Yesterday’s post was Really. I mean Really. What Really will your Cash Flows Be?. If you didn’t read it, please do.  It covered two important topics.  One was the biggest reason why Warren Buffett has made so much money for so long.  The second is how his principle can be applied to operating a company (as opposed to making investments).

A key point I made was A company is advantaged if it knows what its cash flows really will be.  This is why Zayo puts so much emphasis on operational finance and detailed forecasting.

I also made up a new term:  Intrinsic Cost of Capital.  A company will be rewarded by having a lower cost of capital if its cash flows are predictable.  Hence, value at any point in time will be higher and more accurate.  Minimize uncertainty of cash flows and you are rewarded with optimized value.

However, an executive can not stop there.  The executive’s company needs to shine at making it easy for its stakeholders to ascertain what the company’s cash flows really will be.  It is not enough for the company to know.  A company’s Intrinsic Cost of Capital will be optimized when its stakeholders can minimize their need to guess at what cash flows will really be.

The word transparency is often used.   Transparency implies it is easy to see through a barrier and know what is on the other side.  Be good at forecasting.  Make it easy for your investors to do likewise.  Be rewarded with a low Intrinsic Cost of Capital.  Be rewarded with a higher and more accurate valuation.

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Really. I mean Really. What Really will your Cash Flows Be?
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What the heck is Intrinsic Value?
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A few weeks back, I had a string of related posts.  The last of these was CAPM, Beta, and “Really, What will Your Cash Flows Be?” .  The series had several more posts, but I became distracted.  I wrote a series of posts on the unraveling global financial markets.  I then voted for Obama–and took several posts to explain why.  This week, I will finish the series from a few weeks back.

Please read the CAPM post above for continuity.

Intrinsic Value, which is defined by me (as it applies to a company) as: An enterprise is worth what its free cash flows, appropriately discounted, are really going to be.

Warren Buffett says “Risk comes from not knowing what you’re doing.“  Though I don’t have time to look for it right now, the Omaha Oracle also points out why he uses a modest discount rate when evaluating his investments.  He only invests in businesses he understands; and he only invests in companies with predictable cash flows.  By minimizing the uncertainty of what future cash flows will be, he can ascertain intrinsic value accurately.  When he sees a sizable gap between intrinsic value and price, he buys.

Believe it or not, this paragraph captured 90% of why Warren Buffett is viewed as the best investor of all time.

I am a business operator much more so than an investor.  I believe an operator can exploit this principle by ensuring that his or her company places extraordinary emphasis on making cash flows predictable.   A company is advantaged if it knows what its cash flows really will be.  By removing uncertainty, it lowers its true cost of capital.  Perhaps we need a term called “Intrinsic Cost of Capital”, to emphasize that a company can drive its discount rate or cost of capital lower by making its cash flows more predictable.

Step one is placing extraordinary emphasis on making cash flows predictable.  But to really lower the Intrinsic Cost of Capital, an executive needs to go one step further.  I will pick this up tomorrow.

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Transparency
CAPM, Beta, and “Really, What will Your Cash Flows Be?”
Predicting Cash Flows: The Foundation of an Exceptional Company
The Importance of Predicting Cash Flows
What the heck is Intrinsic Value?

[Follow-on to What the heck is Intrinsic Value?]

If you know what free cash flows will really be, you will be able to ascertain Intrinsic Value.  In fact, “really” allows an investor to use a lower discount rate–very low in fact if you know with certainty.

Capital Asset Pricing Model (CAPM) is used to determine a theoretically appropriate required rate of return of an investment.  In layman’s term, the appropriate rate of return is equal to the risk free rate of capital + a premium that is based on the riskiness of the particular investment.  The premium is broken down by multiplying riskiness (which is called “beta”) by the amount of premium that an investor should expect for each unit of risk.

The term beta is a very popular term in the world of finance.  “What’s the beta?” translates to “How risky is the investment?”.  The more risky, the higher the return an investor will expect to make on the investment.  As the expected rate of return goes up, the value of the investment today is pushed down.

Tomorrow I will bridge this discussion into why really is an important term in my definition of Intrinsic Value.

I know what you are thinking: “If that’s the layman’s version of CAPM, how weird is the non-layman’s version?”  For those few who might be interested, try this on for size:

Where:

• is the expected return on the capital asset
• is the risk free rate of interest 
• is the beta coefficient returns,
• is the expected return of the market
• is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).

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Related posts:

Really. I mean Really. What Really will your Cash Flows Be?
Value Creation at its Most Basic Level
Predicting Cash Flows: The Foundation of an Exceptional Company
The Importance of Predicting Cash Flows
Calculating Opportunity Cost

If Brad Feld wrote this post, the title would be “What the F*@! is Intrinsic Value?”.   Except he wouldn’t have used the *@!.

The past week’s worth of posts, which ended with Maximize Intrinsic Value, not Stock Price, used the expression Intrinsic Value many times.  Warren Buffett uses it frequently as well.  In fact, it is so important of an expression that the Omaha Oracle insists that among the key responsibilities of a CEO is Maximizing Intrinsic Value.  For reasons I discussed in the prior posts, Maximizing Intrinsic Value replaces the more commonly held notion that a CEO should view her job as maximizing stock price.

In these entire discussions, I never bothered to explain what Intrinsic Value is.  All employees of Zayo and Envysion–please take the time to appreciate what Intrinsic Value means.  It matters in everything we do.  If we know what it is–and if we know our job is to maximize it–we will be on the same page on how we approach our business.

An enterprise is worth what its free cash flows, appropriately discounted, are really going to be; this is my definition of Intrinsic Value.

Simple enough.  But powerful too.  What will our free cash flows be? If we know this, we will be only one step away from knowing our Intrinsic Value.  We will have to treat future cash flows as less valuable than today’s cash flow–as a dollar today is worth more than a dollar tomorrow.  But if we know free cash flows with a high degree of certainty, the discount rate will be modest and, within a small margin of error, knowable.

How do we maximize what our free cash flows really will be? This should be the basis for all business decision making.  It should guide the dialogues we have with one another.  It should be the focal point of all analysis.

Note that I use the word really in my definition.   I will elaborate on this tomorrow.

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Several posts from last week centered around Warren Buffett’s belief that a CEO should view their goal is to have stock price equal Intrinsic Value.  The Oracle differentiates this goal from the commonly held belief that the CEO should be looking to maximize stock price.

The story doesn’t end here though.  Buffett shares another important principle regarding the job of the CEO.  A CEO’s goal is to Maximize Intrinsic Value.   Keep stock price in line with Intrinsic Value while at the same time do your damnest to maximize Intrinsic Value.

If a company does a good job at maximizing Intrinsic Value, then it will produce a growing stock price.  But this principle (beyond just its merits from a fairness perspective) emphasizes that the focus needs to be on Intrinsic Value, not stock price.

Last week, I must have used the expression Intrinsic Value a dozen or more times.  Many readers might not know what I mean by this expression.  I will discuss this in a follow-on post.

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In this entry, I want to cover an all-important business concept. An enterprise is worth what its free cash flows, appropriately discounted, are really going to be; this is my definition of Intrinsic Value.

At first blush, this might seem obvious to some. Or, to others, it might seem wrong.

For example, isn’t a public business worth its “enterprise value”? For those who don’t know, enterprise value can be calculated by summing the the value of debt and equity a public company. Equity value is basically stock prices times the number of shares outstanding. Many people would say an enterprise is worth its “enterprise value”.

University of Chicago, of which I am an alumni, invented the “efficient market theory”, which states that the most accurate estimate of of the value of a public company is it’s enterprise value. Warren Buffett likes to point out that if the efficient market theory was correct, he would more likely be a pan handler than the world’s 2nd richest man. Said differently, enterprise value is sometimes out of sync with intrinsic value.

Berkshire Hathaway has done phenomenally well because it has an incredible record of determining intrinsic value. It invests when it identifies situations where intrinsic value is materially higher than enterprise value.

In the previous blog entry, we discussed how important it is for a company to develop a strong expertise in forecasting cash flows. This skill set ensures that a company is capable of accurately estimating its enterprise value as well as how day to day business decisions either enhance or detract from value. The better a company does at predicting cash flows and in tying cash flows to the true value (true = intrinsic) of their enterprise, the more valuable the enterprise will be.

Warren Buffett has a strong conviction about an executives’ responsibility in communicating intrinsic value to its investors. His opinion might surprise you as it is arguably in contrast to the behavior of most public company CEOs.

So Now What?

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Related posts:

What the heck is Intrinsic Value?
Really. I mean Really. What Really will your Cash Flows Be?
Maximize Intrinsic Value, not Stock Price
Transparency
Asset Value, Intrinsic Value and the Balance Sheet