Mastering Quick Business Valuation Techniques in Minutes
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Understanding Business Valuation
Have you ever wondered how legendary investors like Warren Buffett and Charlie Munger manage to assess a business's worth in mere minutes? What unique mental approaches do they employ that the average person might not grasp? After years of exploration, I believe I've uncovered some key insights. While this may not be their exact technique, it certainly aligns with the principles they follow in their evaluations and investments.
The goal of this article is to teach you how to assess a business in just two minutes. We will rely on our intuition, experience, and straightforward calculations rather than diving deep into annual reports and extensive due diligence.
Selecting the Right Business
The first principle in valuing a business is to choose one you’re familiar with. For our example, let’s evaluate Apple. It’s a well-known company with a significant investment from Berkshire Hathaway, indicating its strong standing in the market. Most people recognize Apple for its iPhones, iPads, and Macs, which are ubiquitous worldwide, much like Coca-Cola. Apple has a reputation for innovative design and high-quality products.
To keep things efficient, we want to avoid complex companies that require thorough research. Here’s a helpful tip: if you can explain how a business operates in just a few sentences to a five-year-old, that’s the type of company you should consider.
Quick Financial Overview
Since we aim for speed, let’s skip the annual reports and use a stock screener instead. I prefer Yahoo Finance for its user-friendly layout and reliability.
Everyone has their preferred financial metrics to examine. Personally, I focus on revenue, EBIT, depreciation, amortization, borrowings, equity, and capital expenditures.
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This video provides a quick and effective approach to valuing a business, making it easy to understand for beginners.
So, what are we looking for? We want to assess Apple's performance from the most recent reporting year, which is September 29, 2021.
Operating Profit Margin - We calculate this as EBIT divided by Revenue. For September 29, 2021, we can estimate this with a rough calculation of 109/365. I’d approximate it to a 30% profit margin, meaning Apple earns 30 cents for every dollar of revenue—a highly impressive figure, as a profit margin above 20% is generally considered strong.
Return on Invested Capital (ROIC) - I calculate this as EBIT divided by (Equity + Borrowings). For September 29, 2021, I’ll estimate it as 100/(60+100+15), which simplifies to 100/175. While I can’t compute that precisely in my head, if it were 100/200, the ROIC would be 50%, indicating a solid return. Since our denominator is less than 200, the ROIC must exceed 50%. Generally, investors look for a minimum ROIC of 10-15%, making our figure of 50% or more quite impressive.
Depreciation & Amortization vs. Capex - Warren Buffett prefers that companies plan ahead and cover their depreciation and amortization costs. Ideally, depreciation and amortization should align closely with capital expenditures dollar for dollar. For September 29, 2021, Apple reported 11 for D&A and 11 for Capex, which matches perfectly.
Calculating Owners' Earnings
Now that we recognize Apple as a strong company, it’s time to calculate Owners' earnings, a critical figure for determining intrinsic value. The basic formula for Owners' earnings is EBIT + D&A - Capex. For our purposes, this simplifies to 110 + 11 - 11, resulting in a value of 110 million.
Valuing the Business
This section may be what you’ve been eagerly awaiting, and it can be complex, so pay close attention. Buffett employs the discounted cash flow (DCF) method, typically executed with a calculator or spreadsheet. However, we’ll rely on mental math for speed.
The DCF method discounts anticipated future earnings to their present value. If you’re adept at math, you can memorize multipliers to streamline your calculations.
Here are the steps to follow:
- Calculate Owners' Earnings - As mentioned, this is 110 million.
- Select a Growth Rate - For simplicity, let’s assume a growth rate of 5% for the next four years, ceasing growth by year five.
- Sum the Cash Flows - Multiply Owners' earnings by the present value of cash flows at a 5% growth rate. Rounding down, we calculate 110 * 4 = 440.
- Calculate Residual Value - This involves multiplying Owners' earnings by the residual value at a 5% growth rate, which simplifies to 26 * 110 = 2860.
- Determine Intrinsic Business Value - Finally, add the present value cash flows to the residual value: 2860 + 440 = 3300 million.
How Does This Compare?
With a valuation of 3300 million or 3.3 trillion dollars, we see it exceeds the market cap of 2264 million. This gives us a margin of safety of about 45% (3300/2264 - 1), suggesting that buying Apple at its current price could be a prudent decision. Even if you’re cautious, this exercise provides a solid foundation for further investigation.
For those interested in a deeper dive into business valuation multipliers, I invite you to check out my spreadsheet. Remember to download it and navigate to the intrinsic value multipliers tab for a comprehensive understanding of the discounted cash flow method.
This technique is not limited to public companies; it can be applied to any business as long as you can estimate Owners' earnings and make reasonable forecasts, both of which improve with experience.
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