The Business of Value Investing.pdf

8 The Business of Value Investing

Based the on the past fi ve years, the business appears to be

doing well. It ’ s growing its free cash fl ow at a nice rate, but that was

the past. You are buying the business based on the future antici-

pated cash fl ows. And when it comes to predicting future results,

there is always an element of uncertainty involved. Looking back at

the past fi ve years, you realize that the business has increased cash

fl ow by approximately 10 percent a year.

Going forward, you might be inclined to think that this same

rate of growth will occur for the next fi ve years, but I don ’ t think

most rational individuals would buy a business based solely on the

past. For one, as businesses expand, the law of large numbers kick

in. It ’ s a lot easier to grow from $ 100,000 to $ 110,000 than to go

from $ 1,000,000 to $ 1,100,000 — although both fi gures represent a

growth rate of 10 percent.

So, you decide to assume that over the next fi ve years, the

business will grow its cash fl ow by 6 percent a year. A bicycle shop

is generally a local business, so at some point market saturation

will cause a decline in sales level as the number of bike owners

increases in your city. However, the business generates revenue

doing repairs and selling accessories, so you can expect to make

up for slowing sales growth. You predict that, over the next fi ve

years, the business will deliver these numbers:

Year Free Cash Flow Present Value at 10% Discount Rate

1 $ 15,900 $ 14,450

2 $ 16,850 $ 13,930

3 $ 17,860 $ 13,420

4 $ 18,940 $ 12,940

5 $ 20,000 $ 12,400

Total $ 67,140

Remember that money earned in the future is not worth the

same as it would be in your hand today, so we have to discount

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