You’ve been searching for the perfect business to purchase for a very long time now, and you have finally locked eyes on one. It’s a web-based computer reselling business called WeBuild4U.
You are doing your thorough background research on the company. WeBuild4U has been in business for over 20 years. It has many satisfied and repeat customers – including both consumers and businesses. Even better, you discover it’s run by your old soccer coach Paul.
You quickly send an e-mail to WeBuild4U with hopes of contacting your old soccer coach and within 30 seconds, receive Paul’s personal reply with his contact phone number! You contact Paul and let him know you’re interested in purchasing his business and invite him to dinner to discuss the great opportunity.
At dinner, you discover Paul is ready for retirement and is looking for the perfect buyer for his baby (WeBuild4U). You remember him being an outstanding member of the community as well as a person who had sound principles – an ideal person from whom to purchase a great business.
You clearly state to Paul that you’re interested in the business. He asks you to make him a reasonable offer on his business and sends you home with his last 5 years of financials to review. You take the financials home and immediately start looking through them.
Table of Contents
Finding an Ideal Investment
The business isn’t very complicated. It drives traffic from the internet and has excellent relationships with vendors that supply all the necessary components to build computers for its customers.
The main operating expenses are computer components (inventory), shipping, rent, insurance, and employee wages. In addition, from time to time, there are expenses for warehouse upgrades to improve logistics.
You’ve determined that after all the necessary operating and capital expenses, WeBuild4U should generate about $1M a year in cash for you. This $1M is “owner earnings.” This is the amount of money that the owner can take out of the business without impacting its short- and long-term operations.
Discounted Cash Flow (DCF) Analysis
Now that you’ve determined it can provide you with $1M in cash each year, the question remains, “How much should you offer for the business?” Paul asked for a ‘good offer,’ and you don’t want to miss this opportunity. But, on the same note, you want an excellent return on your investment while taking minimal risks.
Let’s use a Discounted Cash Flow (DCF) Analysis to arrive at an answer. The idea behind DCF is to estimate the business’s future cash flows at a discounted rate. The further in the future the money will be received, the less it is currently worth.
Simple Discounted Cash Flow Example
Example: if you expect to receive $1M a year from now, using a 13% discount rate, that money is worth ~$885K to you right now. That’s a $115K discount. The same $1M is only worth about $783K if you receive it in 2 years. And so forth. The further you go out in the future, the larger the discount gets.
Here’s what it looks like:
This formula can be used to determine a fair price for WeBuild4U. You expect the business to generate $1M of cash for you every year, and you want to earn 13% on your investment. Adding up all of the present values of the future cash flows of WeBuild4U, discounted at 13%, would work out to $7.69M. Note: This is adding ALL of the future cash flows indefinitely. See below:
LESSON 1 – Fair Value and Future Cash Flows
The fair value of a business is the total of all the present values of the future cash flows that a company can produce. The discount rate of 13% that was used is one of the most essential factors in the calculation – it must be carefully selected. The hypothetical $1M per year that was used as revenues was done so to keep the example simple. Real-world examples tend to be more complex.
Price to Earnings Ratio
Another commonly used method to determine a company’s value is the Price to Earnings Ratio (P/E Ratio). A company’s P/E Ratio is calculated by dividing its market price by its anticipated annual earnings. In the traditional sense, this is done by:
In this case, there is no per-share pricing. Instead, the DCF divided by the total revenue can provide a similar illustration to determine the value multiple. For example, $7.69M / $1M of annual revenue returns a P/E ratio of 7.69.
A steady $1M of annual revenue that does not increase or decrease is not common, but this is the case in WeBuild4U in our example.
Discounted Cash Flow & Reinvestment Example
Being the savvy entrepreneur that you are, you see a great opportunity in taking some of the profits and reinvesting them into the business with the expectation that it will provide more value to you in the long term. Of course, this will have a more significant upside to your investment but will take some careful planning and consideration to do so.
Let’s begin.
Two Key Factors involved in reinvesting our profits are:
- Reinvestment Rate – the % of profits that are reinvested back into the business.
- Return on Incremental Invested Capital (ROIIC) – the expected return on the cash reinvested into the company.
With your growth strategy, the new way to look at the DCF for WeBuild4U will look like this instead:
Reinvest – 20% of the profits
Expected ROIIC – 25% increase on the invested profits
Discount rate – 13% (same as the previous example)
Year 1: Earnings of $1M
- From the $1M of earnings in Year 1, subtract $200K (20%) that will be reinvested back into the business. Resulting in $800K that the owner can withdraw. The $800K has a present value of ~$708K. Note: This is using a discount rate of 13%.
Year 2: Earnings of $1.05M
- The extra $50K came from the 25% ROIIC of the $200K that was reinvested into the business in Year 1. Again, remove $210K (20%) to reinvest back into the business. The result is $840K, which can be withdrawn by the owner with a present value of ~$658K.
Year 3: Earnings of $1.10M
- The $100K from the 20% ROIIC of the additional $200K reinvested in Year 1 & Year 2. The owner has ~$882K for withdrawal, with a present value of ~$611K.
- This continues for the life of the business. Then, all the present values will be added together, arriving at a fair value of $10M. Remember, this is reinvesting 20% of earnings, those earnings returning 25% at a discounted rate of 13%.
- By reinvesting our profits at the desired levels and earning the expected amounts, this would place a fair value on WeBuild4U at ~$10M. Or 30% higher than the original fair value of ~$7.69M, using the same 13% discount rate.
- The key to all of this is the ROIIC – the more significant this is – the greater the fair value of the business.
- For example, if the ROIIC was increased from 25% to 40%, the fair value goes from $10M to $16M with the same 20% reinvestment and 13% discount rate.
- Remember, though, if the ROIIC decreases or you do not reach your goal, then the fair value decreases as well.
- If you only achieve a 6% ROIIC with the 13% discount rate, the fair value is only $6.78M at a 20% reinvestment rate. This is an 11.9% DECREASE from the simple $1M standard cash flow with no reinvestment.
LESSON 2 – Reinvesting May Not Be Ideal
Reinvesting funds into a business is NOT always a wise decision. If the owner is only able to generate ROIIC at rates lower than the discount rate, the owner would be better off withdrawing those earnings and not reinvesting.
How each parameter affects the outcome:
- Fair value increases as ROIIC increases.
- Fair value decreases as the discount rate increases.
- Fair value increases only if ROIIC is greater than the discount rate.
- Fair value decreases if the ROIIC is less than the discount rate.
- Reinvestment rate increases/decreases depending on whether ROOIIC is greater than/less than the discount rate.
Fair Value is Determined by You and Only You
With the two simple models created to estimate the value for WeBuild4U, you can determine a multiple that you’d like to offer for such a business. You could use a P/E based on the calculated DCF values, or you could go even further only to use 10 or even 20 years of DCF rather than the entire expected life of the business. The idea is to develop a formula that makes sense for your individual investment needs. It could be you expect a higher discount rate. Or you could invest 100% of the earnings back into the business to grow rapidly. Whether the person on the other end agrees with your valuation or offer is entirely up to them.
Below is a chart comparing Discounted Cash Flow with Reinvestment vs. Simple Discounted Cash Flow for 30 years:
Conclusion
- Do your due diligence and research to find the perfect investment opportunity.
- Apply the Discounted Cash Flow (DCF) Analysis, which allows you to estimate the value of an investment based on the expected future cash flows of the investment.
- The purpose of this method is to provide a value of what a future investment is worth to you today.
- The purpose of this method is to provide a value of what a future investment is worth to you today.
- Using your chosen discount rate, you can determine whether or not an investment meets the risk profile and your expected return on the investment.
- There is no exact science behind it. The two hypothetical models using DCF analysis are meant to determine a present value for the example company – WeBuild4U.
- You should now be able to understand basic DCF and DCF with reinvestments and begin applying them to your investment ideas.
Making predictions of future cash flows may prove to be inaccurate. The way to navigate this issue is by having a long proven track record of continuous growth with continuous operating margins.
Warren Buffett provides excellent insight into the primary sources of cash flow he uses for DCF and what owner earnings are in his 1986 Annual Letter to Shareholders.