Fair Value Basics: Concept Explained Using Simple Example

In this article, we’ll learn the basic concept of fair value of companies. We’ll use a simple example of a bakery shop and try to estimate the fair value of its business. This article aims to help the readers get a clear visualization of the fair value estimation of stocks/businesses. After reading this article, the reader will be motivated to estimate the fair value of companies on their own.Suppose there is a bakery in my locality. Its business is to sell loaves of sliced baked bread. It sells each loaf at Rs.45. His total cost of baking, packing, storing, selling, and tax is Rs.30 per loaf. So, the net profit for each loaf of bread is Rs.15.On average, the bakery shop can sell about 33.332 number loafs each day. The shop is open 7 days a week and operates annually. So, let’s estimate its total annual sales and profit.Total Cost (Total Expense): Rs.30 per loafSale Price (Revenue): Rs.45 per loafNet Profit (Profit After Tax): Rs.15 per loafNet Profit Margin: 33.33%Total Sales: 33.33 numbers per dayNos. of weeks operational: 50 Weeks/yearLet’s first estimate how many loaves of sliced bread are sold in a year. In a day, an average of 33.33 number loaves are sold. The bakery remains open all 7 days a week. So, in a week 233.33 loaves (33.33 x 7) are sold. Let’s assume that the shop remains open for 50 weeks in a year (out of 52). It means, 11,667 number loaves (233.33 x 50) are sold in a year.Now, in the second step, we can calculate the total sales and profit. For each loaf of bread, the bakery makes Rs.45 and Rs.15 in sales and profit respectively. So, for 11,667 number loaves, it will make a total sales revenue of Rs.5,25,000 (11,667 x 45) and Rs.1,75,000 in profit (11,667 x 15).Fair Value Calculator Section 1: Company DetailsSection 2: Additional Details Calculate Fair Value How To Estimate The Fair Value?Now, suppose seeing this thriving business in front of me, I have decided to buy a 10% stake in the company. So, I approached the owner with my offer. For businesses like bakeries, working capital is their headache. So, selling a 10% stake in the bakery will give the owner some extra cash. This cash can be used to enhance the raw material and finished goods inventory and thereby increase sales.The owner agreed to sell his 10% stake in the bakery for Rs.2 Lakhs.Now, the onus was on me to judge if Rs.2 Lakhs is a fair price for a 10% stake in the bakery. So I decided to use my intrinsic value estimation methods to do the fair value calculation.I used the following approach to do the maths:[If you do not want to read through the entire approach, you can jump straight to the final calculations]Step #1 – Discounting The Daily SalePresently, the bakery shop was claiming a sale of an average of 33.33 loaves each day. As one cannot be sure about future sales, I’ll discount the present sales by at least 10%. This gives me a daily sales figure of 30 loaves each day.[Note: But I’ll keep the present average daily sales number as 33.33 nos per day. Seeing the size of my locality, it looks to me that the assumed number of 33.33 numbers per day is already heavily discounted.]Step #2 – Assuming a payback period of 6 yearsThere are two ways of thinking about the payback period.First, is to assume it as the number of years it takes for the investment to come back to the investor. If I’m investing Rs.120 in a stock that will pay me Rs.20 per year as dividends, what will be my payback period? It will take me 6 years (Rs.20 x 6 years) to get back my invested money. So my payback period is 6 years.After the payback period is over, all dividends (or capital appreciation) received are my gains. It is also logical to value companies/stocks based on their potential to yield returns beyond the payback period.[Note: Remember, the longer you can wait the higher will be estimated fair value of the company. ]The second approach is a pessimist’s approach. On the date of investing, I’ll ask myself, for how long do I think this company will stay alive? Let’s say, my mind tells me 6 years. This value tells me to value the company only that much which it can pay back in 6 years.Anyway, I prefer valuing small-cap companies with the second approach. For large-cap blue-chip companies, the first approach looks more reasonable.In the example of our bakery business, I’ll value it till the payback period of 6 years only.Step #3 – Cash-flow adjustment [no credit sale]I am also assuming that the bakery business is all cash sales. It means, 100% of payments are collected at the time of sale in advance.For the majority of companies listed in the stock market, at least some portion of the sale is done on credit. For example, if a company reports a sale of Rs.100, only 65% of it gets collected from the customers. Hence, to estimate the fair price of a company, the cash flow factor must also be considered.[Note: It is a critical factor while estimating free cash flow for an actual enterprise. Though it is not done there as a “cash flow factor”, I’m using it here to explain the concept more clearly]Step #4 – Discounting @7.5% The Future Cash InflowsI will do the calculation for both 0% discount rates for our bakery example. I’m doing it just to keep the calculations simple for understanding by beginners.Nevertheless, I will explain the concept using a simple example.Suppose, you are investing Rs.120 today in a business to get Rs.20 each in the next 6 years. What do you think, is this investment a no-profit-no-loss deal? It might look like it in the first instance, but actually, it is a loss-making deal. How?First of all, why you will pay Rs.120 today to get the same amount in the next 6 years? Ideally, you should have got more than Rs.120. Why? Had you not invested in the business, you would’ve put the same money in a bank fixed deposit that would have earned 7.5% interest for you.It means that investing in the company, in a way you are losing the opportunity to earn a near risk-free 7.5% rate of interest. Hence, the 7.5% becomes your risk of investing in the business. For fair value calculation, this 7.5% becomes your discount rate.To know more details about the concept of discount rate and its related calculations, check the link.For now, let’s understand simply the role of discount rates. If a business is going to pay you back Rs.120 in the next 6 years (Rs.20 years), in this case, your investment should be less than Rs.120. How much lower? By the factor of the discount rate (example 7.5%).Step #5 – Future Sales Growth & CapexFor our bakery example, I’m assuming a 0% sales growth and no spending on capex. This is done to keep the calculations simple for first-time readers (beginners).Nevertheless, allow me to explain the effect of sales and capex on the fair value calculations.Suppose there is a company whose sales growth is static and it has a certain fair value. If we add a factor of sales growth to this company, its fair value will expand. The faster the company will grow its sales the bigger will be its fair value.But to grow, the company must spend money. It will need to modernize and also expand its operations. The company’s assets depreciate in performance over time. To keep up the health of its existing fixed assets (like equipment, etc) the company must spend some maintenance capex.For the company to substantially grow its sales, it must increase its operating capacity. This can happen when the company spends on growth capex. Growth capex is spent say to install new machinery, buy new land, etc.So, to grow the company needs to spend some cash. Their expense increase on account of Capital Expenditures (CapEx).In terms of fair value estimation, there is a give and take. On one side, sales growth expands the fair value on the other hand increased capex spending creates a negative effect.Hence, companies need to check and balance the amount of money they are spending on Capex. The spending must be done when it is justified by fair value enhancement in times to come (due to sales growth).Step #6 – Final Calculations (Fair Value)There is an online fair value calculator coded just to do this calculation (check here). But for the moment, I’ll explain how to manually do the fair value calculations for the bakery on paper.My calculations will also show you how certain assumptions will affect the fair value estimation at each stage of the calculation. Finally, what we’ll get is a range of value and between that will lie the fair value of our bakery.#1. Considering Only Net ProfitFirst, calculate the total net profit the company will generate during its payback period. In our example, the bakery makes sales of Rs.5,25,000 every year. We’ve assumed a payback period of 6 years. So in 6 years, it will generate total sales of Rs.31,50,000. The net profit margin for the bakery is 33.33%, so the net profit generated in 6 years will be Rs.10,49,895. If I’ve to buy a 10% stake in the bakery, then the fair value to pay for it will be Rs.1,04,895.#2. Also considering sales growthSecond, if we will consider a sales growth rate of 5% per annum. Adding this variable to the bakery’s business will start generating an incremental profit every passing year. This way, the bakery will yield an increased profit of Rs.11,90,216 in six years. For a 10% stake in the bakery, the fair value to pay for it will be Rs.1,19,021.#3. Considering CapexThird, if we consider the sales growth rate we will also have to consider the capex component. Why? To ensure sustainable growth for longer periods, capex related to capacity expansion and modernization is essential. Let’s consider a maintenance capex of 5% and growth capex of 5% of the net profit. Applying these two variables in our example, let’s see how the fair value estimation changes. This way, the bakery yields a profit of Rs.10,71,194 in six years. For a 10% stake in the bakery, the fair value to pay for it will be Rs.1,07,119.#4. Discounting future cash flowsFourth, there is no point in collecting Rs.1,07,119 (as calculated above) in the next 6 years by investing the full amount today. Hence it is essential to apply a discounting factor to the future cash flows to know the present value. In our bakery example, we have assumed a discount rate of 7.5%. The total profit generated by the bakery in 6 years is Rs.10,71,194. The present value of this profit is Rs.9,96,460. The fair value to pay for a 10% stake in the bakery will be Rs.99,646.ConclusionIn the above steps, we’ve done the calculations to estimate the fair value for a 10% stake in an example bakery business.In point #1, we have estimated the fair value as Rs.1,04,989. However, the calculation was done without considering the future growth or the present value discounting.In point #2, we have estimated the fair value as Rs.1,19,021 after considering a 5% annualized growth in sales. However, the calculation was done without considering capex. The calculation was also done without future value discounting.In point #3, we have estimated the fair value as Rs.1,07,119 after considering a 5% growth and cost implications due to capex. However, the calculation was also done without future value discounting.In point #4, we have estimated the fair value as Rs.99,646 after applying the discount rate of 7.5% to the future cash flows.By applying these rules to estimate the fair value, we have a range of numbers. These values give us an idea of the range of values between which the actual fair price of a business lies.The owner of the bakery had an ask of Rs.2,00,000 for a 10% stake sale. However, according to my estimation, the fair value will be between Rs.99,500 to 1,05,000.I hope the methodology, as explained in this article, gives you an idea of the basics of how fair value estimation is done for simple businesses. For more complex businesses, the basic structure of math will remain the same, but we’ll have to deal with a range of past data from companies. This makes the calculation slightly more complicated.My Stock Engine app does similar calculations to estimate the fair value of about 1300+ number listed stocks in NSE and BSE. Check the features of the Stock Engine here.Have a happy investing.Suggested Reading:

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