What is it worth

A wonderful business bought at a foolish price is still a bad investment. Price is only half the question, and it is the half most people answer with their gut. Pay up with no margin of safety and you need everything to go right just to break even.

Estimating what it's worth

Source: Damodaran, chs. 1-4

A company is worth the cash it will hand its owners over its life, counted in today's money. Why today's money? Because a dollar you receive ten years from now is worth less to you than a dollar today, since today's dollar could be earning a return in the meantime. Shrinking a future dollar back to what it is worth today is called discounting, and the tool that does it for a whole company is the discounted cash flow, or DCF.

A DCF is not valued because it gives an exact answer. It is valued because it forces you to write down your assumptions so anyone can check them. Here is the shape of it. You add up each future year's cash, discounted back to today, plus a final lump that stands in for all the years after your forecast ends:

$\text{intrinsic value} = \sum\_{t=1}^{N} \frac{\text{FCF}\_t}{(1+r)^t} + \frac{\text{TV}}{(1+r)^N}$

$\text{TV} = \frac{\text{FCF}_N \cdot (1 + g_\text{terminal})}{r - g\_\text{terminal}}$

The inputs you have to be honest about:

• The starting cash flow. Use an average of the last three to five years so you are not anchoring on a single high or low year. The owner earnings figure from Chapter 4c is a good choice, because it reflects the cash that truly reaches a long-term owner.
• The growth path. Do not assume the last five years repeat forever. Growth fades toward the growth rate of the wider economy over time. Use a path that slows down, maybe 10%, then 8%, then 6%, then 4%, then 3%.
• The discount rate. This is the return you could earn elsewhere for similar risk. For a steady company with modest debt, 8% to 12% is normal. Use a higher rate for riskier companies and a lower one for very safe ones. Damodaran is firm that this is not a dial you turn to reach the answer you wanted. It should reflect the real cost of money.
• The final growth rate. This is the slow, forever growth rate after your forecast ends. It has to be smaller than the discount rate, or the math breaks. In practice, 2% to 3%, roughly the growth of the overall economy.
• The forecast length. Forecast 5 to 10 years in detail, then use the final lump. Do not try to model 30 years. By then you are guessing.

Damodaran's main point is that a DCF is a story plus numbers, not numbers alone. Tell the story first. What kind of company is this, what is changing about it, and what makes the growth believable? Then let the numbers match the story. If the numbers and the story disagree, one of them is wrong.

Once you have an estimate of worth, the loop closes back to Chapter 2. The gap between your estimate and the current price is your margin of safety. A great company with no gap is a hold, not a buy. And a wide gap on a broken company is a trap, which is what the next chapter is about.