The Dhandho Investor
Dhandho 102: Invest in Simple Businesses
Now that the author has affirmed that the stock market is the best place to look for returns, he discusses why their investments should be restricted to simple and predictable companies.
A stock will sell for a particular value in the market. The investors must compare this selling price to the actual worth of the underlying business. The worth of the underlying business is inferred based on its future cash inflows and outflows.
To validate this, the author cites an example of the gas station that was put up for sale at $500,000 at the end of 2006. Assuming that the gas station can be sold at $400,000 after 10 years and free cash flow expected per year is $100,000. Considering that we have an alternate low risk investment opportunity which can yield 10% annualized return. Which one should be a better alternative?
To decide, the author has used Discounted Cash Flow (DCF) analysis. The table below shows how each year's cash flow has been discounted to its present value. According to this method, the intrinsic value of the gas station today is $7,75,000 approximately. However, we are buying it at $500,000 , which is just two-thirds of its intrinsic value.
Further, considering the alternative investment opportunity of 10% annualized return, its intrinsic value is exactly the same as the investment value, $500,000.
When there is a huge favourable gap between intrinsic value and the price of the investment, one must buy that business.
The author also takes a quick valuation of Bed, Bath and Beyond in 2006. While the stock sells with a market value of about $11 billion, the estimate of the company is probably worth between $8 billion and $20 billion. Hence, this investment should not amuse the investor much.
However, the valuation can change dramatically by changing the expected estimates of its cash inflows and outflows. Only because of this reason, it is extremely important to stick to simple and easy-to-understand business. If the future of a business can be predicted, its intrinsic value can be calculated more accurately. In turn, this enables the investor to recognize that he is buying a company at a discount.