The Business of Value Investing.pdf

96 The Business of Value Investing

What Is Intrinsic Value?

Every business has an intrinsic value. According to John Burr

Williams in his 1938 publication The Theory of Investment Value ,

intrinsic value is determined by the cash infl ows and outfl ows —

discounted at an appropriate interest rate — that can be expected

to occur during the remaining life of the business. The reliance

on cash fl ows instead of profi ts is critical in determining intrinsic

value. At the end of the day, it ’ s all about the cash that the business

generates. Cash is real and tangible and cannot be manipulated

as profi ts can. For example, a company can easily increase its sales

and hence its profi ts by extending very generous credit terms to its

customers. When you use your Macy ’ s charge card to make a pur-

chase at Macy ’ s, the sale has been made and is recorded. But until

you pay your bill, the cash has not been received. The profi ts look

good because of the increased sales, but the cash fl ow shows the

real fi nancial picture.

The defi nition of intrinsic value is painfully simple. Let ’ s con-

sider an illustration.

Imagine that at the end of this year, your local movie - rental store

is up for sale, and the owner is offering it at $ 500,000 today. Further,

let ’ s assume that the movie store can be sold for $ 400,000 after

10 years. The store generates free cash fl ow — money that can be

pulled out of the business — of $ 100,000 a year for the next 10 years.

Meanwhile, you have an alternative low - risk investment opportu-

nity that would yield an annualized 10 percent return on that same

$ 500,000. Tables 6.1 and 6.2 display the results of discounted cash

fl ow analysis of both investment options. Should you buy the movie

store, or take the virtually assured 10 percent return? Take a look.

Obviously, the intrinsic value of the $ 500,000 invested at 10 per-

cent and discounted at 10 percent is exactly $ 500,000. The movie -

store investment provides a better investment opportunity, provided

that your annual cash fl ow and sale price are virtually assured.

CH006.indd 96CH006.indd 96 9/2/09 6:58:06 PM9/2/09 6:58:06 PM