (See
Section 8.4 High Growth vs. Terminal / Stable Growth Period of a Company).

As a side note and in line with the formula outlined in the chapter Calculating the
Investor’s Required Return / Discount Rate, the chart below shows how I calculated
the Discount Rate. Note that I have set a minimum rate of 12%, although the
calculated rate may be lower. I would suggest a Discount Rate of no lower than 10%.
Australian economic and share market data has been used and the resultant
numbers are averaged over the particular year.

32Calculated using the CAGR formula, see Section 8.3 Calculating the Projected Growth of a Company.
33I have used the average of 2009 and 2010 for the Beginning Value and the average of 2016 and 2017 for the
Ending Value in the CAGR formula for all three calculations, EPS, Book Value and Residual Income.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
10 Year Government 6.59 5.56 5.33 5.16 3.00 5.54 3.70 2.98 2.12 2.41
Bond Yield (%)
Inflation (%) 4.40 1.40 3.10 3.50 1.20 2.40 3.00 1.50 1.00 1.90
Equity Risk Premium (%) 5.80 5.20 4.30 5.00 6.00 4.25 4.30 4.50 4.50 4.50
Discount Rate (%) 16.79 12.16 12.73 13.66 10.20 10.19 11.00 8.98 7.62 8.81
Revised Discount Rate 16.79 12.16 12.73 13.66 12.00 12.00 12.00 12.00 12.00 12.00
=>12% (%)

Now that we know how to calculate the Residual Income and where to obtain the
Discount Rate as shown in the table above, we can input the data into the Residual
Income formula. The actual formula to calculate the Intrinsic Value of a business
using the Residual Income Method (RIV) is much like other discount methods e.g.
Discount Cash Flow (DCF) and Dividend Discount Method (DDM):

𝑅𝐼1 𝑅𝐼2 𝑅𝐼3 𝑅𝐼𝑛 𝑅𝐼𝑡

𝑉 = 𝐵0 + + 2
+ 3
+⋯ 𝑛
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (𝑟 − 𝐺) × (1 + 𝑟)𝑡

The difference here is we now also include Book Value 𝐵0. This is calculated from
the current financial year’s Balance Sheet34.

Where:

V = Intrinsic Value
B0 = Book Value per Share
RI1, RI2, RI3 = Residual Income for years 1, 2 and 335
r = Investor’s Required Return/Discount Rate (See Section 7)
n = Continuing number of years36
RIn = Continuing Residual Income
G = Residual Income Stable Growth Rate (See Section 8.4)
RIt = Starting Residual Income of Stable or Terminal Growth Period
t = Starting year for Stable or Terminal Growth Period

Our next step is to calculate the projected Residual Income for each year over the
next ten years using our calculated growth rate of 7.5%. We will use the last two
years average Residual Income of $1.26 as our starting point.

34 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦/𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

35 You can continue to calculate the Residual Income on an individual basis as far into the future as
practicable but forecasting greater than ten years may become difficult given the increase in
economic uncertainty.
36 For example, if you were to forecast 4 years rather than 3, we would replace the n with 4, and so

on.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

𝑅𝐼1 = 𝑅𝐼 × (1 + 𝐺)

= 1.26 × (1 + 0.075)

= $1.35

𝑅𝐼2 = 𝑅𝐼1 × (1 + 𝐺)

= 1.35 × (1 + 0.075)

= $1.46

And just keep repeating the formula to calculate the remainder.

𝑅𝐼3 = $1.57

𝑅𝐼4 = $1.68

𝑅𝐼5 = $1.81

𝑅𝐼6 = $1.94

𝑅𝐼7 = $2.09

𝑅𝐼8 = $2.25

𝑅𝐼9 = $2.42

𝑅𝐼10 = $2.60

For the terminal growth period we need to grow the final year’s Residual Income of
$2.60 by a further 5%.

𝑅𝐼𝑡 = 𝑅𝐼10 × (1 + 𝐺)

= 2.60 × (1 + 0.05)

= $2.73

Now we can insert all the forecast Residual Income figures into our formula as well
as the Book Value per Share (B0) and calculate the Intrinsic Value of the business.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

𝑅𝐼1 𝑅𝐼2 𝑅𝐼3 𝑅𝐼4 𝑅𝐼5 𝑅𝐼6 𝑅𝐼7

𝑉 = 𝐵0 + 1
+ 2
+ 3
+ 4
+ 5
+ 6
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)7

𝑅𝐼8 𝑅𝐼9 𝑅𝐼10 𝑅𝐼𝑡

+ + + +
(1 + 𝑟)8 (1 + 𝑟)9 (1 + 𝑟)10 (𝑟 − 𝐺) × (1 + 𝑟)10

1.35 1.46 1.57 1.68 1.81

= 13.84 + + + + +
(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3 (1 + 0.12)4 (1 + 0.12)5

1.94 2.09 2.25 2.42 2.60

+ 6
+ 7
+ 8
+ 9
+
(1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12) (1 + 0.12)10

2.73
+
(0.12 − 0.05) × (1 + 0.12)10

= 13.84 + 1.21 + 1.16 + 1.11 + 1.07 + 1.03 + 0.99 + 0.95 + 0.91 + 0.87 + 0.84

+ 12.54

= $36.52 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $40)

Here is another worked example using ASX Listed Company InvoCare Limited (IVC):

Fiscal Year Ends in December

Per Share Statistics
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Earnings EPS ($) 0.28 0.33 0.27 0.26 0.41 0.45 0.50 0.50 0.65 0.88
Earnings CAGR (%) 17.9 -1.8 -2.4 10.0 10.0 10.1 8.6 11.1 13.6
Book Value ($) 0.62 0.75 0.95 1.29 1.38 1.55 1.71 1.85 2.13 2.55
Book Value CAGR (%) 21.0 23.8 27.7 22.1 20.1 18.4 16.9 16.7 17.0
Discount Rate (%) 16.8 12.2 12.7 13.7 12.0 12.0 12.0 12.0 12.0 12.0
Residual Income RI ($) 0.18 0.24 0.15 0.08 0.24 0.26 0.29 0.28 0.39 0.57
RI CAGR (%) 35.6 -7.8 -22.1 8.6 8.5 9.0 6.8 10.6 14.0

Note: Growth Rates have been calculated using the Compound Average Growth Rate (CAGR)
formula (See Section 8.3 Calculating the Projected Growth of a Company).

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As you can see from the table and the accompanying graphs, the EPS, Book Value
and Residual Income have been increasing relatively steadily over the last ten years.
The EPS has grown at a compound rate of 13.6% a year, with the Book Value and
Residual income growing at 17.0% and 14.0% respectively. As the Earnings per
Share (EPS) has seen relatively large increases over the last two years, which
subsequently leads to a similar increase in Residual Income (RI), it could be
beneficial to use a two yearly average for each of these figures in our calculations,
which will help reduce the perhaps overstated impact that we currently see on our
growth figures37 as well as giving us a more conservative result.

Calculating the growth rates using a 2-yearly average of 2016 and 2017:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝐸𝑃𝑆 = (𝑌𝑒𝑎𝑟 1 + 𝑌𝑒𝑎𝑟 2) / 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

= (0.65 + 0.88) / 2

= $0.765

𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑅𝐼 = (𝑌𝑒𝑎𝑟 1 + 𝑌𝑒𝑎𝑟 2) / 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

= (0.39 + 0.57) / 2

= $0.48

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 (𝐸𝑃𝑆) = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
0.765 (9)
= ( ) −1
0.28

37 The growth rates of the EPS, Residual Income and Book Value per Share detailed in the table above were
calculated without using any averaging of the Beginning Value or Ending Value figures.

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

= 11.8%

1
𝐸𝑛𝑑𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠)
𝐶𝐴𝐺𝑅 (𝑅𝐼) = ( ) −1
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒
1
0.48 (9)
= ( ) −1
0.18

= 11.5%

Now we need to decide what level of growth would be appropriate to use in our
Intrinsic Value calculation for the High Growth Period of InvoCare. Knowing that
InvoCare will see a reduction in its earnings due to the ‘Protect and Grow’ strategy, it
would pay to be on the conservative end of our calculated results. A ten-year High
Growth Period of 11% is, I believe, appropriate for this situation.

Our next step is to calculate the projected Residual Income of each year over the
next ten years using our growth rate of 11% and we will use the 2 yearly averaged
Residual Income of $0.48 as our starting point.

𝑅𝐼1 = 𝑅𝐼 × (1 + 𝐺)

= $0.48 × (1 + 0.11)

= $0.53

𝑅𝐼2 = 𝑅𝐼1 × (1 + 𝐺)

= 0.53 × (1 + 0.11)

= $0.59

And just keep repeating the formula to calculate the remainder.

𝑅𝐼3 = $0.66

𝑅𝐼4 = $0.73

𝑅𝐼5 = $0.81

𝑅𝐼6 = $0.90

𝑅𝐼7 = $1.00

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

𝑅𝐼8 = $1.11

𝑅𝐼9 = $1.23

𝑅𝐼10 = $1.36

For the terminal growth period we need to grow the final year’s Residual Income of
$1.36 by a further 5%.

𝑅𝐼𝑡 = 𝑅𝐼10 × (1 + 𝐺)

= 1.36 × (1 + 0.05)

= $1.43

Now we can insert all the future Residual Income figures into our formula as well as
the final years (2017) book value of $2.55 and calculate the Intrinsic Value of the
business.

𝑅𝐼1 𝑅𝐼2 𝑅𝐼3 𝑅𝐼4 𝑅𝐼5 𝑅𝐼6 𝑅𝐼7

𝑉 = 𝐵0 + 1
+ 2
+ 3
+ 4
+ 5
+ 6
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)7

𝑅𝐼8 𝑅𝐼9 𝑅𝐼10 𝑅𝐼𝑡

+ 8
+ 9
+ 10
+
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (𝑟 − 𝐺) × (1 + 𝑟)10

0.53 0.59 0.66 0.73 0.81

= 2.55 + 1
+ 2
+ 3
+ 4
+
(1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11)5

0.90 1.00 1.11 1.23 1.36

+ 6
+ 7
+ 8
+ 9
+
(1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11) (1 + 0.11)10

1.43
+
(0.12 − 0.05) × (1 + 0.11)10

= 2.55 + 0.48 + 0.47 + 0.47 + 0.46 + 0.46 + 0.45 + 0.45 + 0.45 + 0.44 + 0.44

+ 6.58

= $13.70 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $13)

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8.5.5 Balance Sheet Methods

Compared to the Discounted Cash Flow methods and the Benjamin Graham formula
above, Balance Sheet valuations are relatively simple and require little mathematical
knowledge or calculations. By using figures that can be taken from the Balance
Sheet of a company we can fairly simply calculate the Intrinsic Value. Using assets
and liabilities recorded on the Balance Sheet will provide an estimate of the
company’s worth. This is done by adding the value of its ‘hard’ assets and current
assets such as cash and receivables and deducting all debts and liabilities. This
does however rely on the accuracy of the figures reported in the Balance Sheet and
the likelihood of those assets realising the values ascribed to them if they were to be
sold today. Also, the Balance Sheet Methods make no allowance for intangible
assets such as intellectual property, patents, copyrights or business brands nor do
they reflect future growth projections or earnings power which could positively impact
on the business. Due to these factors this method will generally give a valuation that
is well under the market price and other Intrinsic Value methods outlined earlier in
this chapter.

A Balance Sheet valuation would be best applied to a business that is facing

liquidation or has suffered a major drop in price and faces the possibility of heading
into administration, in which case you may have the opportunity of purchasing
shares which are trading under ‘Net Asset Value’. The difference between the
Discount Methods and the Balance Sheet methods can be seen as the value given
to the earnings power of the business, its future growth prospects and any intangible
assets and goodwill which are inherent in the Discount Method calculations. It may
not make sense using the Balance Sheet methods for companies that have little
requirement for ‘hard’ tangible assets to generate its earnings.

8.5.5.1 Book Value

The Book Value per share is generally calculated by first subtracting the total
liabilities from total assets and then dividing that figure by the total shares
outstanding, or in other words, Shareholders Equity divided by total shares
outstanding. Another form of Book Value is known as Tangible Book Value which is
very similar to Book Value but excludes intangible assets. Tangible Book Value is
calculated by deducting intangible assets and total liabilities from total assets and
dividing the resultant number by total shares outstanding.

Tangible Book Value provides a value per share of the business if it was to close
down and liquidate all of its assets. It can also be seen as an indication of how much
you could potentially lose if the business was to go into administration. If it is trading
close to its Tangible Book Value, say within 20%, this should give you some
confidence that your investment will have a potential loss of no greater than 20%. In
this case the assumption is the assets have been fairly valued on the Balance Sheet
and will achieve the stated price at a time of crisis such as when the business is
being liquidated.

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Book Value:
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Or

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Tangible Value:
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐴𝑠𝑠𝑒𝑡𝑠
𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Or

𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − 𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
Below is a chart of market price versus Book and Tangible Book Value of Perpetual
and InvoCare.

We can see that both businesses are trading well above their book values, as they
both have strong brands and are able to produce relatively high Returns on Equity. I
have also included below, the Price to Book Ratio formulae, which basically indicates
how many times the business is trading above its Book/Tangible Book Value. The
lower the number the better as it is then trading closest to its underlying asset value.

𝑃𝑟𝑖𝑐𝑒/𝐵𝑜𝑜𝑘 = Current Market Price/Book Value

𝑃𝑟𝑖𝑐𝑒/𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝐵𝑜𝑜𝑘 = Current Market Price/Tangible Book Value

Perpetual Limited (PPT):

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = $13.84 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~$40)

𝑃𝑟𝑖𝑐𝑒/𝐵𝑜𝑜𝑘 = 2.89 (𝑡𝑖𝑚𝑒𝑠 𝑖𝑡 𝑖𝑠 𝑡𝑟𝑎𝑑𝑖𝑛𝑔 𝑎𝑏𝑜𝑣𝑒 𝑖𝑡𝑠 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒)

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𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = $6.62 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~$40)

𝑃𝑟𝑖𝑐𝑒/𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝐵𝑜𝑜𝑘 = 6.04 (𝑡𝑖𝑚𝑒𝑠 𝑖𝑡 𝑖𝑠 𝑡𝑟𝑎𝑑𝑖𝑛𝑔 𝑎𝑏𝑜𝑣𝑒 𝑖𝑡𝑠 𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒)

InvoCare Limited (IVC):

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = $2.55 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~$13)

𝑃𝑟𝑖𝑐𝑒/𝐵𝑜𝑜𝑘 = 5.1 (𝑡𝑖𝑚𝑒𝑠 𝑖𝑡 𝑖𝑠 𝑡𝑟𝑎𝑑𝑖𝑛𝑔 𝑎𝑏𝑜𝑣𝑒 𝑖𝑡𝑠 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒)

𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 = $1.22 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~$13)

𝑃𝑟𝑖𝑐𝑒/𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒𝐵𝑜𝑜𝑘 = 10.66 (𝑡𝑖𝑚𝑒𝑠 𝑖𝑡 𝑖𝑠 𝑡𝑟𝑎𝑑𝑖𝑛𝑔 𝑎𝑏𝑜𝑣𝑒 𝑖𝑡𝑠 𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝑉𝑎𝑙𝑢𝑒)

The Price to Book that Benjamin Graham liked to use when performing an initial
valuation of a business to see if it is worthy of further investigation was 1.5 or less.
This is derived from what is known as the Graham Number. This is calculated as
follows:

𝑉 = √22.5 × 𝐸𝑃𝑆 × 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

Where:

V = Intrinsic Value
EPS = Current Earnings per Share
22.5 = Derived from Grahams belief that the Price to Earnings Ratio (P/E)
should be no more than 15 and a Book Value of no more than 1.5
(15 multiplied by 1.5 equals 22.5)

The result would give an Intrinsic Value of a business, which does not take into
account future growth and other fundamentals that can be incorporated in the
Discount Methods shown earlier. Tangible Book will usually result in a more
conservative Intrinsic Value calculation.

The Intrinsic Value of Perpetual using the Graham Number method:

𝑉 = √22.5 × 𝐸𝑃𝑆 × 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

= √22.5 × 2.95 × 13.84

= $30.35 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $40)

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The Intrinsic Value of InvoCare using the Graham Number method:

𝑉 = √22.5 × 𝐸𝑃𝑆 × 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

= √22.5 × 0.89 × 2.55

= $7.15 (𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 ~ $13)

8.5.5.2 Liquidation Value

The Liquidation Value is a method Benjamin Graham developed to estimate a value
of the assets of a business if it was to be liquidated. It is basically the Tangible Book
Value of a business but adjusted to better represent the liquidation value of its
assets. When a business is trading near its Liquidation Value, it obviously has some
problems. It would be amiss of someone to expect a struggling business to be able
to sell its assets and inventory at Book Value, or the value quoted on the company’s
Balance Sheet. This inability for a company to sell its assets at Book Value could be
due to the company’s products not being as desirable or in such high demand as it
used to, or the industry in which the business operates becoming obsolete. Unless
you have the ability to analyse each asset and individually estimate the current
market value of the assets, you can instead refer to estimates of the recovery rates
for each asset class as determined by Benjamin Graham in his extensive research.
The table is as follows:

Percentage of Recovery Rate

Type of Asset
Recovery Rate Median Recovery Rate
Cash Assets 100% 100%
Receivables 75% - 90% 80%
Inventory 50% - 75% 66.5%
Fixed Assets 1% - 50% 15%

Breakdown of each asset class

Cash Assets – Assets which include cash, government and other high-grade bonds
and marketable securities. These are highly liquid assets that can be bought and
sold at face value.

Receivables – Assets which include moneys owed to the business (debtors). We can
expect a high recovery rate from these items as customers can be held accountable
for what is owed.

Inventory – Assets which include products or raw materials for sale (trading stock).
Inventories can bring a lower recovery rate as growing inventories are often a pre-
cursor to the liquidation. If the products being sold were still in high demand, then
chances are the company would still be in business and not facing liquidation.

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Fixed Assets – Assets which include plant, property and equipment. Often the plant
and equipment are specialised to cater for that particular product or business and
therefore if that product has become unfashionable or obsolete and the industry as a
whole is struggling, then so too the business would struggle to sell its fixed assets at
Book Value.

To apply this valuation method, we now simply look at the Balance Sheet and
calculate the Liquidation Value of the assets and multiply them by the recovery rate.

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Here is a worked example using ASX Listed Company Perpetual Limited (PPT):
PERPETUAL LTD (PPT) BALANCE SHEET (Fiscal Year Ends in June)
Recovery Liquidation Liquidation Liquidation
2015 2016 2017
Rate Value Value Value

Assets
Cash and cash equivalents (M) 100.0% 289 289 278 278 323 323
Receivables (M) 82.5% 91 75 88 73 96 79
Investments (M) 82.5% 52 43 75 62 63 52
Property and equipment (M) 25.0% 15 4 25 6 24 6
Goodwill (M) 0.0% 267 0 277 0 277 0
Other intangible assets (M) 0.0% 66 0 62 0 54 0
Other assets (M) 50.0% 342 171 347 174 334 167
Total assets (M) 1123 582 1153 592 1172 627
Liabilities
Short-term borrowing (M) 100.0% 0 0 0
Payables and accrued expenses (M) 100.0% 37 37 39 39 52 52
Long-term debt (M) 100.0% 87 87 87 87 87 87
Deferred taxes (M) 100.0% 47 47 42 42 37 37
Minority Interest (M) 100.0% 0 0 0
Other liabilities (M) 100.0% 368 368 380 380 362 362
Total liabilities (M) 540 540 548 548 537 537
Shareholders' equity
Common stock (M) 482 493 502
Other Equity (M) 15 14 17
Retained earnings (M) 78 95 112
Acc. other comprehensive income (M) 9 3 3
Total shareholders' equity (M) 584 606 634

Total liabilities and shareholders' equity (M) 1123 1153 1172

Liquidation Value (M) 43 44 89
Shares Outstanding (M) 45 45 46
Liquidation Value Per Share ($) $ 0.95 $ 0.98 $ 1.95
Book Value per Share ($) $ 12.95 $ 13.44 $ 13.83
Tangible Value per Share ($) $ 5.56 $ 5.90 $ 6.62
Note: This data was obtained via www.gurufocus.com.
𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑅𝑎𝑡𝑒

𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 = 𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

The table above is the Balance Sheet of Perpetual, with the blue columns being the
Liquidation Values of the assets which I have calculated. These figures are simply
achieved by multiplying the asset value in the Balance Sheet by the recovery rate.
The recovery rate is what percentage you believe the asset’s Balance Sheet value
would actually be worth if the business was to be liquidated. Once the assets have
been revalued to a Liquidation Value, we simply add the total assets then deduct the
total liabilities to give us the Liquidation Value of the business. To put this into a per
share basis you divide the result by the shares outstanding. I have also included the

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Book Value and Tangible Value for comparison. These have been calculated using
the Balance Sheet and the formulae shown earlier in the chapter, see 8.5.5.1 Book
Value.

Here is another worked example using ASX Listed Company InvoCare Limited (IVC):
INVOCARE LTD (IVC) BALANCE SHEET (Fiscal Year Ends in December)
Recovery Liquidation Liquidation Liquidation
2015 2016 2017
Rate Value Value Value
Assets
Current assets
Cash and cash equivalents (M) 100.0% 9 9 12 12 16 16
Receivables (M) 82.5% 36 30 44 36 46 38
Inventories (M) 62.5% 24 15 26 16 29 18
Prepaid expenses (M) 25.0% 6 2 6 2 5 1
Other current assets (M) 50.0% 39 20 43 22 47 24
Total current assets (M) 114 75 129 88 142 97
Non-current assets (M)
Property, plant and equipment (M) 25.0% 471 118 493 123 538 135
Accumulated Depreciation (M) 0.0% -149 0 -161 0 -183 0
Net property, plant and equipment (M) 0.0% 322 0 332 0 355 0
Equity and other investments (M) 0.0% 0 0 0 0 0 0
Goodwill (M) 0.0% 147 0 148 0 144 0
Intangible assets (M) 0.0% 6 0 5 0 4 0
Other long-term assets (M) 50.0% 419 210 471 236 540 270
Total non-current assets (M) 894 327 956 359 1042 405
Total assets (M) 1009 402 1085 446 1185 501
Liabilities
Current liabilities (M)
Accounts payable (M) 100.0% 26 26 33 33 42 42
Deferred income taxes (M) 100.0% 10 10 10 10 12 12
Deferred revenues (M) 100.0% 9 9 10 10 12 12
Other current liabilities (M) 100.0% 63 63 65 65 67 67
Total current liabilities (M) 108 108 118 118 132 133
Non-current liabilities
Long-term debt (M) 100.0% 231 231 234 234 243 243
Deferred taxes liabilities (M) 100.0% 36 36 41 41 55 55
Deferred revenues (M) 100.0% 50 50 52 52 53 53
Pensions and other benefits (M) 100.0% 2 2 3 3 4 4
Minority interest (M) 100.0% 1 1 1 1 1 1
Other long-term liabilities (M) 100.0% 377 377 402 402 415 415
Total non-current liabilities (M) 698 698 734 734 771 771
Total liabilities (M) 806 806 852 852 903 903
Shareholders' equity (M)
Common stock (M) 134 135 136
Other Equity (M) -1 0 0
Retained earnings (M) 63 91 140
Acc. other comprehensive income (M) 6 7 5
Total shareholders' equity (M) 202 233 281
Total liabilities and shareholders' equity (M) 1009 1085 1185
Liquidation Value (M) -403 -405 -403

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Shares Outstanding (M) 110 110 110

Liquidation Value Per Share ($) -$ 3.68 -$ 3.69 -$ 3.65
Book Value per Share ($) $ 1.84 $ 2.12 $ 2.55
Tangible Value per Share ($) $ 0.45 $ 0.74 $ 1.22
Note: This data was obtained via www.gurufocus.com.

𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠 × 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑅𝑎𝑡𝑒

𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 = 𝐿𝑖𝑞𝑢𝑖𝑑𝑎𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐴𝑠𝑠𝑒𝑡𝑠

𝑇𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

InvoCare has already included a depreciation figure for its property plant and
equipment titled ‘Net property, plant and equipment’. If you wish you could take this
as the face value of the Liquidation Value for the property, plant and equipment, or
apply a higher recovery rate as the items have already been depreciated. For this
example, I chose to ignore the net value and apply a lower recovery rate to remain
consistent with the previous example.

This example expresses a negative Liquidation Value, which implies that the
liabilities outweigh the Liquidation Value of the assets and therefore the shareholders
should not expect to recover any of their investment if the company was to be
liquidated.

8.5.5.3 Net Current Assets Value

Net Current Assets Value approach is quite simple and very similar to the other
Balance Sheet methods previously described in this chapter. Net Current Assets
Value (NCAV) is calculated by adding up all the current assets whilst ignoring the
non-current assets, then deducting total liabilities. More often than not this approach
will give a negative result and will rarely exceed the current share price of the
business. Benjamin Graham liked to use this method to value his businesses and
then build his portfolio with undervalued businesses. He would have very diversified
portfolios of up to 100 stocks to protect the portfolio from the obvious volatility that
you could expect from such undervalued businesses. You would be hard pressed to
find such undervalued businesses today, especially in those volumes.

Using the two tables displaying the Balance Sheets of Perpetual and InvoCare we
can calculate the Net Current Assets Value (NCAV) of each business.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑁𝐶𝐴𝑉 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

Perpetual LTD InvoCare LTD

Year 2015-06 2016-06 2017-06 2015-12 2016-12 2017-12
Current Assets (M) 432 441 482 114 129 142
Total Liabilities (M) 540 548 537 806 852 904
Shares Outstanding (M) 45 45 46 110 110 110
Net Current Asset Value ($) -$ 2.40 -$ 2.38 -$ 1.20 -$ 6.29 -$ 6.57 -$ 6.93

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

8.6 Comparing each Intrinsic Value

The table below gives an overall assessment of the Intrinsic Values resulting from
the different methods described in this chapter. I have also included the key
measures used to obtain the values; the High Growth Rate (when applicable), Stable
Growth Rate (when applicable) as well as the Earnings or Profit figure used (when
applicable). The earnings figures comprise Free Cash Flow per Share, Dividend per
Share (DPS), Residual Income per Share and Earnings per Share (EPS). Most of
these earnings figures were normalised for the Intrinsic Value calculation to allow for
any major variations from one year to the next.

Intrinsic Value - Comparison Results

Perpetual Limited (PPT) InvoCare Limited (IVC)
Valuation Key Measures Key Measures
Method Intrinsic Share Intrinsic Share
Value Price Earnings High Stable Value Price Earnings High Stable
Figure Growth Growth Figure Growth Growth

Discount Methods
Discount
$ 46.40 ~ $40.00 $ 2.99 6.0% 5.0% $ 7.40 ~ $13.00 $ 0.25 10.0% 5.0%
Cash Flow
Dividend
Discount $ 39.00 ~ $40.00 $ 2.73 N/A 5.0% $ 7.33 ~ $13.00 $ 0.44 7.5% 5.0%
Method
Residual
Income $ 36.52 ~ $40.00 $ 1.26 7.5% 5.0% $ 13.70 ~ $13.00 $ 0.48 11.0% 5.0%
Method

Average $ 40.64 ~ $40.00 $ 9.47 ~ $13.00

Benjamin Graham Methods

Benjamin
Graham $ 17.93 ~ $40.00 $ 2.89 N/A 4.2% $ 7.22 ~ $13.00 $ 0.68 N/A 10.3%
Formula
Graham
Number $ 30.35 ~ $40.00 $ 2.95 N/A N/A $ 7.15 ~ $13.00 $ 0.89 N/A N/A
Formula

Average $ 24.14 ~ $40.00 $ 7.19 ~ $13.00

Balance Sheet Method

Book
$ 13.84 ~ $40.00 N/A N/A N/A $ 2.55 ~ $13.00 N/A N/A N/A
Value

Tangible
$ 6.62 ~ $40.00 N/A N/A N/A $ 1.22 ~ $13.00 N/A N/A N/A
Book

Liquidation
$ 1.95 ~ $40.00 N/A N/A N/A -$ 3.65 ~ $13.00 N/A N/A N/A
Value

Net Current
-$ 1.20 ~ $40.00 N/A N/A N/A -$ 6.93 ~ $13.00 N/A N/A N/A
Assets Value

Average $ 5.30 ~ $40.00 -$ 1.70 ~ $13.00

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How to Value a Business Chapter 8 - Determine the Intrinsic Value

The major difference between the methods detailed above, is that the Discount
Methods and the Benjamin Graham Formula (not the Graham Number Formula)
include a forecast growth rate for a business, hence the larger Intrinsic Value figures
(in most cases). An issue that can arise from using forecast growth in calculating
Intrinsic Value is its very susceptible to bias from the investor. Meaning you could be
more optimistic about the growth of the business than the next person and hence
result in a higher valuation. Forecast growth is also difficult to predict as there are
countless external events that can have an impact on the growth of a company, for
example; an economic downturn, changes to commodity prices or currencies,
changes in technology, increased or unforeseen future competition, a change in
management, interest rate increases38 and the list could go on. Most of these items
can be accounted for in your checklist, for example you may have a checklist item
that restricts you from investing in businesses which are highly susceptible to
changes in commodity prices like oil companies or airlines which have a large
exposure to the price of oil or fuel.

If these scenarios are accounted for within your checklist, at least to the extent that is
possible, you can have a greater confidence in your valuations and the levels of
growth you will use when calculating the Intrinsic Value of the business. For
example, a business that sell items like mobile phones, televisions, laptops etc. will
have a harder time in an economic downturn or during a period of high interest rates
as compared to a business that sells toothpaste, or even one business that was
used regularly in the examples above, InvoCare, which could be seen as a business
that will always generate sales in most future scenarios. The company may just see
a decline in the high-end products which they offer.

The Discount Methods are the most popular methods used to calculate Intrinsic
Values, especially the Discount Cash Flow Method (DCF). They will generally give a
more accurate result as they include the growth component in the calculation. The
Balance Sheet Methods value the company if it was to go out of business and after
all its liabilities were accounted for and its assets sold. You can use these methods
to provide a measure of your downside risk when considering a particular
investment.

There are many other methods for calculating Intrinsic Values, and many individual
investors and companies will have their own versions which they use to establish an
approximate valuation of a business.

38This doesn’t just affect those businesses with higher debt levels, but also the consumers of the
products or services provided by the business.

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How to Value a Business Chapter 9 - Summary

9 Summary
9.1 A quick recap

Now you have read this eBook, you should have an understanding of the steps
required to make smart investment choices in relation to the stock market. A list of
the major learnings that are detailed in this eBook are:

• You now know that the stock market is not always efficient when it comes to
placing a value on a business as described by Benjamin Graham in his ‘Mr
Market’ analogy.
• You know how to use a Stock Filter to help filter out those companies that do
not meet your principles or investment criteria. This will save you lots of time.
• You have a comprehensive understanding of what a Checklist is and how it is
an invaluable part of an investor’s toolkit. You also have over 35 key checklist
items that you can use to create your own personalised checklist.
• Possibly the most important and helpful section of this eBook explains the
Margin of Safety and how an investor should use it in all their investments. It
is what protects us from ourselves as well as the ever-changing market and
economy, which we sometimes think we can predict with accuracy.
• You are now able to determine what minimum investment return you require
to help account for the risks associated with equity investing. By Calculating
the Investor’s Required Return / Discount Rate and then applying it to your
Intrinsic Value calculations, you will give yourself the best chance of ensuring
the price you pay for your investment will result in a return that is sufficient for
the level of risk associated with that particular investment.
• You now have the tools needed to Determine the Intrinsic Value of a business
and after applying a Margin of Safety to this value, you have arrived at a
purchase price with inherently reduced downside investment risk.

Throughout the whole process, it is always best to be on the conservative side for
all estimates and calculations. This may sound simple enough to do, but after
spending much time researching a company which you believe could be a great
investment, you can develop a cognitive bias toward this particular investment. A
common scenario that can emanate after heavily researching a business is that
you believe you have covered all possible scenarios leading to you becoming
overconfident, which eventually may lead you to overestimate the value of a
business.

“It is better to be vaguely right than exactly wrong” – Carveth Read

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How to Value a Business Chapter 9 - Summary

9.2 Thank you

I would like to thank you for taking the time to read this eBook. I have spent many
hours compiling all the information that I have gathered so far in relation to investing
in general and Value Investing in particular and tried to simplify it into a more
understandable format. This eBook contains what I believe are the most critical
points to understand when attempting to value a business. I hope this eBook has
helped to simplify the Value Investing approach, which, at the outset seems to be
quite a simple approach, to buy low and sell high, but when put into practice, it can
be rather daunting to try to value a business’s actual worth or Intrinsic Value.

Please try to refrain from duplicating this copy for others. If you have found this
eBook beneficial however, I would really appreciate if you could refer people to my
website www.growthwithvalue.com where they can download their own copy of this
eBook. If you have any questions or queries, not just in relation to this eBook but
also in relation to investing on the stock market and in particular Value Investing,
please do not hesitate to contact me at [email protected] with
any questions and I will endeavour to give you an answer that is both clear and
concise.

Thanks very much

Alistair Cowley.

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How to Value a Business Chapter 10 - Glossary

10 Glossary
Name/Ratio Acronym Category Description Formula
Amortisation is similar to depreciation, which is another
Balance
Amortisation - Sheet
Balance Sheet item. It writes of the cost of an asset over N/A
time, most commonly used for intangible assets.
Assets are reported on a company's Balance Sheet and
Balance are items of value and can be both tangible or intangible
Assets - Sheet items e.g. property, cash, machinery, inventory, patents,
N/A
branding and goodwill.
A statement of the assets, liabilities and capital of a
Financial
Balance Sheet - Report
business. Generally prepared at the end of the fiscal N/A
period (financial year).
Book Value is the net asset value of a company and is 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦
Book Value (Book Balance
Value per Share) B Sheet
divided by the total shares outstanding to give us a Book 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 =
Value per Share. 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
CAPEX to Revenue Measures how much a company is spending on Capital 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Ratio CAP/R Ratio
Expenditure in comparison to its Revenue (Sales). 𝐶𝐴𝑃𝐸𝑋 𝑡𝑜 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Cash Flow Capital Expenditure is the money that has been spent by
Capital Expenditure CAPEX Statement a company to acquire, maintain or improve assets.
N/A
A Cash Flow Statement shows the flow of cash (in and
Cash Flow Financial
out) during a period and how those flows affect the N/A
Statement Report
Balance Sheet.
A Chief Executive Officer is the highest-ranking
Chief Executive executive in a company, ultimately responsible for
Officer CEO N/A
managerial decisions and implementing the Boards
N/A
policies.
The Compound Annual Growth rate is a measure of the
Compound Annual growth required to grow the value of an investment from
Growth Rate CAGR Calculation
its beginning value to an ending value, assuming that
N/A
growth is compounding over the period of time.
The Cost of Goods Sold is just as it sounds; the direct 𝐶𝑂𝐺𝑆
Cost of Goods Sold Income costs attributed to the production of the goods sold by a = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
– COGS COGS Statement company. it is the amount spent on things like labour + 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠(𝑜𝑓 𝑛𝑒𝑤 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦)
and materials etc. − 𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

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How to Value a Business Chapter 10 - Glossary

Name/Ratio Acronym Category Description Formula

Balance Cash and other assets that are expected to be
Current Assets - Sheet converted to cash within a year.
N/A
Balance Amounts due to be paid to creditors within twelve
Current Liabilities - Sheet months
N/A
The Current Ratio is a liquidity ratio that measures a
company’s ability to meet its short-term obligations and 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
Current Ratio Cr Ratio
is a comparison of whether a company’s current assets 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
are able to cover its current liabilities.
The Debt to Equity Ratio measures the company’s 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
Debt to Equity Ratio D/E Ratio financial leverage, or in other words, how much debt a 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡
company has when compared to its equity. =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝐸𝑞𝑢𝑖𝑡𝑦
Balance Depreciation is a method of allocating the cost of a
Depreciation - Sheet tangible asset over its useful life span.
N/A
The amount by which an investor discounts future cash
flows to give them a value in today’s terms. Can also be 𝑟 = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Discount Rate r Calculation
seen as the investors minimum required return to satisfy + 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒
them of the risk associated with a particular investment.
A Dividend is an amount paid on a regular basis, usually
every three, six or twelve months. In most cases it is 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Cash Flow
Dividends per Share DPS paid out of a company’s profits, but it is not unheard of 𝐷𝑃𝑆 =
Statement 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
for a company to use cash reserves or even to take on
debt in order to pay a dividend.
EBIT – Earnings The profits made by a company before any interest or
Income
before Interest and EBIT Statement
tax payments have been made. 𝐸𝐵𝐼𝑇 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Tax
EBITDA – Earnings The profits made by a company before any interest, tax,
𝐸𝐵𝐼𝑇𝐷𝐴 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
before Interest, Tax, Income depreciation or amortisation payments have been made
Depreciation and EBITDA Statement or accounted for.
+ 𝑇𝑎𝑥𝑒𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
+ 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛
Amortisation
An economic moat is the company’s ability to maintain a
Economic Moat - N/A competitive advantage over its competitors in order to N/A
protect profits and market share.
Earnings per Share or EPS are the Net Profits of a 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
EPS – Earnings per Balance
Share
EPS Sheet
business divided by the Shares Outstanding which give 𝐸𝑃𝑆 =
us the portion of profits allocated to each share. 𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

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How to Value a Business Chapter 10 - Glossary

Name/Ratio Acronym Category Description Formula

Balance Equity is equal to the value of assets minus liabilities.
Equity - Sheet
𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
An Equity Risk Premium is the difference between what
you expect to receive on your investment compared to a
long term ‘no risk’ government bond. It is used when 𝐸𝑅𝑃 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑒𝑡𝑢𝑟𝑛
Equity Risk Premium ERP Calculation
calculating your discount rate and is used to − 𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝑅𝑎𝑡𝑒
compensate the investor for the higher risk that is
associated with equity investing.
Free Cash Flow is the amount of cash a business
Cash Flow 𝐶𝐹 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
Free Cash Flow CF Statement
generates after accounting for operating expenses and
− 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
Capital Expenditure.
Balance Goodwill is the price paid for intangible assets like
Goodwill - Sheet brands and patents etc. during a take-over.
N/A
Gross Profit is the profit made by a business after
Income 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Gross Profit - accounting for the Cost of Goods Sold. It doesn’t include
Statement − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Operating Expenses, taxes and interest expenses.
Gross Profit Margin is a measure in percentage terms of 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
Gross Profit Margin - Ratio the Gross Profit compared to the Sales Revenue. 𝐺𝑟𝑜𝑠𝑠 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
The Income Statement is a Financial Report/Statement
generated by a company to report its performance over
Financial
Income Statement - Report
a specific accounting period. It displays the Revenues N/A
and Expenses of a company. It is also referred to as the
Profit and Loss Statement.
Economic Inflation measures the fall in the purchasing power of
Inflation CPI Figure money. (Referred to as Consumer Price Index or CPI)
N/A
Intangible Assets are shown on the Balance Sheet and
Balance
Intangible Assets - Sheet
are assets that have no physical presence. They include N/A
things like patents, branding, franchises and goodwill.
The interest coverage ratio measures the company’s 𝐸𝐵𝐼𝑇
Interest Coverage
Ratio
ICR Ratio ability to pay the interest charge (expense) on its debts 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
out of its profits.
Interest Expense Income Interest Expense is reported on the Income Statement
(charge)
IE Statement and is the amount payed on any debts.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 × 𝐷𝑒𝑏𝑡

Intrinsic Value IV N/A The Intrinsic Value of a business is a calculation of a N/A

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How to Value a Business Chapter 10 - Glossary

Name/Ratio Acronym Category Description Formula

business’s worth on a fundamental level and does not
take into account current market price. There are many
ways of calculating the Intrinsic Value of a business.
Balance Assets which include products or raw materials for sale
Inventories - Sheet (trading stock).
N/A
Inventory Turnover The Inventory Turnover Ratio is a measure of the time it 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
ITR Ratio 𝐼𝑇𝑅 =
Ratio takes a business to sell its inventory. 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑤𝑜 𝑌𝑒𝑎𝑟𝑙𝑦 𝐴𝑣𝑒.
Investors Required See Discount Rate
Return - Calculation N/A
Liabilities are reported on a company’s Balance Sheet
Balance
Liabilities - Sheet
and are debts or obligations that are owed by the N/A
company.
Balance Long-Term Debt refers to debt not due for payment
Long-Term Debt - Sheet before twelve months. N/A
The Margin of Safety is the difference between the value 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑃𝑟𝑖𝑐𝑒
Margin of Safety - N/A of a business (Intrinsic Value) and the price which you 𝑀𝑎𝑟𝑔𝑖𝑛 𝑜𝑓 𝑆𝑎𝑓𝑒𝑡𝑦 = 1 – ( )
pay for that business (market price). 𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑉𝑎𝑙𝑢𝑒
Market Price is the quoted price of a company on a
Market Price - N/A
Stock Exchange.
N/A
Income Net Profit is the profit made by a company after
Net Profit (Income) - Statement accounting for all costs and taxes.
N/A
The Net Profit Margin expresses Net Profit as a 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
Net Profit Margin - Ratio
percentage of Revenue. 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Balance Non-Current Assets are long term investments/assets
Non-Current Assets - Sheet which are not intended for sale within twelve months.
N/A
Non-Current Balance Non-Current Liabilities are long term debt obligations
Liabilities
- Sheet that are not due for payment within twelve months.
N/A
Cash Flow Operating Cash Flow is a measure of the cash
Operating Cash Flow OCF Statement generated from the general operations of a business.
N/A
Operating Profit Income See EBIT – Earnings before Interest and Tax
(Income)
- Statement
N/A
Operating Profit Margin measures in percentage terms 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
Operating Profit Profit
- the profitability of a company’s Operating Profit in 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑀𝑎𝑟𝑔𝑖𝑛 =
Margin Margin 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
relation to its Revenue.

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How to Value a Business Chapter 10 - Glossary

Name/Ratio Acronym Category Description Formula

Owner Earnings is a valuation method derived by
Warren Buffett and is a calculation of the cash produced 𝑂𝐸
Owner Earnings OE Calculation by a business. He said the value of a business is the = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
total Owner Earnings expected to occur over the life of + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝐴𝑚𝑜𝑟𝑡𝑖𝑠𝑎𝑡𝑖𝑜𝑛
the business.
The Payout Ratio is a measure of the amount that is 𝐷𝑃𝑆
Payout Ratio PR Ratio paid to a shareholder (via a dividend) from a company’s 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 =
earnings. 𝐸𝑃𝑆
Profit Margins are an indication of how much the
Profit Margins - Ratio company keeps after expenses and is expressed as a N/A
percentage.
The PEG Ratio is a valuation ratio that compares a
company’s P/E Ratio with the projected growth of the 𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜
PEG Ratio PEG Ratio company. By using the growth of a company, it helps 𝑃𝐸𝐺 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝐺𝑟𝑜𝑤𝑡ℎ
justify the sometimes-high P/E Ratios that some high
growth companies may have.
The Price to Book Ratio is a valuation ratio used to 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
Price to Book Ratio P/B Ratio Ratio compare a company’s current market price to its Book 𝑃/𝐵 𝑅𝑎𝑡𝑖𝑜 =
Value. 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒
The Price to Earnings Ratio is a valuation tool that 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒
Price to Earnings
P/E Ratio Ratio compares the current market price with a company’s 𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜 =
Ratio 𝐸𝑃𝑆
EPS.
Balance Moneys owed to the business (debtors).
Receivables - Sheet
N/A
The Receivables to Revenue Ratio compares the
Receivables of a company to its Revenue. It is 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
Receivables to
Revenue Ratio
REC/R Ratio expressed as a percentage and shows at what percent 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑜 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 =
the Receivables are when compared to Revenue, a 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
lower number is preferred.
Residual Income is the amount of Net Profit or EPS left
Residual Income RI over in a business after accounting for the cost of 𝑅𝐼 = 𝐸𝑃𝑆 − 𝑟 × 𝐵
capital.
Retained Earnings is the amount a business keeps from
Retained Earnings Balance 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
per Share REPS Sheet
its Net Profits after paying a Dividend. Retained EPS can
= 𝐸𝑃𝑆 – 𝐷𝑃𝑆
be used for further reinvestment or to pay down debt etc.

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How to Value a Business Chapter 10 - Glossary

Name/Ratio Acronym Category Description Formula

This Ratio compares the amount of earnings retained by
Retained Earnings a company to the change in share price over a period of 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒
Vs Market Value RE/MV Ratio time. Ideally, we would like to see a greater increase in 𝑅𝐸 /𝑀𝑉 =
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠
Ratio share price than what has been retained by the
company
The Return on Assets Ratio shows in percentage terms
Return on Assets ROA Ratio how efficient the assets of a company have been in 𝑅𝑂𝐴 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡/𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
producing profit.
The Return on Invested Capital Ratio measures how (𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠)
ROC or
Return on Capital Ratio efficient a company has been when investing its 𝑅𝑂𝐼𝐶 =
ROIC Retained Earnings. 𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
The Return on Equity Ratio measures the performance
of a company when comparing its Net Profit to the 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
Return on Equity ROE Ratio
Shareholders’ Equity. (How well it has managed the
𝑅𝑂𝐸 =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦
Shareholders’ funds)
The Risk-Free Rate is a rate of return from an
investment that is deemed to be guaranteed. The risk-
Risk Free Rate - free rate is accepted as being the current yield of a long- N/A
term government bond, generally of 10 years or longer
duration.
Balance The Shareholders Equity represents the net value of a
Shareholders’ Equity SE 𝑆𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑒𝑠
Sheet company.
The Shares Outstanding are the total number of issued
Balance
Shares Outstanding - Sheet
shares of a company that have been purchased by N/A
investors.
Balance Tangible Assets are assets that are physical items and
Tangible Assets - Sheet classified as either current or non-current.
N/A
A fiscal period, which is interchangeable with Financial
Period, is used by governments for accounting and
Fiscal Period - budgeting purposes as well as financial reporting by
N/A
businesses and other organisations.

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How to Value a Business Chapter 11 - Resources

11 Resources
Here is a list of resources that I have found extremely helpful in my pursuit to learn
as much as possible about investing, in particular Value Investing, as well as
teaching me how to grow as a person.

Disclaimer: Some of the links below are affiliate links, meaning, at no additional cost
to you, I will earn a commission if you click through and make a purchase.

Books on Investing:

• Financial Shenanigans – Howard M. Schillit

• The Conscious Investor – John Price
• One Up on Wall Street – Peter Lynch
• The Warren Buffett Way – Robert Haustrum
• The Intelligent Investor – Benjamin Graham
• Security Analysis – Benjamin Graham
• Berkshire Hathaway Shareholder Letters – Warren Buffett
• Superforecasting – Philip Tetlock
• The Black Swan – Nassim Nicholas Taleb
• Margin of Safety – Seth Klarman
• 100 Baggers – Christopher W. Mayer
• The University of Berkshire Hathaway – Daniel Pecaut
• The Most Important Thing: Uncommon Sense for The Thoughtful Investor –
Howard Marks
• Common Stocks and Uncommon Profits – Phillip A. Fisher
• The Education of a Value Investor – Guy Spear
• Value-Able – Roger Montgomery
• Charlie Munger: The Complete Investor – Fred Stella
• The Millionaire Next Door – Thomas J Stanley
• The Little Book that Still Beats the Market – Joel Greenblatt
• Common Sense on Mutual Funds – John C Bogle
• The Barefoot Investor – Scott Pape
• Secrets of the Millionaire Mind – T. Harv Eker
• A Wonderful Company at a Fair Price – Brian McNiven
• Debt – David Graeber
• What Works on Wall Street – James P. O’Shaughnessy
• Unshakeable – Tony Robbins
• So You Want to Start a Hedge Fund – Ted Seiders
• Buy High, Sell Higher – Joe Terranova
• Trading in the Zone – Mark Douglas

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How to Value a Business Chapter 11 - Resources

Books on Personal Development and Life Principles

• Principles – Ray Dalio

• The Alchemist – Paulo Coelho
• The ONE Thing – Gary Keller
• The Power of Habit – Charles Duhigg
• The 80/20 Principle – Richard Koch
• Extreme Ownership – Jocko Willink
• Thinking Fast and Slow – Daniel Kahneman
• Sapiens – Yuval Noah Harari
• Homo Deus – Yuval Noah Harari
• The Richest Man in Babylon – George Clason
• How to Win Friends & Influence People – Dale Carnegie
• The 7 Habits of Highly Effective People – Stephen R. Covey
• Getting Things Done – David Allen
• The Magic of Thinking Big – David Swartz
• Meet the Frugalwoods – Elizabeth Willard Thames
• Think and Grow Rich – Napoleon Hill
• Rich Dad Poor Dad – Robert T. Kiyosaki
• The 4-Hour Work Week – Tim Ferriss
• Way of the Wolf – Jordan Belfort
• Mindful Money – Canna Campbell
• The Automatic Millionaire – David Bach
• The Art of the Good Life – Rolf Dobelli
• Lying – Sam Harris
• The Start Up of You – Reid Hoffman
• Win Fast – Simon Reynolds
• Fail Fast, Fail Often – Ryan Babineaux
• Drive: The Surprising Truth about What Motivates Us – Daniel H. Pink

Books on Business and Companies

• Start with Why – Simon Sinek

• Zero to One – Peter Thiel, Blake Masters
• The $100 Startup – Chris Guillebeau
• Good to Great – Jim Collins
• Delivering Happiness – Tony Hsieh
• Crushing It – Gary Vaynerchuk

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How to Value a Business Chapter 11 - Resources

Biographies and Auto-Biographies

• Can’t Hurt Me – David Goggins

• Total Recall – Arnold Schwarzenegger
• Elon Musk – Ashlee Vance
• Joan of Arc – Mark Twain
• What I Know for Sure – Oprah Winfrey
• Gandhi – Mohandas K Gandhi
• The Governator – Ian Halperin
• Benjamin Franklin: An American Life – Walter Isaacson
• The Everything Store: Jeff Bezos and the Age of Amazon – Brad Stone

Websites, Forums, Articles and Podcasts

• www.investopedia.com
• www.marketindex.com.au
• www.gurufocus.com
• www.oldschoolvalue.com
• www.investing.com
• www.market-risk-premia.com
• www.finance.yahoo.com
• www.morningstar.com
• www.buffettsbooks.com
• www.theinvestorspodcast.com
• www.smartpassiveincome.com

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