Value Models Made Easy

**teenvestor2** Mon Feb 06, 2006 11:23 pm

Value Models Made Easy
Once a wise man purchased a cow for $750, the cow proceeded to produce about $500 of milk each year, after about ten years it had a calf; this story is about the calf.

After about two years with the calf the farmer decided to retire so he put ad in the paper to sell the calf.

Two days later a guy came and offered $250 for cow, saying it was he could get for slaughtering the cow and selling all of the meat, and brain.

"Oh, but that is just the salvage value," the wise man began, "the cow is worth much more than that."

The next person came and said she would pay $500 for the cow, which what she figured she could get from one years worth of milk.

Again the farmer turned the deal down, "The cow will be alive for a lot longer than 1 year, while better than my first attempter, your offer is also bad."

The next person was an accounting student, "I looked through the books you kept on the cow and found you paid $750 for its mother, that's the book value and I'll pay you that much for the cow."

"The book value of the cow is $750, but any fool can see it is worth much more than that, go back and find a book that tells you how to find what a company is worth."

The next would-be-buyer came with is blackberry at hand, after talking with the farmer for 15 minutes he made some quick calculations and offered $5000, this is what he said he could make after ten years of selling the cow's milk.

"But, you see," said the farmer, "a dollar tomorrow is worth less than a dollar today, find a website and learn about that dot-comer."

A doctor was next, he told the farmer he didn't really know much about cows, but he saw the last guy offered $5000, "This must be the current market price, I'll pay that."

The farmer quickly replied, "You'd better stay in you circle of competence and only buy medicine companies until you understand other businesses, also just paying the price that the knucklehead before you was willing to pay is a good way to go broke, keep you cash and buy yourself a nice Hummer."

The next person was a broker fresh out of college that piqued the farmer's interest.

Immediately upon arrival the woman asked to see the farmer's books he had kept on the cow, he gave them to her.

A few days later she returned with her price ready to go, she only had to explain it to the farmer.

"The first thing I had to do was take expenses into hand when calculating income from your cow, milking, hay and other things cost money, I've subtracted that from the $500 you reported for the cow, that gives us $300."

"Wow! I thought I was making $500 from that cow."

"The next thing we have to do is take into account depreciation, a few years ago you bought an H2, for $50,000, 3% of the driving time on that car has come from transporting milk, this is $1500, if we depreciate this over thirty years, we get an expense of $50, now our income is $250."

"OK."

"Now I have to anticipate risk, what happens of the cow gets mad cow, or there's a milk surplus? On the other hand there could not be enough milk and the prices would rise so I'll have to equally weigh risk and reward."

"OK, how do you find out what you're going to pay me?"

"I want to earn 15% on my investment, so I won't pay a dime over what I'd have to pay for that 15% return."

"How do you figure that out?"

"We agreed on $250 for our earnings, if we divide that by the 15% return I want we should get an estimation of the price I'll pay. $250/15% equals $1666.66, I'll pay you this amount."

"OK, I'll need to look more into this and get back to you."

A few days after her first encounter with the old farmer the broker came back to his farm to purchase the cow.

Upon arriving she found the farmer sitting at his desk with un-organized papers lying everywhere, three calculators were found and the farmer smiled back at her when he saw here enter the room.

"Hi! Nice to see you here, I have some things to talk about."

"All right I've come with $1667 to pay for the cow."

"I have some changes to make, come sit down across from my desk and I'll explain them to you."

"The first thing I have a problem with is the earnings figure you gave me. I don't think it tells me much of anything," The Farmer began.

"Yes, it measures efficiency and economic utility," The broker tried to explain."

"Yes, but yesterday when I was contemplating this deal I looked into my safe and found $300 in cash. You told me my earnings were lower because of some un-important depreciation expense that I never actually expended, the Hummer has nothing to do with my cow."

"All right if depreciation isn't important, then what is?" questioned the broker.

"Cash. Money that I can use to put my kids through college or by a Hummer. My cow will go on for years producing revenues after costs, and it is the future, not the past we need to use in our valuation model."

"To find my asking price I assumed my cow will produce $300 worth of milk for the next five years, and $200 for five years after that..."

"Don't forget risk," the broker interrupted."

"Yes, I will be discounting by the seven-year treasury rate plus a risk premium. After I found what the cow will yield in cash over the next ten years, I added the amount the cow will be worth if you sell the beef after it dies."

"This is pretty simple, you want to the present value of future receipts, then add salvage value. I understand this, but I'm interested in how you found you're discount rate." The broker answered.

"Every day I read the articles from The Motley Fool, a while ago they interviewed Bill Nygren, who said he uses the seven-year bond rate, plus a risk premium. The seven year bond rate is 3.8%, we'll use a 5% risk premium rate, to be safe, and round to 9% as our discount rate."

"Sounds good," answered the broker.

The farmer showed the broker his chart on the value of the cow.

Bessy Valuation (2005)
Year 1 2 3 4 5
Cash Earned $300.00 $300.00 $300.00$300.00
-
300.00 Discount Rate 1.09 1.19 1.30 1.41
-
1.54
Present Value $275.23 $252.50 $231.66$212.53
-
$194.98

Year 6 7 8 9
-
10
Cash Earned $200.00 $200.00 $200.00 $200.00
-
$200.00
Discount Rate 1.68 1.83 1.99 2.17
-
2.37
Present Value $119.25 $109.41 $100.37$ 92.09
-
$ 84.48
-
-
Present Value of All Cash Flow $1,672.50
Salvage Value $ 250.00
Value of Bessy $1,922.50
-
-
Value w/o Discounting Cash $2,500.00 Difference $ 577.50

"This is a great model, but you must know that it's easy to discount nice and steady cash flows, but who knows what will happen to the cow as it gets older? There will probably be one-time non-recurring vet expenses. I'll give you $1800, but I think I'm over-paying."

"It's a deal," The farmer answered smiling

-Mike

**jianyunli** Wed Feb 08, 2006 8:57 pm

Re: Value Models Made Easy
Excellent story!

**teenvestor2** Thu Feb 09, 2006 1:14 pm

Thanks :-) :D

**Value-Investing-Forum** Sun Feb 12, 2006 7:20 pm

Congratulations for winning the VIF 10,000 points for this week's writing contest!

**blast_investor** Sun Feb 12, 2006 7:23 pm

Congratulations!

**teenvestor2** Sun Feb 12, 2006 9:35 pm

Thanks :-)

**springsnailt** Wed Mar 01, 2006 12:07 am

Doesn't this infringe copyright? :shock:

**teenvestor2** Wed Mar 01, 2006 12:16 am

no. How would it infringe copyright?

**springsnailt** Wed Mar 01, 2006 12:24 am

I've read it somewhere else, but maybe you are the same guy. :D

**blast_investor** Wed Mar 01, 2006 12:39 am

That is possible. Mike is editor in other web sites too.

springsnailt wrote: I've read it somewhere else, but maybe you are the same guy. :D

**teenvestor2** Wed Mar 01, 2006 9:09 am

If it was on Fat Pitch Financials, Shai Dardashti on Grahamian Value, VInvesting or Value Investing, and a Few Cigar Butts it's what I wrote :)

It is not infringing the copyright of the book though because I changed the story that the writer himself changed from a different writer in the 70's.