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The Math of Intrinsic Value

Objective:

In India and every other country, the most common investment options are bank fixed deposit, gold, real
estate, bonds, and stocks. Over the past two centuries, there were many books published on various
investment opportunities. A couple of them were valuable, and they assisted common investors and
investment professionals in developing their skills in various investment options. As an ordinary investor,
I have read a collection of investment books in this last ten years. I could sufficiently learn to understand
a business model, accounting standards, fundamental analysis, long-term investment approach and
related subjects through various books and investment articles that I came across. Even though I read
many books written on different investment options, those books written about equity investments
influenced me a lot. Eventually, I realized, learning the intrinsic value concept is very crucial for a business
purchase or a stock purchase. There are numerous methods have been followed by investors for business
valuation. Among those, valuation based on historical price earnings ratio, price to book value, discounted
cash flow method, and asset based model is common among investors community. After using these
metrics for my investment decisions for many years, I felt these methods didn’t convince me on business
valuation approaches. None of these methods didn’t explain the exact math behind the business
valuation. I did a wide study on the internet and all the available sources to find the answer, but nothing
helped me to reach a stable result. Later on, I decided to work myself to discover the answer, and I began
my research with an objective to formulate a mathematical equation to calculate the intrinsic value of any
business. I took seven years to complete the research, and I believe my results are solid and meaningful.
This article will not have stories, and it is concentrated. I recommend you to pay attention to every single
chapter to get the complete picture of this article. I have primarily focused on how a business is valued,
the math behind the business valuation and how one can justify the intrinsic value of the business from a
private owner perspective. Using this equation, you can arrive value (mathematically) of private
companies, public listed companies, Stocks, startups and any business ownership. I hope you find this
article benefits you in your investment decision.

Intrinsic value- the all-important concept:

Business valuation comes into the picture when business ownership transaction takes place. Business
owners, venture capitalist, private equity, investment bankers are those who commonly into business
ownership transaction for various reasons. Business owners dilute the stake in the company for multiple
purposes like business expansion, reducing the debt, general corporate requirement, etc. Often the
present owner of the business wants to exit his ownership partially or entirely for various reasons.
Mergers and acquisition is another place where business ownership transaction takes place.

Apart from bulk business ownership transaction, common stocks (or pieces of business ownership)
transaction is very common in stock exchanges. Retail investors, high net worth individuals, mutual funds,
insurance firms, private equity, foreign institutional investors and various investment companies actively
do the stock transaction on every stock exchange.
In all the cases, ‘fair value’ of the business is the most critical factor in deciding the deal. Both buyer and
seller want to make the transaction at a fair value of the business. There are many methods currently
available to help the investors in deciding whether the business is fairly valued. Some commonly followed
business valuation methods are asset based valuation, discounted cash flow method and market based
valuation (using historical PE ratio or Price to book value). Most commonly accepted method by investors
and analyst are historical PE ratio method for non-finance based companies and historical price to book
value method for finance based companies. However, even these two methods don’t really explain to an
investor how these numbers are mathematically arrived and justifiable at respective prices.

It is evident in the stock market–companies with more promising future trades at a high PE ratio and
companies with uncertain future trades at a low PE ratio. For example, a stable FMCG company in India
trades at a valuation about 40 times the present earnings, and a Tyre manufacturing company trades at a
valuation about 12 times the present earnings. The different is very significant. An analyst might explain
the reason for such high difference in PE ratio between FMCG and Tyre industry as “FMCG companies are
very stable in their future earnings and tyre manufacturing companies are comparatively less stable in
their future earnings.” In other terms, it can be said: “FMCG companies are less riskier than tyre
manufacturing companies.” Even I agree– the ‘risk’ plays a huge role in arriving intrinsic value of any
business. The risk is an essential factor in valuation. However the question comes naturally, is the risk
quantifiable? If yes, whether the risk can be plugged into value equation to arrive the intrinsic value of a
given business? If it can be plugged into value equation, can one quantify how the risk factor affects the
present value of future earnings with respect to time? I believe the answer is “Yes” to all three question
and I will explain it in detail in upcoming chapters.

Next comes the growth of the business. Most analysts believe that different earnings growth rate
projection would result different business valuations; in other words, companies with high growth rate
projection in earnings deserve a higher valuation (high price to earnings ratio), and companies with low
growth rate projection in earnings deserve a lower valuation (low price to earnings ratio). Here is where
my results differed from most analyst. I agree ‘growth’ is a positive factor and one of the crucial element
in value equation, however my results showed different ‘earnings growth rate’ projection doesn’t change
the intrinsic value of a business. My definition of ‘growth’ differs from many analysts. I will explain this in
more detail in the upcoming chapters.

Business – A perpetual bond:

To understand the business valuation, I feel it is necessary that one should first understand the character
of a perpetual bond. I believe the value of a business is similar to the value of a perpetual bond. The reason
why business ownership should be viewed similarly to a perpetual bond is both business ownership and
perpetual bond don’t have a maturity date, however they do have future coupons forever. A business
owner always wants the business to retain the earnings and reinvest them at an attractive rate of return.
The business will retain the earnings as long as the business finds opportunities to reinvest the earnings
at an attractive rate of return. It is predicted at the time of business negotiation, frequent management
changes will happen in the future, board of directors will represent the owner’s interest in the business,
at any given moment the management will put their best effort to retain and increase the earnings of the
business. Securing the current earnings and increasing the future earnings will be attained through
retaining the unit volume, adjusting the company’s products nature to the market need, expanding the
current business model to new regions and executing the new projects. In general, every business present
with the possibility of functioning for many decades from the day of business negotiation– generation
after generation- virtually forever -to make cash for its owners.

As a result of this, it makes sense to say, both business and perpetual bond should be valued based on
future coupons from the date of purchase till infinity year. In other words, the number of years to consider
the future coupons should not be restricted in the value equation of perpetual bond as well as business.
In the perpetual bond, the discount rate denominator reduces the present value of the future coupon and
eventually making future coupon value to zero beyond certain years. In case of business, the risk factor
reduces the future value coupon to zero beyond some years.

Value of perpetual bond:

𝐶𝐹 𝐶𝐹 𝐶𝐹
= 1
+ 2
+ ⋯……..+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)∞

= 𝐶𝐹 ∗ 1/𝑖

CF- future coupon of perpetual bond


𝑖 -current treasury bills interest rate

The intrinsic value equation:

The intrinsic value equation answer to an investor for the question “how much it is worth paying today to
acquire all the future cash flow of the given business?” considering all aspects of the business. Let me first
explain the intrinsic value equation and later I will explain how to justify the valuation from a private
owner perspective. Variables in intrinsic value equations are,

 Base cash flow (CF)


 Risk associated with base cash flow (r)
 Interest discount factor for time (i)
 Reinvestment gain (Rg)

Intrinsic value of business=

(𝐶𝐹 + 𝑅𝑔1) ∗ (1 − 𝑟) (𝐶𝐹+𝑅𝑔2) ∗ (1 − 𝑟)2 (𝐶𝐹 + 𝑅𝑔∞) ∗ (1 − 𝑟)∞


= + + ⋯…….+
(1 + 𝑖1) (1 + 𝑖1) ∗ (1 + 𝑖2) (1 + 𝑖1) ∗ (1 + 𝑖2) … ∗ (1 + 𝑖∞)
𝐶𝐹 ∗ (1 + 𝑅𝑔1/𝐶𝐹) ∗ (1 − 𝑟) 𝐶𝐹 ∗ (1+𝑅𝑔2/𝐶𝐹) ∗ (1 − 𝑟)2
= +
(1 + 𝑖1) (1 + 𝑖1) ∗ (1 + 𝑖2)
𝐶𝐹 ∗ (1 + 𝑅𝑔∞/CF) ∗ (1 − 𝑟)∞
+ ⋯..+
(1 + 𝑖1) ∗ (1 + 𝑖2) … ∗ (1 + 𝑖∞)

= 𝐶𝐹(1 − 𝑟) + 𝐶𝐹 (1 − 𝑟)2 + 𝐶𝐹(1 − 𝑟)3 + ⋯ . +𝐶𝐹(1 − 𝑟)∞

= 𝐶𝐹 ∗ {(1 − 𝑟) + (1 − 𝑟)2 + (1 − 𝑟)3 + ⋯ . +(1 − 𝑟)∞ }

= 𝐶𝐹 ∗ {(1/𝑟) − 1}

(Reinvestment gain Rg and interest discount factor for time dismiss each other in value equation and
explanation for the same will be given later)

CF= base cash flow


r= risk associated with base cash flow (CF)
i= risk-free interest rate (after tax) in respective years
Rg= (Sum of discounted value of returns) - (Cash input into the business)

CF - Base cash flow:

CF is simply the net profit or net earnings of the latest four quarters of the business under negotiation for
sale. The present net profit or net earnings is projected into future as the base cash flow in intrinsic value
equation. The net earnings must be adjusted for any extraordinary items. One-time settlement with the
government, unusual spend on marketing or R&D, one-time inventory losses, one time losses due to
business consolidation or acquisition and any non-repetitive items must be adjusted in the latest four
quarters of profit and loss statement for calculating the owner earnings. What an investor must project
into the future as base flow is ‘the sustainable net earnings’ which will be entirely available for business
owners to make use of it –for reinvesting the amount back to the business, paying out a dividend and
shares buyback.

Some analyst believes depreciation must be added back to net profit in arriving owner earnings. I disagree.
Depreciation expense is a real expense like salary payout, rental cost, and cost of raw material. Even
though depreciation expense doesn’t cause an immediate cash outflow, eventually the business has to
replace the machinery and equipment in future date at a higher price to allocated depreciation cost taking
inflation into account. Therefore, the business has to keep aside the amount they allocated as
depreciation cost to grow at least the rate of inflation to meet the future capital requirement of replacing
the machinery and equipment at a future date. Finally, the goodwill is a subjective topic, and I will not
explain it in detail. Usually, goodwill amount deducted from the profit and loss account is added back to
net profit in calculating owner earnings. In this document, I have used the terms ‘net profit’ and ‘net
earnings’ in different places, however, both represent the same.
r - Risk associated with base cash flow (CF):

The risk is the possibility of damage that can happen to the base cash flow in the future. The buyer of the
business will not pay the full price to base cash flow because he takes a risk today to receive base cash
flow in the future. Therefore, it logically makes sense to reduce the base cash flow by ‘potential loss’ with
the hope of receiving ‘potential gain’ when the loss doesn’t occur in future. Risk can be described as “what
% of projected base cash flow is doubtful on the day of business negotiation?” And the risk is more in
subsequent years when one looks at the future from the day of business negotiation. Therefore the risk
element is compounded in the intrinsic value equation with respect to time. For example, if an investor
believes 5% of estimated base cash flow are ‘doubtful’, he would pay (1-5%) or 95% of first year estimated
base cash flow to acquire it, and he would be pay 95% x 95% of the second year base cash flow to acquire
the second cash flow value and this sequence continue till infinite years.

 High risk: possibility of high damage to base cash flow


 Low risk: possibility of low damage to base cash flow

The risk % vary business to business and industry to industry. Companies with a strong brand, competitive
advantage, pricing power and able management come with a low risk %, and companies with no such
advantage come with a high risk %. There is no hard rule to calculate risk %. Investors and analysts have
to calculate himself the risk % whether it is a private or public company. Common factors come into the
picture when one try to arrive the risk% are,

Future possibility of,

1. Reduction in unit volume of product either due to competition or less demand for the product
2. Reduction in realization either due to competition or less demand for the product
3. Unable to pass the cost increase to customer (fear of unit loss)
4. Government regulation that impacts unit volume, pricing power, and cost of the product
5. Currency fluctuation that impacts both sales and cost of the product
6. Company internal issues

Note that, even though the buyer of business apply a risk% to acquire the future base flow at a discounted
price, ideally he expects the business to overcome the entire risk and expects the business to retain the
net earnings in future. The difference between estimated earnings discounted to risk and actual earnings
the business going to generate through business operation explains the risk premium the buyer hoping to
receive it in the future. (Let’s call this as risk premium1)

Interest discount factor for time (i):

Once the present earnings is projected into future for infinite years as base cash flow, the discount must
be applied to calculate the present value of future coupons using risk-free interest rate (return on treasury
bills-after tax). The discount is applied to reward the buyer of the business for the time he is going to wait
to receive the future value; the risk-free interest rate is kept as variable here to account the future
fluctuation in risk-free yield one passive investor will receive in respective years by constantly investing
his principal amount in government treasury bills. Let me explain in following paragraphs why it makes
sense to consider future return from short-term government treasury bills as risk-free return (even though
it is not constant and unknown at the time of negotiation) than considering the current yield on long-term
government bond as risk-free return (though it is known value at the time of negotiation)

What rate of return can be considered as ‘risk-free rate of return’? Theoretically, the return that can be
attained with zero risk (zero possibility of losing the principal and return value) is risk-free rate of return.
However in practical, there is no such investment exist, even the safest investment carry a least amount
of risk.

The yield on long-term government bonds often referred as risk-free return. I disagree with anyone saying
return from the long-term government bond is risk-free. Even though the long-term government bond
provides an investor the highest level of safety to future coupons (virtually no default on interest and
principal amount), it comes with ‘interest rate risk’ which means any change in future interest rate will
impact the future bond value.

Any sharp increase in interest rate will bring down the value of bond significantly in the future. The
significant reduction in market value of the bond in such case will be meaningful because when the
interest rate increases, an investor then will have the option to invest in a bond which provides a higher
interest rate. Therefore to account the loss in the yield, the bond value will be recalculated using revised
interest rate to discount the future cash flow. One can argue that the bondholder will receive full amount
on the maturity date regardless the reduction of bond value in the market- it is true the bondholder will
be served with full payment regardless the decrease in market value of bond- however ‘yield received on
bond lesser to market yield must be considered as a loss.’ The flipside of this is true as well, the bondholder
has the possibility of receiving an additional yield compared to market yield when the future interest rate
falls. In such event, the additional yield one receives over the future market yield should be treated as
‘risk premium’ for the risk taken on ‘interest rate risk.’ However, the ‘interest rate risk’ present with long-
term government bonds doesn’t go anywhere. More the extended period of maturity, higher the risk the
bond carries with it.

As a result of this circumstance, return one get from the long-term government bond can’t be considered
as risk-free return. If the returns from the long-term government bonds can’t be considered as risk-free
returns, then which return can be considered as ‘risk-free return’?

Though the risk factor can’t be eliminated entirely, the return that can be attained from short-term
maturity government treasury bills can be ‘considered’ as risk-free return (or return with least risk) –
because, the short-term maturity nature of treasury bills provides an investor negligible ‘interest rate risk’
(Fluctuation in future interest rate will have insignificant impact on present value of future coupon as the
maturity is very near) and extreme low ‘default risk’ (possibility of default is extremely low compared to
long-term bonds).

In other words, a long-term investor who wants to receive risk-free return should always invest in short-
term government treasury bills and keep reinvesting end of every cycle to receive risk-free return. In such
case, the return an investor going to receive in the long term is unknown at the time of the investment;
however, the future return will always match to future market return and so the investor will virtually
receive no risk premium or a loss. Treasury bills are available with different maturities. I consider here
yield on 364 days (just less than a year) treasury bills as risk-free return in all intrinsic value calculation.
The ‘treasury bills’ here represents the treasury bills of the currency in which the net earnings of the
business is reported. In case treasury bills are not available in the currency in which earnings is reported,
returns from short-term government bonds shall be considered as ‘risk-free return’.

In the intrinsic value equation, every year risk-free interest rate is kept distinct to account the fluctuation
in the future treasury bills interest rate (i1, i2, i3, i4, i5 ……∞).

Reinvestment gain (Rg):

Reinvestment gain (Rg) can be defined as ‘The gain an investor has the possibility of receiving through
future reinvestment of earnings.’

Reinvestment gain (Rg) factor is positive in the value equation as every business inherently the possibility
of retaining a significant portion of business earnings inside the business and reinvest them at an above-
average rate of return (over the risk-free rate of return). This possibility of event provides an investor to
find value over the reinvestment capital into the business. Value of reinvestment capital can be explained
by the following equation,

Value of capital= {R1/ (1+i1)} + {R2/ (1+i1)*(1+i2)} + {R3/ (1+i1)*(1+i2)*(1+i3)} +……+ ∞

R- Return or cash flow from the reinvestment capital

i-risk-free interest rate in respective years through treasury bills (after tax)

Explanation: The equation to calculate the value of reinvestment capital into the business is formulated
based on comparing the returns from reinvestment capital against the returns that can be achieved
through investing the same capital into risk-free earning instrument (treasury bills)

Assume capital X is reinvested into a business and that reinvestment capital is producing returns (cash
flow) like below sequence,

[Capital X into business]R1, R2, R3, R4, R5………..∞

Now, assume the same capital X is invested in one-year treasury bills; end of the first year, the return (i)
received through treasury bills is taken out, and the principal amount (X) is reinvested to purchase new
treasury bills. Assume this event is being repeated forever; therefore, in this case, one can virtually forgo
the capital (X) forever and receive risk-free return every year forever like a below sequence,

[Capital X into treasury bills] i1, i2, i3, i4, i5……….∞

Now, applying discounted cash flow calculation will provide relative valuation of capital into the business
against treasury return,

Value of capital= {R1/ (1+i1)} + {R2/ (1+i1)*(1+i2)} + {R3/ (1+i1)*(1+i2)*(1+i3)} +……+ ∞

Therefore, reinvestment gain (Rg) can be calculated as,

Reinvestment gain (Rg) = (Sum of discounted value of returns) - (cash input into the business)

= (Value of capital) - (capital input)


From the above equation, it can be understood that reinvestment gain to be a positive in value equation,
the sum of the discounted value of return from the reinvestment capital should be higher than the
reinvestment capital input into the business. In other words, reinvestment gain (Rg) to attain a positive
value, ROE% of reinvestment capital into the business should be above the risk-free interest rate% for the
very long time from the initial year of capital investment into the business. If reinvestment capital is going
to lag in initial years in producing above-average return, the capital should generate extraordinary returns
in later years to compensate higher discount rate applied in later years to achieve a positive reinvestment
gain (Rg).

Therefore, one can calculate the net potential value the buyer of the business expects at the end of every
year from the business through the following equation,

= (net profit) - (cash input into business) + (sum of discounted value of return of capital input into business)

=net profit + {(sum of discounted value of return of cash input into business) - (cash input into business)}

=net profit + Reinvestment gain

=CF + Rg

Let me explain the reinvestment gain (Rg) with few examples.

(Please download the excel file from this link http://bit.ly/2CEpPNm and refer to the tab ‘value of capital’
as this file is critical for understanding this/following parts of this book)

Scenario1: Assume a business earned a net profit of $200 at the end of the first year after business is
acquired. Management of business decides to payout $100 to business owners and chooses to reinvest
remaining $100 into the business which is producing an additional cash flow of $10 from next year.
Assume risk-free interest rate stays constant at 5% (after tax return) in the long run. The following cash
flows sequence can be imagined for reinvestments of $100 into business and $100 into risk-free treasury
bills

[$100 reinvestment capital] 10, 10, 10, 10, 10, 10………………..∞

[$100 treasury bills] 5, 5, 5, 5, 5, 5……………∞

Now one can calculate the value of the $100 reinvestment capital into business equal to $200 based on
the value of capital equation.

=10/(1+5%)^1 + 10/(1+5%)^2 + 10/(1+5%)^3………………..∞

Based on this scenario, it is appropriate to say, the buyer of the business will receive net value of $300 =
$100 (through dividend payout) + $200 (through reinvestment gain) end of the first year which is 150% of
the first year reported earnings.

In this case, every 1$ reinvested into the business created a value of 2$, otherwise, the value created = 2x
capital into the business. Business with average return on equity will produce lesser times the value
invested capital and similarly business with high return on equity will produce higher times the value
invested capital (sometimes as much as five times the capital into the business because of an attractive
rate of return).
Scenario2: In scenario1, both cash flow from reinvestment capital and risk-free interest rate are kept
constant for easy understanding purpose; but in real, both return from the reinvestment capital and the
risk-free interest rate from treasury bills will fluctuate in future; hence let’s assume the second scenario
like below sequence

[$100 reinvestment capital] 7, 3, 8, 6, 10, 9, 5………………..∞

[$100 treasury bills] 5, 4, 6, 8, 5, 7, 6……………∞

Here one can still calculate the value of capital that exceeds the capital invested into the business using
the value of capital equation. It is important to understand that, there are some year business return (ROE
%) may underperform with respect to treasury bills yield (i) and still the reinvestment capital can produce
a value excess to reinvestment capital into the business due to of other year’s outperformance.

Scenario3: Let’s us modify the assumption in scenario1 and see how the reinvestment gain works, assume
the reinvestment capital of $100 into the business is producing a return of $10 every year for the initial
20 years and the capital is not making any return from 21st year; now assume a constant risk-free interest
rate of 5%. One can arrive a discounted value of return to be $124.6 which is well above $100 investment
into the business.

Scenario4: Finally let’s look at the case where the reinvestment gain can be negative. When the business
is reinvesting the earnings back into business at a poor rate of return (ROE% is lesser than the risk-free
return %), the reinvestment gain will be negative. Consider the following cash flow sequence from
reinvestment capital in the business and treasury bills

[$100 reinvestment capital] 3, 3, 2, -5, 0, -2, 5………………..∞

[$100 treasury bills] 5, 4, 6, 8, 5, 7, 6……………∞

In this scenario, the capital input into the business will exceed the value created by the incremental capital
into to the business; in other words, the reinvestment gain is a negative value;

From the above scenarios, it can be understood, business with a high return on equity will find it easy to
create a value above the reinvestment capital and business with a low return on equity will find it difficult
to a create value above the reinvestment capital. Overall it can be said that, every business will try to
attain a value exceeding the reinvestment capital.

Reinvestment gain (Rg) – a risk premium:

Reinvestment gain (Rg) is truly a risk premium amount an investor receives for the reinvestment risk that
he takes– reinvestment capital into business has the possibility of not producing a value above the
reinvested capital into the business. Importantly, this risk premium (let’s call it risk premium2) is not an
immediate payout to owners; it will be paid out to the owner over a period of time as an excess return to
risk-free rate of return that could have been received through investing the original capital into treasury
bills.

Every risk factors (explained under the topic ‘r - Risk associated with base cash flow (CF)’) applicable to
base cash flow are applicable to reinvestment capital as well. These risk factors will make the business
difficult to create value above the reinvestment capital. The business has to overcome the risk inherent
in the reinvestment capital to make a positive reinvestment gain (Rg)

It is impossible to predict future movement in risk-free rate of return, and it is unpredictable whether the
future reinvestment capital into the business will create a rate of return excess to the future risk-free rate
of return; if so, then what factor drives reinvestment gain (Rg) variable to become a positive component
by default in intrinsic value equation?– It is positive because of the possibility existence; every business
has the ‘possibility’ of making a rate of return excess to future risk-free rate of return for the given
reinvestment capital into the business. In other words, every business comes with the ‘possibility’ of
creating a value above the reinvestment capital into the business despite the dynamic nature in the future
risk-free rate of return and unknown circumstance of business operation in the future.

The magnitude of reinvestment gain (Rg):

It is essential to understand that the activity of reinvestment is not only adding an additional value to
particular year earnings but also increases the future cash flow available for future reinvestment in
subsequent years. Therefore, the potential magnitude of reinvestment gain increases year on year as the
business has possibility of having more capital to reinvest in following years; i.e.

Possibility exists for Rg1<Rg2<Rg3<Rg4<Rg5………………∞

Reinvestment gain is an additional value to every year net earnings as the reinvestment gain value is a
derivative from net earnings; reinvestment gain added with net earnings can be seen as a following
sequence,

(CF+Rg1), (CF+Rg2), (CF+Rg3), (CF+Rg4), (CF+Rg5)…………………..∞

One might ask when the second year and subsequence year’s earnings are revised based on first-year
reinvestment, why it is not reflected in above sequence. The answer stays inside the sequence. Even
though the second year and subsequent year’s cash flow is revised based on first-year reinvestment, Rg1
takes into account of all additional cash flow through first year reinvestment starting from the second
year. Therefore, additional cash flow can’t be added again in subsequent years. Similarly Rg2, Rg3, Rg4,
Rg5… reflects the additional cash flows from their respective years through reinvestment.

Now let’s try to imagine the magnitude of reinvestment gain (Rg) factor in the intrinsic value equation in
following years. It is not difficult for one to understand that more the capital business going to consume
in future, more the reinvestment gain a business can produce in the future; to know how much capital a
business can consume back into the business, let’s understand what will drive the reinvestment capital
requirement. The following points explains the factors that will drives the future capital requirement of
business every year.

1. Inflation – a significant portion of earnings will be reinvested back to business in order to meet
the additional capital requirement caused by inflation for maintaining the same unit sales
2. Expansion of existing product unit volume- capital will be invested for making more units sales of
existing product portfolio in the same and new regions
3. New product unit volume- capital will be invested for making more units sales of innovated net
products in the same and new regions
4. Capital consumption towards optimization of process (will cut down the cost and will increase
the future cash flow)
5. Capital consumption towards quality improvement and revamping the existing product portfolio
will help the business to attain better realization in sales
6. Capital investment in brand building and investment towards discounts with the intention of
acquiring more customers in future (through which increase in unit sales can be attained)
7. Capital investment in R&D to develop new products/service for the incremental future sales
8. Capital investment on joint venture to produce more unit sales and profit
9. Capital investment towards acquiring other business with the aim of
a) Expanding the existing products of acquired company
b) Expanding the parent company products through acquired company’s channels
c) Reducing the overlapping cost between two companies
d) Accessing intellectual properties -technology, trademarks, patterns and skilled people,
etc. available in acquired company

To approximately measure the magnitude of reinvestment gain in value equation, one needs to visualize
the future from the day of business negotiation. Almost every business will work towards increasing the
future earnings of the business at a healthy rate by continuously reinvesting a significant portion of every
year future earnings. Among all the points discussed above, the first three points are the primary factors
which help one to understand the magnitude of reinvestment gain over the years. Business with low
return on equity will require very high % of profit back into business and business with a very high return
on equity will require less % of profit back into business to grow their earnings at the inflation rate. Apart
from cash inputs into business to meet the additional capital requirement caused by inflation, business
will also consume a significant portion of every year profit back into business for expansion of existing
products unit volume and for producing incremental sales of innovated new products. Overall every
business has the possibility to grow the future profit at a healthy rate (over the inflation rate), and so the
possible magnitude of the reinvestment gain (Rg1, Rg2, Rg3,….) in the future also increases roughly at the
same rate.

How far can one imagine the future reinvestment gain from now? 10 years or 20 years or 50 years or 100
years? I believe the answer is ‘forever’ or ‘till infinity year’– because there is going to be always some
opportunity exist for business to expand or reinvest their earnings at an attractive rate of return.

Future management and board of directors of the business will decide then what would be the best
possible way to use the capital; in general, the business is expected to expand in the same industry in
which they already operate in, through organic and inorganic growth; however the management and the
board of directors will decide to invest in a different industry when they find an attractive investment
opportunities to invest the capital in a different industry. The capital that the management believe can’t
be reinvested back to business at an above-average rate of return are expected to paid out to the owner
as a dividend or will be kept inside the business for future investments opportunities.

Of course an investor can’t predict on the day of business negotiation where the business will expand in
future down the line many years from now, what will be the return on equity on those future reinvestment
capital and what would be the risk associated with those incremental cash flow; however what rationally
can be said is, “there is possibility exist for business to find value above the reinvestment capital
(reinvestment gain) regardless of the industry that the business are going to operate in the future, and
there is possibility exist for receiving incremental reinvestment gain (Rg) value following years through
incremental capital consumption into business"

The Reinvestment gain (Rg) factor in intrinsic value equation is sharing the risk associated with base cash
flow as well as the interest discount factor for time along with the base cash flow; the following
statements explains the reason,

 Any damage to base cash flow in the future will impact the future reinvestment gain (any
permanent reduction in base cash flow will reduce the net capital available to reinvest and so
reduces the magnitude of reinvestment gain); therefore the risk that applies to base cash flow is
also applicable to future risk premium (reinvestment gain)
 Reinvestment gains are arriving late (must be discounted for time using risk-free interest rate)

Arriving the final intrinsic value equation:

We shall now discuss arriving the final equation to calculate the intrinsic value of the business.

Value of a business is always negotiated for the entire lifetime of the business as the buyer of the business
acquiring the ultimate ownership to receive entire future cash flow that the business is going to produce
in the lifetime from the date of purchase.

Here comes a complexity in arriving an exact value for a business; both buyer and seller of the business
don’t know the future; it is impossible to predict the future cash flow of the business and future risk-free
rate of return; therefore both buyer and seller negotiating the value based on all aspects of the business.
Subsequently buyer and seller considering all positive and negative factors those will have impact on
future cash flow for arriving a negotiated value; primary variables taken into consideration are

 Base cash flow (CF)


 Risk associated with base cash flow (r)
 Interest discount factor for time (i)
 Reinvestment gain (Rg)

Intrinsic value of business=

(𝐶𝐹 + 𝑅𝑔1) ∗ (1 − 𝑟) (𝐶𝐹+𝑅𝑔2) ∗ (1 − 𝑟)2 (𝐶𝐹 + 𝑅𝑔∞) ∗ (1 − 𝑟)∞


= + + ⋯…….+
(1 + 𝑖1) (1 + 𝑖1) ∗ (1 + 𝑖2) (1 + 𝑖1) ∗ (1 + 𝑖2) … ∗ (1 + 𝑖∞)

𝐶𝐹 ∗ (1 + 𝑅𝑔1/𝐶𝐹) ∗ (1 − 𝑟) 𝐶𝐹 ∗ (1+𝑅𝑔2/𝐶𝐹) ∗ (1 − 𝑟)2


= +
(1 + 𝑖1) (1 + 𝑖1) ∗ (1 + 𝑖2)
𝐶𝐹 ∗ (1 + 𝑅𝑔∞/CF) ∗ (1 − 𝑟)∞
+ ⋯..+
(1 + 𝑖1) ∗ (1 + 𝑖2) … ∗ (1 + 𝑖∞)
CF= base cash flow
r= risk associated with base cash flow (CF)
i= risk-free interest rate (after tax) in respective years
Rg= (Sum of discounted value of returns) - (Cash input into the business)

Now let’s take a look at the value of business in graphical form. This diagram explains what buyer and
seller visualizing inside the business in future years from the date of business negotiation.

The future value of the business can be picturized as three areas

 Line ‘Present earnings (CF)’ explains the base cash flow


 Area under the curve ‘CF discounted to risk’ explains the sum of (base cash flow discounted to
risk inherent in base cash flow)
 Area between two curves ‘Present earnings (CF) ’ and ‘CF discounted to risk’ explains the sum of
risk premium in base cash flow (risk premium1)
 Area between two curves ‘Present earnings (CF)’ and ‘Expected net value (CF+Rg)’ explains the
sum of all future reinvestment gain the business expected to generate in future (risk premium2)

Reinvestment gain (Rg) factor as compensation for interest discount factor for time (i):

There are two factors in value equation act in a different direction.

 Interest discount factor for time (i) is negative impact in value equation as buyer of the business
receives the return in later years from the date of purchase; therefore every year future estimated
value is discounted by risk-free interest rate in order to compensate buyer with risk-free interest
amount in future for the delay in receiving future returns
 Reinvestment gain (Rg) is positive impact on value equation as business can find more value on
return it is going to produce every year by reinvesting a significant portion of profit at high rate of
return; therefore buyer of the business has the possibility of receiving additional value to future
net profit every year in the future

Reinvestment gain (Rg) is not quantifiable at the same time it is not ignorable on the day of negotiation-
there is a strong possibility exist for huge untapped value attached to every subsequent year profit from
the day of business negotiation; therefore seller of the business demands for future reinvestment gain
that the business is going to produce it in the future during the price negotiation. Even buyer of the
business agree that there is a possibility of receiving enormous reinvestment gain in future through future
reinvestment actions yet the value is not quantifiable on the day of negotiation; In the final negotiation,
buyer of the business agree to take all future reinvestment gain as compensation to interest amount that
he supposed to receive for delay in receiving future earnings; buyer and seller believe that reinvestment
gain (Rg) can compensate buyer more than the interest amount that the buyer supposed to receive in
future. Here comes the question, is it worth trading interest amount for future reinvestment gain from
the buyer perspective? To answer this question, we need to understand the characteristic of two variables
that we are discussing in the intrinsic value equation,

1.) Characteristic of discount factor for time (i)- the denominator value is compounded every year at
the rate of future risk-free interest rate
2.) Characteristic of reinvestment gain (Rg) factor- the numerator value is compounded every year at
a healthy rate (expected)

One thing is clear; the risk-free interest rate here refers the risk-free interest rate of the same currency
being used to purchase the business. And the reinvestment gain (Rg) will be influenced by various
currencies as the business can operate globally.

The magnitude of future reinvestment gain values (Rg1, Rg2, Rg3…..) is explained by future growth
potential in the earnings of the business. Despite many countries in which the business operates and
different currency risk involved with future earnings, the business inherently has the ‘possibility’ to
achieve a long term average growth rate in earnings above the long term average of the future risk-free
interest rate by continuously reinvesting earnings back to business.
If the business has the ‘possibility’ of growing the future earnings over the long term average of future
risk-free interest rate, it makes sense to say that the future reinvestment gain (Rg) value also has the
possibility to grow over the long term average of future risk-free interest rate; If the future reinvestment
gain value can grow over the rate of future risk-free interest, it can be considered as compensation value
to discount factor for time in the intrinsic value equation.

Right from the first year reinvestment gain Rg1 as percentage of CF is sufficiently expected to cover the
first year interest rate i.e. (1+Rg1/CF) > (1+i1); then, the expectation of growth rate in reinvestment gain
(Rg) above the future risk-free interest rate in subsequent years (Rg1<Rg2<Rg3<Rg4<Rg5……..∞) is helping
one to understand the following sequence that both buyer and seller picturizing it in future,

(1+Rg1/CF)> (1+i1),

(1+Rg2/CF)> (1+i1)*(1+i2),

(1+Rg3/CF)> (1+i1)*(1+i2)*(1+i3),

(1+Rg4/CF)> (1+i1)*(1+i2)*(1+i3)*(1+i4),

(1+Rg5/CF)> (1+i1)*(1+i2)*(1+i3)*(1+i4)*(1+i5),

……………….∞

The future operation of the business will validate the above sequence. If business’s future earnings is
growing over the future average risk-free interest rate in the long term, the magnitude of reinvestment
gain (Rg) will exceed the magnitude of interest discount factor for time (i) in the intrinsic value equation,
and the above sequence will become true; As a result of this ‘possibility’, the buyer agrees to take the
entire future reinvestment gains as the compensation for interest amount that he supposed to receive in
the future. One thing is clear here; the interest amount is traded for reinvestment gain considering the
‘possibility’ not for the ‘certainty’. The future is really not predictable; if the future reinvestment is going
to be unsuccessful, it will disappoint the buyer of the business.

Therefore, in the final negotiation, reinvestment gain (Rg) factor and interest discount factor for time (i)
dismiss each other in the intrinsic value equation, and the final equation ends with two variables,

1. Base cash flow (CF)


2. Risk associated with base cash flow (r)

Intrinsic value=
= 𝐶𝐹(1 − 𝑟) + 𝐶𝐹 (1 − 𝑟)2 + 𝐶𝐹(1 − 𝑟)3 + ⋯ . +𝐶𝐹(1 − 𝑟)∞

= 𝐶𝐹 ∗ {(1/𝑟) − 1}

The following graph explains the final negotiated value between buyer and seller of the business. The base
cash flow discounted to the risk associated with base cash flow and then summed all discounted value
provides the final intrinsic value.
Justifying the intrinsic value from private owner perspective:

In this chapter, I will be explaining how the intrinsic value of the business is justified from a private owner
perspective. If the price paid for purchasing business has to be justified from a private owner perspective,
then the historical price to earnings ratio, price to book value, industry price to earnings ratio and similar
metrics can’t be considered. In other terms, the private owner should assume that he and his generation
will own the business forever and he must find value inside the business to arrive a conclusion whether
the price is worth paying.

To arrive a conclusion whether the price paid for purchasing the business is worth, it is essential to answer
the question “what is the maximum return that can be produced with the given amount?”

Now imagine two wealthy persons present with an equal amount of cash in hand. The first person is a
passive investor who doesn’t want to take any risk. Therefore he is investing the entire amount in 364
days treasury bills (core currency). End of the first year he is reinvesting in new 364 treasury bills the entire
amount that he received from first year investment (principal + interest). Imagine he is repeating this
activity forever and he is not taking out any amount for himself from this investment activity. Therefore
the passive investor will receive risk-free return every year and the principal amount in net value term will
grow in future at the rate of future risk-free interest rate which explains the maximum value that can be
produced in the long term with zero risks for the given investment amount.
Now comes the second person who is an active investor and who is fine accepting a risk to receive a better
possible return than the treasury bills return that he could have got with zero risks. Therefore he decides
to purchase a business which is having most promising future. The only reason why he chooses to buy a
business instead of investing in risk-free treasury bills is ‘Maximum return that he hopeful of receiving
from the business is higher than the maximum return that he hopeful of receiving from treasury bills
investment for the given investment amount.’ I.e.

Maximum potential return through business in lifetime > Maximum potential return through treasury bills
investment in lifetime (for an equal investment amount)

Note: lifetime here denotes ‘infinite years’

Let me explain this with an example. Imagine a business with a book value of 8,000 cr. and producing 20%
return on equity. Therefore net earnings (after tax) of the business would be 8,000 x 20% = 1600 cr. (Note:
1 cr = 10 million) assume the business present with diversified portfolio products which is directly linked
to consumers, able management operating the business, products protected with strong brand names,
don’t have any close substitute products by competitor, well established distribution network, tight cost
control and healthy research and development department to drive the future sales and profit at
significant rate.
Considering all these advantages about the business, seller demands an expensive price to the buyer. Let’s
assume buyer agrees to purchase the entire business ownership at 62,400 cr in the final negotiation. In
this case, both buyer and seller believe that there is very low risk present in the business; therefore, they
are applying 2.5% risk rate in the intrinsic value equation. The math work like below,

Intrinsic value of business=


= 𝐶𝐹(1 − 𝑟) + 𝐶𝐹 (1 − 𝑟)2 + 𝐶𝐹(1 − 𝑟)3 + ⋯ . +𝐶𝐹(1 − 𝑟)∞
= 𝐶𝐹 ∗ {(1/𝑟) − 1}
= 1600 x [(1/2.5%)-1]
= 1600 x 39
= 62,400 cr.

(Reinvestment gain factor compensate for interest discount factor for time; therefore both factors dismiss
each other in value equation). The above calculation is detailed in the excel file in the tab ‘Intrinsic value.’

Here comes the question whether this 62,400 cr price paid for purchasing the business is worth and
justifiable from a private owner perceptive? To answer this question, we will first understand the
maximum return that can be produced with this amount investing in treasury bills and then later we will
compare treasury bills returns against the maximum potential return of the business.

Consider an investor purchasing 62,400 cr worth of one-year treasury bills, and he is continuously
reinvesting every proceeds (principal and return) in treasury bills end of every year and assume he is
repeating this investment activity forever. Therefore the value of this amount will grow in the future at
the rate of future risk-free interest rate which explains the maximum possible growth rate in value that
can be attained by investing the amount in a risk-free investment.
Now we shall compare the potential return that is expected out of business against the potential return
that is expected out of treasury bills investment. Assume the average risk-free interest rate stays close to
5% in the long term.

If all earnings from the business are going to be paid out as dividend and if treasury bills yield stays closer
to 5% in the long term, then the price can’t be justified as maximum dividend yield from the business will
be 2.56% which is far lesser than the treasury bills yield of 5%. In such case, obviously buyer of the business
will receive far lesser return compared to the treasury bills investor.

However, in most cases, every business continuously reinvest a significant portion earnings back to
business to increase their future earnings at a healthy rate, and there is strong possibility exist for it.

Imagine, in future

1. If business matches the long term average growth rate in earnings to the long term average of
risk-free interest rate by continually reinvesting a significant portion of every year earnings and
business is paying some dividend every year (or)
2. If business long term average growth rate in earnings exceeds the long term average of risk-free
interest rate by continually reinvesting the entire earnings of business

Can you imagine what will happen in 100 years from now? If an equal amount is used to purchase business
and treasury bills, the business will outperform the treasury bills in terms of net return in both cases. In
other words, the business with dividends accumulated (and reinvested at future risk-free interest rate) +
one year net earnings from the business will exceed the net treasury bills value at some date in future.
(Refer to the excel file tabs ‘Justification- case1’ and ‘Justification- case2’)

Elaborating this further, in this example, If we assume that both business owner and treasury bills holder
is accumulating all their respective future returns and in the event of ‘successful business return’, the
business owner will able to comfortably buyout the net accumulated treasury bills from the treasury bills
holder using dividends value accumulated from business + one year earnings from the business at some
point in future (however the maturity date is unknown at the time of business negotiation) and business
owner will be receiving excess returns through business operation even after buyout of entire value from
treasury bills holder. Every return that business owner will receive after such point of the buyout will work
as an additional return to the business owner for the risk he had taken to purchase the business over the
treasury bills. These examples prove that business provides an investor the possibility of producing better
return than treasury bills return in the life time holding period for a given purchase price.

Every business provided with this opportunity/possibility looks expensive at first glance however when
one considers the business ownership in a very long-term perspective, it can be understood that the price
paid for purchasing business is justifiable or worth paying. The graphical form of this events is shown
below,
Treasury bills return vs Business return (dividend payout):
Treasury bills return vs Business return (zero dividend payout):

Interpretations and logical conclusions:

A deep thought process is required to get a clear understanding on the justification of business price. In
almost every case, the justification of purchasing price is arrived by taking many decades of business
future into consideration. One obvious question arises from above example “Is the event of business
returns outperforming treasury bills investment certain to happen in the future? Is it possible for anyone
to predict that at time of business negotiation?” Of course, it is practically impossible for anyone to predict
what would happen in such long future and it is foolish to believe even if someone says that he can predict.
Here comes the next question, if such event is unpredictable and not certain, how does it make sense for
the buyer to pay an expensive purchase price for a hypothetical case?

The ‘possibility’ of business existence for many decades (virtually forever) from the day of business
negotiation and the ‘possibility’ for business return outperforming treasury bills investment during the
lifetime of business for a given investment amount is the only reason why buyer accept this offer.
Underline the word ‘possibility’ –seller and the business by itself don’t give any guarantee for such future
outperforming event at the time of business negotiation. Hence it can be understood ‘the price paid by
the seller for purchasing business is for the possibility of outperformance not for the certainty of
outperformance.’ After the business is exchanged for a price, the business may or may not perform well.
It can be said that the purchasing price by itself doesn’t explain how the business will perfume in the
future. Additionally, it can be said, it is really no use if the buyer of business tries to predict the future to
arrive the negotiated value of given business. In other words, the buyer is forced to accept the price based
on the future aspect of the business not based on what actually going to happen in future as the future is
truly unknown to both buyer and seller at the time of business negotiation.

Moreover, the purchasing price of business doesn’t change for different earnings growth rate projection
at the time of business negotiation as the entire future reinvestment gain (Rg) value is set to compensate
for the whole interest amount (capital gain) that the buyer supposed to receive. Therefore the negotiation
price is same for all the following cases 1.) If the business is going to grow the net earnings ten times in
ten years 2.) If the business is going to double the net earnings in ten years 3.) If the business is going to
have the same net earnings after ten years 4.) If the business is going to have negative net earnings after
ten years 5.) If the business is not going to exist in ten years from now. The buyer pays the price based on
infinite year discounted cash flow calculation explained above, and he is relying on business to overcome
the twin risk present inside the business purchase, i.e., after purchasing business, the buyer of business is
expecting,

1. The business to continuously overcome the risk inherent in the base cash flow (risk premium1 to
be positive and steady)
2. Reinvestment gain (Rg) to be positive and the value of reinvestment gain to grow at a significant
rate in long term (risk premium2 to be positive and grow at a healthy rate)

(Note: one can imagine the negotiated value of a business as a selling price of your entire future
generation cash flow. I am sure you would probably invest on your children, and your children will earn in
the future on the invested amount. Similarly, your children will be reinvesting their earnings on their
children and your grandchildren will earn on the invested amount. This cycle is expected to continue
forever. In such scenario, the number of years into consideration for calculating the present value of your
future generation cash flow must be infinite (as there is a possibility for your future generation exist
forever) and the price must be calculated based on all positive and negative aspect in the future)

In the example I have used here to explain the justification, factors such as future risk-free interest rate,
the future growth rate in earnings and future return on equity of the business are kept as constant. That
is only for an easy understanding purpose. In reality, these factors will highly fluctuate, and one can’t
predict future fluctuation on these factors on the day of business negotiation. However, despite the
varying nature of these factors in future, the calculation and reasoning behind the intrinsic value remain
the same. In other words, the ‘possibility’ for business return to outperform the treasury bills investment
for a given amount remains the same even with every year fluctuating values of these factors (Refer to
the excel file tab ‘Justification- case3’). In real, the buyer of business understands and accept the dynamic
nature in future and still hoping that the business will outperform the treasury bills return at some point
in future for his given investment amount. This can be explained by the following chart.
Moreover, it is true that every year future return will have an impact on subsequent year cash flow as the
business will be continually reinvesting and so any underperforming year can reduce the following year
cash flow which will reduce the velocity of business outperforming the treasury bills investment. However,
the existence of future fluctuating nature in individual year performance doesn’t impact the final
negotiated value at the time of business negotiation. The buyer of business is negotiating to acquire
lifetime future cash flow of the business, therefore the buyer is viewing ‘collection’ of individual year
future performance as single event of ‘opportunity’ which decides the final negotiated value and so the
existence of future fluctuating nature in individual year performance doesn’t impact the final negotiated
value.

Intrinsic value –an opportunity cost:

From the example I have explained above, one can understand that the intrinsic value of business is
indeed an ‘opportunity cost’ as investor is purchasing a business in order to be in a circumstance which
provides him the possibility of receiving an extraordinary return for a given amount when the investor
could invest the same amount in treasury bills.

One can have a better understanding of this from the graphical representation shown above. The curve
[‘Net treasury bills value end of the year’] explains what an investor could receive in the future by
constantly investing in treasury bills the equal amount that is used to purchase the business. However,
the investor decides to purchase the business considering the ‘opportunity’ of receiving an extraordinary
return for a given purchase price when the same amount could be invested in treasury bills. The curve
[‘Accumulated dividend value+ current year earnings’] explains the ‘opportunity’ the buyer of business
receives and the curve [‘Net treasury bills value end of the year’] explains the ‘cost’ of opportunity which
is sacrificed in order to take the ‘opportunity’ of receiving an extraordinary return. At the same time, one
should understand that the ‘opportunity’ represents a possibility of an extraordinary return not the
guarantee of an extraordinary return. Saying it in graphical terms, the curve [‘Accumulated dividend value
+current year earning’] surpassing the curve [‘Net treasury bills value end of the year’] at some point in
future is a possibility not a guarantee of an event. Therefore intrinsic value or the purchasing price of
business can be described as ‘opportunity cost’ of purchasing an ‘opportunity’ which provides the
possibility of producing an extraordinary return for a given appropriate buying price of business.

How the intrinsic value changes over the years?

We shall now look at how the intrinsic value of the business changes over the year after the business is
purchased. Assume the business transaction materialized and seller disconnects himself from the entire
business ownership. Now the buyer takes full control of the business, and he is getting the operational
return from the business that he purchased.

It is very clear from previous chapter explanation, the buyer of business will have to wait for many years
to truly validate the successfulness of business purchase, i.e., it will take many years for the business
owner to confirm whether the [cumulative dividend value + one year earnings] from the business
operation surpass the [calculated cumulative treasury bills value] at some point in future for the given
purchase price. In the event of buyer holding the business for a very long period and business purchase
turn out to be ‘successful', the buyer will not only see the business return outperform the [calculated
cumulative treasury bills value], but also he might receive multiple times the return that could have been
achieved through investing the same amount in treasury bills. This can be understood from the graphical
representation shown above.

In the meantime present owner is looking ahead to achieve this extraordinary return through operational
income (dividend from business) and incremental earnings through reinvestment of capital (the event
towards to achieve [cumulative dividend value+ one year earnings] surpass [calculated cumulative
treasury bills value] at some point in future), let’s assume another person is interested in purchasing the
business from present owner. Selling the business to the new potential buyer is his choice however
present owner is provided with an option to sell his business if he wants, by accepting the offer from the
potential buyer. Here comes the question, what is an appropriate price the present owner can think of
selling his business to the potential buyer and such price also should be appropriate for the buyer to make
the offer? To answer this question, let’s go back to our original example.

The present owner bought the business at price of 62,400 cr when the book value was at 8,000 cr, and
net earnings were at 1,600 cr. We shall now assume, end of the first year, the business paid out a dividend
of 400 cr and rest of earnings from first earnings are reinvested back to same business. Therefore the
business will have revised book value of 9,200 cr. Assume the return on equity of business remains the
same (20%) even with this additional capital into the business, then the business is expected to have
revised future base cash flow of 1,840 cr from the second year. The reinvested capital into business not
only increases the future cash flow of the business but also raises the future capital available for future
reinvestment. We shall now assume the new potential buyer is negotiating with the present owner to
acquire the entire business at this point. What shall be the appropriate price at which buyer and seller can
think of exchanging the business?

To arrive an appropriate price, it is essential to understand potential buyer intention of acquiring the
business from the present owner based on present state of condition. Logically, the potential buyer
intention can’t be different from the present owner’s earlier intention when he originally purchased the
business, i.e., potential buyer believes that owning the business is an ‘opportunity’ to receive an
extraordinary return for the given purchase price (opportunity cost). In other words potential buyer look
at lifetime cash flow of given business and he is visualization the possibility of [cumulating dividend value
+ one year earnings] surpass [net treasury bills value] at some point in future as an ‘opportunity’ for the
ongoing negotiating price (opportunity cost). This possibility always comes into the picture every time
business negotiation takes place. At the same time, all the variables right from base cash flow, risk linked
to base cash flow, future reinvestment gains and interest discount factor for the time comes into picture
when potential buyer look forward to purchasing the business from present owner. Every reasoning and
approach applied to the initial business purchase by the present owner applies to the ongoing business
negotiation as well.

Eventually, since there is no change in the intention behind the business purchase and no change in
approach toward pursuing the future circumstance, the underlying equation to calculate intrinsic value
doesn’t change from when it was originally constructed. The equation remains the same, only the input
changes. Therefore potential buyer of business is calculating the intrinsic value as shown below,

Intrinsic value of business=

= 𝐶𝐹(1 − 𝑟) + 𝐶𝐹 (1 − 𝑟)2 + 𝐶𝐹(1 − 𝑟)3 + ⋯ . +𝐶𝐹(1 − 𝑟)∞


= 𝐶𝐹 ∗ {(1/𝑟) − 1}
= 1,840 x [(1/2.5%)-1]
= 1,840 x 39
= 71,760 cr.

(Reinvestment gain factor perform as compensation for interest discount factor for time; therefore both
factors dismiss each other in value equation)

Therefore net gain during the holding period can be calculated as

=dividend yield + change in intrinsic value

= 400/62,400 + (71,760-62,400)/62,400

=0.641% + 15%

=15.641%

Accepting the offer price and selling the business to a potential buyer is an independent choice of the
present owner. Regardless whether the business is sold or retained, the change in business intrinsic value
is valid and meaningful. At the same time, gain in intrinsic value can be realized only when the business is
sold to some other buyer.

From this example, it can be understood that the increase in intrinsic value is entirely driven by the
reinvestment capital into the business. Since the business retained a significant portion of earnings and
reinvested successfully, the future earnings are revised. This increase in earnings not just should be
viewed as an increase in future cash flow of the business, instead it should be considered as increased
future cash flow (capital) available for future reinvestment actions. Any such increase in future cash flow
(capital) immediately increases the opportunity cost of acquiring the revised cash flow (capital) or
increases the intrinsic value of the business. Therefore, the increase in the intrinsic value of the business
signifies the increase in the opportunity cost of acquiring the business.

As the business operation continues, the intrinsic value of the business moves up or moves downs
corresponding to the revised earnings of the business since any change in earnings move the opportunity
cost of acquiring future cash flow of business. Change in the intrinsic value is enduring as the business is
expected to continue the operation forever. Therefore there is no maturity date for the intrinsic value of
the business. An investor gain/loss is always calculated based on the change in intrinsic value plus dividend
received from the business during his holding period.

The factors causing the intrinsic value to move in a positive direction can be seen under the chapter ‘The
magnitude of reinvestment gain (Rg)’ and similarly, those factors causing the intrinsic value to move in
negative direction can be seen under the chapter ‘r - Risk associated with base cash flow (CF).’ Since the
entire future reinvested gain (Rg) is compensated for the interest component during the business
negotiation, the buyer of business expects the business to retain as much capital it can and he expects the
business to produce incremental earnings every year- the event which will increase the intrinsic value of
business every year. In other words, the buyer of the business assuming himself a person who purchases
an opportunity cost with the intention of receiving ever-growing opportunity cost in the future.

Ideal expectation of business buyer:

We will now try to understand the ideal expectation of the business buyer. This can be understood
through exploring the movement in intrinsic value of business. Let’s look at the following derivation,

Let us call it V1 what an investor pays for purchasing the business, therefore

𝑉1 = 𝐶𝐹1 ∗ (1 − 𝑟) + 𝐶𝐹1 ∗ (1 − 𝑟)2 + ⋯ … + 𝐶𝐹1(1 − 𝑟)^∞


CF1- cash flow when the buyer purchases the business

After a year of business operation, the business owner receives dividend from the business and revised
future cash flow of business through reinvestment; this can be seen as below series,

𝑉2 = 𝑑1 + [𝐶𝐹2 ∗ (1 − 𝑟) + 𝐶𝐹2 ∗ (1 − 𝑟)2 + ⋯ … + 𝐶𝐹2(1 − 𝑟)∞ ]


d1- dividend received end of first year
CF2-revised cash flow through reinvestment

(Reinvestment gain factor and interest discount factor for time dismiss each other in value equation hence
not shown in V1 and V2 equation)

𝑉2 = 𝑑1 + [𝐶𝐹2 ∗ (1 − 𝑟) + 𝐶𝐹2 ∗ (1 − 𝑟)2 + ⋯ … + 𝐶𝐹2(1 − 𝑟)∞ ]


(With an assumption of risk% hasn’t changed from first year)

𝑉2 = 𝑑1 + [𝐶𝐹1 ∗ (1 + 𝑔1) ∗ (1 − 𝑟) + 𝐶𝐹1 ∗ (1 + 𝑔1) ∗ (1 − 𝑟)2 + ⋯ … + 𝐶𝐹1 ∗ (1 + 𝑔1) ∗ (1


− 𝑟)^∞ ]
g1- earnings growth rate % at first year

𝑉2 = 𝑑1 + (1 + 𝑔1) ∗ [𝐶𝐹1 ∗ (1 − 𝑟) + 𝐶𝐹1 ∗ (1 − 𝑟)2 + ⋯ … + 𝐶𝐹1 ∗ (1 − 𝑟)∞ ]

V2=d1+ [(1+g1)*V1]

Net gain at the end of first year (through business ownership) =V2-V1

=d1+ [(1+g1)*V1]-V1

=d1+ V1+ g1*V1- V1

=d1+ g1*V1

=V1* (d1/V1 + g1)

=V1*(dividend yield % at first year + earnings growth rate % at first year) Equation1

Let’s see now what could have been achieved through investing the same amount in treasury bills during
the same period,

Investment amount at beginning of first year =V1

Value of investment end of first year V2=V1*(1+i1)

i1- treasury bills interest rate at first year

Net gain at the end of first year (through treasury bills investment) =V2-V1

=V1*(1+i1)-V1

=V1+V1*i1-V1

=V1*i1

=V1*Treasury bills interest rate at first year Equation2

By comparing the Equation1 and Equation2, it can be concluded that the buyer of the business would
expect [dividend yield % + growth rate % in earnings] to be higher the treasury bills interest at the end of
the first year to receive a better return through business ownership.
This derivation can be further imagined for many years and it can be concluded that the buyer of the
business would expect the long term average of [dividend yield % + growth rate % in earnings] to be higher
than the long term average of treasury bills interest rate in his holding period in order to receive a better
return through business ownership.

I.e., If we assume k= [dividend yield % + growth rate % in earnings], ideal expectation of buyer can be seen
as,

Average (k1,k2,k3,k4,k5…….kn)>Average (i1,i2,i3,i4,i5……..in)

n - business holding period in years

Since the % increase in earnings increase the intrinsic value of business roughly at the same rate, this
result can be further interpreted as buyer of the business would ideally expect long term average of
[dividend yield % + % increase in intrinsic value of business] to be higher than the long term average of
treasury bills interest rate in his holding period. This conclusion applies to both a private owner who is
intended to hold the business forever as well as for short-term investors.

Additionally, it is absorbed that this conclusion in line with the hypothetical examples that we discussed
earlier. I.e. if the long term average growth rate in earnings matches the long term average of risk-free
interest rate, then there should some dividend payout If business return has to outperform the treasury
bills return in the long run and, if the business is not paying out any dividend, then long term average
growth rate in earnings should exceed long term average risk-free interest rate If business return has to
outperform the treasury bills return in long run. This can be expressed as,

1. If g%=i%, then d% should be above zero if one has to get the result [d% + g%] > i%
2. If d%=0, then g% should be above i% if one has to get the result [d% + g%] > i%

(d%- long term average of dividend yield, g%- long term average of growth rate in earnings, i%- long term
average of risk-free interest rate).

Finally, since [d% + g%] > i% is sufficient to make the business outperform the treasury bills investments,
the following conclusions are valid

1. Possibility exists for business return outperform the treasury bills return even without
reinvestment- it is possible when business efficiently retain the present earnings, and dividend
yield stays above treasury bills interest rate for a consistent period after the business is purchased
(initial risk% applied is above the treasury bills interest rate accrued later)

2. Possibility exists for business return outperform the treasury bills return even with declining
earnings trend (no reinvestment)- it is possible because, even though business earnings continue
to fall (declining rate isn’t high), the declining dividend yield % can stay above the treasury bills
interest rate stays for a consistent period after the business is purchased (initial risk% applied is
well above the treasury bills interest rate accrued later)
3. Possibility exists for business return outperform the treasury bills return even with negative
reinvestment gain (Rg) - it is possible because, even though reinvestment is not increasing
business earnings at a significant rate (consumption of capital is not high), still the dividend yield
% (after the reinvestment) can stays above the treasury bills interest rate for a consistent period
after the business is purchased (initial risk% applied is well above the treasury bills interest rate
accrued later)

4. Possibility exists for business return outperform the treasury return even with negative
reinvestment gain and declining earnings trend - it is possible because, even though reinvestment
is not increasing the business earnings at a significant rate (consumption of capital isn’t high) and
business earnings continue to decline (declining rate isn’t high), still there is rare possibility exists
for falling dividend yield % (after the reinvestment) can stays above the treasury bills interest rate
for a consistent period after the business is purchased (initial risk% applied is well above the
treasury bills interest rate accrued later)

Is reinvestment gain factor (Rg) in intrinsic value equation always a positive value?

I believe yes. Based on my understanding and observation, the reinvestment gain factor (Rg) in intrinsic
value equation is always treated to be a positive value and always work as the compensatory variable for
interest discount factor for time.

Question: Is reinvestment gain factor (Rg) positive even for a business with a very low return on equity
(present return on equity is lesser than current treasury bills rate of return) and for a company showed a
very poor performance with retained capital in the past? Answer: Yes, the reinvestment gain factor (Rg)
in the value equation is treated positive and considered as compensatory value for interest amount. No
matter how inefficient the management was in deploying the retained capital into the business in the past
and no matter how poor the present return on equity (ROE) of the business, because- (see below points)

a) There is possibility exist for company reinvesting the future earnings successfully despite their
poor performance on retained capital in the past
b) There is possibility exist for previously deployed and poorly performing capital up till the day of
negotiation can perform well in the future (this can be assumed as possibility of reinvestment gain
with zero capital of reinvestment)
c) There is possibility exist for poor return on equity business turn out to be a high return on equity
business anytime in the future because of operational initiatives, government regulation, better
pricing power due to favorable market conditions and similar factors (this can be assumed as a
possibility of reinvestment gain with zero capital of reinvestment)

All above possibilities collectively make the reinvestment gain factor (Rg) positive in the intrinsic value
equation – even though future reinvestment gain possibility through future reinvestment of earnings
mainly drives the variable to be positive.
Additional information:

In this section, I have explained some essential points that I have felt important to understand in business
valuation. Some of them are direct information, and some are question and answer.

1.) Is risk% applied to base cash flow constant forever? – No, it can change depending on the situation.
Factors like intense competition, customer preference, restructure in the management, government
regulation and overall demand for the product in the future can make a significant shift in risk%.
Moreover, there is no perfect algorithm to arrive the risk %; investor himself has to come up with an
appropriate risk% for the given business based on outlook of the business

2.) Cash and cash equivalents: cash and cash equivalents in the balance sheet (belongs to owner equity)
kept for future investment opportunities are always treated as an additional value to the intrinsic value
of business. In such cases, one should make sure earnings input in intrinsic value equation is adjusted for
cash holding (by adjusting the other income and tax component in P&L statement)

3.) A corporate with different subsidiaries: A corporate may hold many dissimilar businesses; in such
case, the value of individual businesses should be calculated separately and then summed up to arrive the
total value of the corporate

4.) Dividend distribution tax: Dividend distribution tax doesn’t impact the intrinsic value of business since
the business has the option to retain the entire future earnings (as long as paying out dividend is not
mandatory). Future dividend distribution tax amount is billed to buyer of the business

5.) Can anyone predict the future earnings in the long term? No, nobody can predict future earnings of
the business in a long term; it is just that buyer of the business ‘hope’ to receive incremental earnings in
the future

6.) Can anyone predict the future treasury yield? No, nobody can predict the future movement in
treasury bills rate of return; it is just that buyer of the business ‘hope’ to receive a better rate of return
through business ownership than a rate of return that he could have attained through investing the same
amount in treasury bills

7.) Bank valuation differ from other business valuation? No, bank valuation is same as any other business
valuation, and intrinsic value should is calculated based on earnings of the bank; however, a bank value
can be arrived based on bank book value if the bank is very consistent in return on equity

Intrinsic value of different businesses:

I have explained here how different private businesses can be valued with some cases studies; companies
taken for these case studies are imaginary.

Case1: Above-average return on equity (ROE) and normal earnings power:

Imagine a consumer based paint manufacturing company with a book value of 4,000 cr and net earnings
of 1,000 cr. Earnings growth rate was 12% in the last ten year; business bound with durable competitive
advantages and positive outlook about the future might demand a very low risk. If the risk inherent in the
base cash flow is assumed as 2.5%, then the intrinsic value of the business can be calculated as,
Intrinsic value of business= 1,000 x (1/2.5%)-1= 39,000 cr.

Case2: Average return on equity (ROE) and flat earnings:

Imagine a tyre manufacturing company with book value of 7,000 cr and net earnings of 1,000 cr; even
though the business retained a significant portion of earnings in the last five years, the business earnings
didn’t increase in the last five years; if the risk is assumed to be 8% due to the intensively competitive
nature of the industry, the intrinsic value of business can be calculated as,

Intrinsic value of business= 1,000 x {(1/8%)-1} =11,500 cr

Refer to section ‘Is reinvestment gain factor (Rg) in intrinsic value equation always a positive value?’ to
understand why flat earnings in past will not downgrade the reinvestment gain factor in value equation

Case3: Below average return on equity and decreasing earnings:

Imagine a telecom service provider with a book value of 30,000 cr and earnings of 900 cr. (ROE=3%) also,
assume the business earnings was declining in the last ten years even though the business reinvested a
significant portion earnings back to the business every year; if the risk is assumed as 5% in the base cash
flow, the intrinsic value can be calculated as

Intrinsic value of business= 900 x {(1/5%)-1} = 17,100 cr.

Refer to section ‘Is reinvestment gain factor (Rg) in intrinsic value equation always a positive value?’ to
understand why low return on equity and weak past performance with retained capital doesn’t
downgrade the reinvestment gain factor (Rg) in value equation

Case4: Above-average return on equity and extraordinary earnings power:

Imagine a specialized two wheeler automobile manufacturing company with a book value of 3,000 cr. and
net earnings of 1,000 cr; imagine it is almost certain the business earnings are going to be 1,500 cr in the
near future. If the risk % is assumed to be 4%, the intrinsic value can be calculated based on expected
earnings,

Intrinsic value of business= 1,500 x {(1/4%)-1} = 36,000 cr.

Case5: Above-average return on equity and good earnings power- a bank

Imagine a bank with a book value of 50,000 cr and earnings of 10,000 cr also assume growth rate in
earnings of the bank was 20% in the last ten years. If the risk% is assumed as 5% for the quality
management and operational efficiency of the business,

Intrinsic value of business= 10,000 x {(1/5%)-1} =190,000 cr.

If the bank is very consistent in return on equity, let’s say 20%, the intrinsic value can be arrived as below
Intrinsic value of business= (Book value x Return on equity) x {(1/5%)-1}

= (50,000 x 20%) x {(1/5%)-1}

=190,000 cr.

Case6: Above-average return on equity and heavy losses in earnings- a well-established startup

Imagine a 10-year-old e-commerce well-established startup with a book value of 2,000 cr and assume the
business never reported a profit. The losses were increasing year on year from the very beginning of
business operation. However the losses were mostly driven by discounts and advertisements. If the
discounts and advertisements are considered as ‘extraordinary’ elements in profit and loss statement, the
‘owner’ earnings in the long term can be picturized after eliminating the extraordinary items; let assume
the profit has arrived at 1,000 cr when these two extraordinary items are excluded from profit and loss
statement.

Next, applying a risk of 3% considering the company’s strong presence in the e-commerce market, the
intrinsic value of the business can be calculated as below,

Intrinsic value of business = 1,000 x (1/3%) = 32,333 cr.

Author profile:

Logeshkumar Jaganathan is an Engineering graduate from Crescent Engineering College, Chennai. He is a


long-term investor in Indian stock market. He is well known in his friends’ circle for his stable approach
towards selecting quality businesses, investing in a concentrated portfolio of companies and his distinct
valuation method. At present, he is working as a service delivery lead in a leading Supply Chain Consulting
firm in Bangalore (Chainalytics LLC).

Feedback:

Send you feedback, comments, queries regarding this book to creslogesh@gmail.com

Copyright © 2018 by Logeshkumar Jaganathan

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Author is neither a registered investment advisor nor associated with any broker/dealer. Author do not
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ideas, strategies, and examples expressed in this book are purely author’s opinion and views. Author’s
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