The Business of Value Investing.pdf

98 The Business of Value Investing

For the most part, however, cash fl ows are never guaranteed,

and that ’ s why the intrinsic value fi gure is only an approximate

value, not an exact amount. Yet it does provide the most accurate

approximation of a business ’ s true worth. The better your under-

standing of a business, the better your calculation of intrinsic value

will be. And the more data and reasoning you have, the more accu-

rate your intrinsic value becomes.

Comparing the two investment opportunities, you see that the

movie store is worth over 50 percent more at the end of the 10 - year

period. Thus, it may seem that there exists a 50 percent margin of

safety in making the movie - store investment when compared to the

low - risk investment. Such a level of safety is valuable because it pro-

tects you, the investor, from uncertainties that may arise over the

course of the next 10 years. A new movie store could open up and

take away a little (or a lot of business), which would affect the cash

fl ows. In reality, several other factors must be considered before

determining that such a wide margin of safety exists in the movie

store versus the low-risk investment.

This example was deliberately simplifi ed to illustrate how intrin-

sic values are calculated and how to determine the margin of safety.

The price, or $ 500,000, is where it all begins. Had the movie store

been selling for $ 700,000, you can see from the numbers that you

have very little room for error in your analysis. Also, annual cash

fl ows were kept stagnant, which is not what happens in most busi-

nesses. And as you can see, the most signifi cant variable in an intrin-

sic value analysis is the discount rate applied to the cash fl ows.

A Primer on the Discount Rate

Most of us are familiar with the concept of the time value of money.

Simply put, a dollar today is worth more than a dollar in the future. It ’ s

easy to see why. If someone offered you $ 1,000 today or $ 1,000 three

years from now, you ’ ll take the money now and put it in an interest -

bearing account, and it will be worth more three years from now.

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