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The Value of Capital - Outside View by Nitin Gregory
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The Value of Capital
Jan 4, 2016

'Price is what you pay. Value is what you get.' - Warren Buffett

In a previous article, we discussed how capital is used to fulfill consumer demand. Consumer choices are always changing, and businesses have to continuously adapt. The best businesses are able deploy capital usefully and make a profit after accounting for all costs.

We are yet to answer the question: How do we value capital?

Gene Callahan in Economics for Real People has stated that the value of capital is derived from the plans people have for it. For example, some scrap metal lying on the floor has no value until somebody decides to melt it and use it to make productive machinery. Let's assume this metal is used to manufacture a small truck for delivering milk on a daily basis.

Can the value of this truck now be estimated with no further information? The answer is no. The truck is used for delivering milk, which results in some revenue. From this revenue, we need to account for costs incurred. Common costs are wear and tear of the truck, time invested delivering milk (labour costs), fuel, and other incidentals.

In the scenario that this is generating a profit, what would be the value of this enterprise (truck + driver + standard delivery route)? At this stage, some investors would start applying multiples and other methods to arrive at a ballpark price. However, my answer would still be no.

Taking this further, there is the cost of repairs and maintenance to the truck; maybe the axle is strengthened to increase load capacity. This typically pops as capital expenditure in a business. This represents cash that is ploughed back into the business to grow/maintain it.

With a clear understanding of profits, depreciation (wear and tear), and capital expenditure, we are now in a position to understand the 'free cash' generated from this small enterprise (for the sake of simplicity, working capital changes are ignored).

The above milk-delivery business generates a steady profit every year and uses a portion of that profit to maintain and grow the business. The cash that remains is called free cash flow to equity (investor). This is a good indicator if you want to value a business.

Let us take a look at some numbers to make this clearer...

This milk-delivery generates a profit after depreciation and taxes of INR 1 lakh. A portion of the profits are used to maintain the truck in running condition. To keep it simple, let's say the yearly depreciation is the same as the maintenance capex (no cash impact). Assuming no growth and the business has a life of ten years (no residual value), what would this business be worth to you?

The business will produce free cash flow of INR 1 lakh for ten years. This is cash that can be pulled out of the business with no consequence to the future of the business. It has also been referred to as owner earnings by Warren Buffet. Now we know the cash value of this business for the next ten years. Assuming your return expectation is 15%, a simple 'discounted cash flow' calculation will give the value of this business. You should be ready to pay anything below five lakh to invest in this business.

Enterprise valuation is an art with many complexities. There is enough financial literature about price-to-earnings multiples, capital asset pricing models (CAPM), and beta calculations to occupy you for months. The above method is broad. It has overlooked many complex questions such as: Why will the business be able to generate a steady profit for ten years? What is its moat? How can this business be grown into a fleet of delivery trucks? What will happen at the end of ten years?

A great business is like a virtual compounding machine. It generates free cash and is able to reinvest this surplus at high rates of return.

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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