Value investing is simply buying businesses for less than what you think they are worth. In order to do this, you must be able to come up with a value for said businesses. While there are complex valuation techniques such as the discounted cash flow, let’s look at a simple way to value a business.
A Small Business
We have an owner, Kevin. Kevin opens a soda business. He hires one person to run the business. Kevin isn’t going to do anything to help run the business.
In one hour the business can generate $100 in revenue (sales). From that $100, $20 will be used to pay the single employees wages. $40 will be used to pay for the soda. $10 will be used to pay the rent.
These 3 items make up the cost of revenue. The cost of revenue = $70. ($20+$40+$10)
The businesses income before taxes is $30. (100-70). $10 will be paid in taxes. The net income (earnings) will be $20. ($30 – $10).
As Kevin is the sole owner of the business he is entitled to that $20. Kevin now has a choice. He can pay himself the $20. He can put the money back into the business so that the business can make more than $100 in revenue per hour. Or he can pay himself $10 and put $10 back into the business.
Kevin’s Business in One Year
Instead of looking at the business for 1 hour let’s look at it for 1 year.
Kevin’s ice cream business generates $100,000 in revenue per year. $20,000 is spent on wages. $40,000 is spent on ice cream. $10,000 is spent on rent. The total cost of revenue is $70,000. ($20,000 + $40,000 + $10,000)
The income before taxes is $30,000. ($100,000 – $70,000)
$10,000 is paid in taxes.
The net income (earnings) is $20,000 per year. ($30,000 – $10,000)
How much would you pay?
Would you pay $400,000 for this business?
How about $200,000?
Let’s assume the business makes $20,000 per year for the remainder of its lifetime. Let’s also assume the business has very little risk of failure.
If you paid $400,000 for this business it would take 20 years for you to get your money back. (400,000 / 20,000 = 20)
That would be a return of 5% per year. (20,000 / 400,000 = 5%)
If you paid $200,000 for this business it would take 10 years for you to get your money back. (200,000 / 20,000 = 10)
That would be a return of 10% per year. (20,000 / 200,000 = 10%)
If you paid $100,000 for this business it would take 5 years for you to get your money back. (100,000 / 20,000 = 5)
That would be a return of 20% per year. (20,000 / 100,000 = 20%)
Let’s assume you want a 10% return per year. That would mean you would not be willing to pay more than $200,000 for Kevin’s business.
The difference between a small business and a large business
In a large business, the owners include anyone that owns a share in the company. There can be thousands of owners in large businesses.
The shareholders are represented by a group of people called the board of directors.
The CEO and all the employees work for the owners (shareholders).
When the business makes a profit the management team can pay the shareholders. This payment is called a dividend. If they decide to put the profits back into the business this is called retained earnings.
When looking at a large business the two numbers to look for are the net income and the Earnings per share (EPS). Net income is the net profit for the entire business. Earnings per share is the net income divided by the total number of shares outstanding. That is the earnings your would be entitled to if you owned a single share.
In the real world, earnings do not remain constant for the lifetime of a business. They increase and decrease over time. In order to accurately value a business, you must be able to predict future earnings. Something which is very difficult.
While this is an overly simplistic way to value a business the key principles are there. Valuing a business is all about working how much you are willing to pay for the business’s earnings.