Make few bets, big bets and wait for the right pitch while doing so. Maximise your returns by maximizing rewards and minimizing risks. Two key takeaways in the Dhandho Investor book.
![]() Dhandho Investor Free Cash FlowLet’s say that we have an alternative low-risk investment that would give us a 10 percent annualized return on the money. Free cash flow—money that can be pulled out of the business—is expected to be $100,000 a year for the next 10 years. Further, let’s assume that the gas station can be sold for $400,000 after 10 years. The definition is painfully simple.He then goes on to explain this concept using the example of a gas station –To illustrate let’s imagine that toward the end of 2006, a neighborhood gas station is put up for sale, and the owner offers it for $500,000.It is simple.Mohnish then uses this concept to a real-life retail business that is Bed Bath and Beyond (BBBY). We also have the formula to figure out what these businesses are worth. Investing in the gas station is a better deal than putting the cash in a 10 percent yielding bond—assuming that the expected cash flows and sale price are all but assured.The stock market gives us the price at which thousands of businesses can be purchased. If we did the DCF analysis on the 10 percent yielding low-risk investment, it looks like Table 7.2.Not surprisingly, the $500,000 invested in our low-risk alternative has a present value of exactly that—$500,000. As Table 7.1 demonstrates, the gas station has an intrinsic value of about $775,000.We would be buying it for $500,000, so we’d be buying it for roughly two-thirds of its intrinsic value. Alternately, you could use Excel. Ti 83 mac emulator(FCF = Net Income plus Depreciation, which is a non-cash expense minus Capital Expenditure)It looks like BBBY is growing revenues 15 percent to 20 percent and net income by 25 percent to 30 percent a year. The “back of the envelope” net free cash flow was about $408 million. Capital expenditures for the year were $191 million and depreciation was $99 million. What is BBBY’s intrinsic value?BBBY had $505 million in net income for the year ended February 28, 2005. We know BBBY is being offered on sale for $10.7 billion. I’d say that’s a pretty good deal, but look at my assumptions—they appear to be pretty aggressive. BBBY has about $850 million in cash in the business presently (see Table 7.3).So, the intrinsic value of BBBY is about $19 billion, and it can be bought at $10.7 billion. Further, let’s assume that the business is sold at the end of that year for 10 to 15 times free cash flow plus any excess capital in the business. Let’s assume that free cash flow grows by 30 percent a year for the next three years then grows 15 percent a year for the following three years, and then 10 percent a year thereafter. We can compare November 2005 data to November 2004 data. The company has not yet released numbers for the year ended February 28, 2006, but we do have nine months of data (through November 2005). What if we made some more conservative assumptions? We can run the numbers with any assumptions. If we made the investment, we would end up with an annualized return of a little under 10 percent. BBBY’s current market cap is $10.7 billion. If we assume that the bottom line growth rate declines by 1 percent a year—going from 15 percent to 5 percent and its final sale price is 10 times 2015 free cash flow, the BBBY’s intrinsic value looks like Table 7.4.Now we end up with an intrinsic value of $9.6 billion. It looks like the top line is growing at only 10 percent annually and the bottom line by about 15 percent to 16 percent. And earnings increased from $324 million to $375 million. For me, it’s an easy pass.Now, the objective of this exercise, as Mohnish writes in his book is not to figure out whether BBBY is a stock worth investing into at the current valuation of $11 billion. There isn’t that much upside and a fairly decent chance of delivering under 10 percent a year. And in these calculations, I’ve assumed no dilution of stock via option grants, which might reduce intrinsic value further.With a present price tag of around $11 billion and an intrinsic value range of $8 to $18 billion, I’d not be especially enthused about this investment. So what is BBBY’s real intrinsic value? My best guess is that it lies somewhere between $8 to $18 billion. Please read the same before you start using the excel.And before I end, here’s my usual disclaimer – It’s good to work on spreadsheets, but please avoid twisting spreadsheets to fit your version of reality. I have also explained some cells using comments. This is like the Reverse DCF process that I explained in an old post on how to value stocks using DCF.Before you see the excel, please note that the examples of Infosys and Asian Paints I have used are just for representation purposes and do not suggest my view on these stocks. It contains not just the process – that I have termed “Dhandho IV” – outlined in the book, but also a reverse process – that I have termed “Reverse Dhandho IV” – where I find the stock market’s free cash flow growth rate assumption embedded in the stock’s current market cap. But those bent on Ben Graham will use this process and then add a margin of safety to cover for any risk that may arise from the intrinsic value calculations (even wide ranges) going haywire.Anyways, here is an excel sheet I have created using the process explained by Mohnish in his book. ![]()
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