The Dhandho Investor’s Guide to Calculating Intrinsic Value

One of the best books I’ve ever read on investing, and one written in a simple language, is Mohnish Pabrai’s The Dhandho Investor.

Mohnish explains in the introduction –

Dhandho (pronounced dhun-doe) is a Gujarati word. Dhan comes from the Sanskrit root word Dhana meaning wealth. Dhan-dho, literally translated, means “endeavors that create wealth.” The street translation of Dhandho is simply “business.” What is business if not an endeavor to create wealth?

The premise of Dhandho investing is, as is repeated time and time again in the book is simple – Heads, I win; tails, I don’t lose much.

One of my favourite chapters from the book is “Dhandho 102: Invest in Simple Businesses.” Here, Mohnish explains the concept of intrinsic value and also why, for most investors, it pays to identify simple businesses and then buy them at prices that provide sufficient margin of safety.

I would recommend you read this book in its entirety, and especially this chapter for it explains one of the most critical aspects of the investment process i.e., intrinsic value calculation, in its simplest sense. Though I am sure a lot of readers would not like such a simplistic approach to calculating values, for our minds generally don’t accept things that are simple and rather search for things that are complex (which make us look and feel smart). Else, Confucius wouldn’t have said that life is really simple, but we insist on making it complicated.

Anyways, coming back to this chapter from Mohnish’s book, he expands on John Burr Williams’ concept of calculating intrinsic values by discounting future cash flows. He quotes Williams’ concept thus –

Per Williams, the intrinsic value of any business is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the business. 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. Further, let’s assume that the gas station can be sold for $400,000 after 10 years. 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. Let’s say that we have an alternative low-risk investment that would give us a 10 percent annualized return on the money. Are we better off buying the gas station or taking our virtually assured 10 percent return?

I used a Texas Instruments BA-35 calculator to do these discounted cash flow (DCF) calculations. Alternately, you could use Excel. 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. 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. 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. We also have the formula to figure out what these businesses are worth. It is simple.

Mohnish then uses this concept to a real-life retail business that is Bed Bath and Beyond (BBBY). Here is how his explanation goes –

As I write this, BBBY has a quoted stock price of $36 per share and a market cap of $10.7 billion. We know BBBY is being offered on sale for $10.7 billion. What is BBBY’s intrinsic value?

BBBY had $505 million in net income for the year ended February 28, 2005. Capital expenditures for the year were $191 million and depreciation was $99 million. The “back of the envelope” net free cash flow was about $408 million. (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. It also looks like it stepped up capital expenditure (capex) spending in 2005. 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. 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. 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. I’d say that’s a pretty good deal, but look at my assumptions—they appear to be pretty aggressive. I’m assuming no hiccups in its execution, no change in consumer behavior, and the ability to grow revenues and cash flows pretty dramatically over the years. What if we made some more conservative assumptions? We can run the numbers with any assumptions. 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). We can compare November 2005 data to November 2004 data. Nine month revenues increased from $3.7 billion to $4.1 billion from November 2004 to November 2005. And earnings increased from $324 million to $375 million. It looks like the top line is growing at only 10 percent annually and the bottom line by about 15 percent to 16 percent. 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. BBBY’s current market cap is $10.7 billion. If we made the investment, we would end up with an annualized return of a little under 10 percent. If we have good low-risk alternatives where we can earn 10 percent, then BBBY does not look like a good investment at all. So what is BBBY’s real intrinsic value? My best guess is that it lies somewhere between $8 to $18 billion. 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. There isn’t that much upside and a fairly decent chance of delivering under 10 percent a year. 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. It is to show that even as the method of calculating intrinsic value using the formula given by John Burr Williams and then later talked about by Warren Buffett is simple, calculating it for a given business may not be so.

So, even with a simple business like BBBY that sells bedding, bath towels, kitchen electrics, and cookware, you will end up with a pretty wide range of its intrinsic values.

Those bent on precision in calculating intrinsic values will junk such a process. 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. 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. This is like the Reverse DCF process that I explained in an old post on how to value stocks using DCF.

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. In fact, if you need spreadsheets to tell you whether you should buy or avoid a stock based on the numbers the sheet throws at you, you are doing something wrong in your investment process.

For most of us, searching for simple businesses that don’t require answering difficult questions, and then buying them at valuations that could be performed back of the envelope – or like Mohnish did, on a calculator – is going to be profitable enough. And so will be reading Mohnish’s book – The Dhandho Investor.