Build from scratch or buy an existing business?

Do you build a company from scratch or it is better to buy an existing business? Which one is cheaper?

Finance people will tell you that in order to evaluate an investment you can use what is called a DCF analysis. DCF stands for discounted cash flow analysis. This is used recurrently in the Finance world, but this tool is very biased. Why?

First, some pointers. When you do a DCF analysis, you:

1/take weighted averages of near cash flow projections(good information)

2/take weighted averages of distant cash flow projections(bad information)

3/add them together. When you add good information with bad information, guess what you get?That is right, bad information.

4/You ignore Balance Sheets. It is all projected earnings and multiples of earnings. A balance Sheet is the most reliable source of information of a company.

5/The assumptions that go to a DCF analysis are:

-profit margins

-growth rates projected into the future

-cost of capital

Nobody know what they are for most companies.

What you can ask is:

-Is this company viable from the financial point and will still be operating 10 years from now?Do you see people still using this company(product/service)?

-Does this company have a competitive advantage?Monopoly?Oh year, pleeease.

In valuation, you always start with:

1/the assets

2/look to the earnings power and see if it is protected by the assets

Only then,look to pay something for growth, protected by a significant margin of safety of what you think the company is worth.

You basically ask yourself:

Is this company will still be here?

Can we get a 15% conservative growth from this company?Is there room to keep growing?This is only valuable if the investment in growth earns more than the cost of capital. Put it other way, if you have interest payments higher than the growth of capital, that is a horrible investment.So you must have a lower interest than the growth of the earnings of the company.

Is there a competitive advantage?Barriers to entry like scale or a monopoly,customer protection, a patent, technology? Or is it something that any fool can start today?

A business by definition must be something much better than what exists presently, because the ones already operating are usually pretty good at what they do.

So it must be something better: Not necessarily something new, but something that solves a problem better.

Coming back to our EPV model, the valuation idea is: how much would you pay for the replica of Walmart today, and still get the same results? Out of this question we will get a price/share that is either higher, same or lower than the current market price. Only then you can make an assessment regarding the investment in that company.

Let's begin:

Step 1: Firstly create an excel section with the inputs, just like below.

Step 2: Secondly, create the output section, just like below. Pay attention to my notes on each row.

Step 3:

Excess Depreciation = Average Tax Rate x Average DDA

Normalized EBIT = Average Profit Margin + Average Revenue Annualized + Average SG&A Annualized x 25%

After Tax Normalized EBIT = Normalized EBIT x (1 - Av. Tax Rate)

Normalized Earnings = Excess Depreciation + After Tax Normalized EBIT

Step 4:

The next step is to calculate Average Maintenance CAPEX (Capital
Expenditures, meaning what the company needs to reinvest every year in
the business to keep it working at the present stage). See the table below:

Step 5:

To fund a company you need capital provided by equity and debt investors.
WACC (Weighted Average Cost of Capital) is a weighted average between
debt, common and preferred equity that will result in a percentage of cost of
capital. As an investor, you ask yourself: “It costs this to finance this project
and the return i will get is this.” Based on this and other metrics the investor
decides to go ahead or not. At the time of our valuation, Walmart’s WACC in
July 2016 was 9%. So this means that in order to raise capital to start
Walmart at that time the cost was 9% 

Step 6:

The next step is to check the price we came up with against the present
market value. 

Please note that when you are studying an investment you must define your
margin of safety, and you always want to define a certain margin before
hand. Finance people like to complicate things but this one is simple. It is
basically you saying to yourself: “This investment is worth "x" price, so just
in case i am wrong, let’s define a value below that so we can have a safety
net below the valuation assessment”. In our valuation we arrived at the value
of $41.64 per share. If you define a 30% margin of safety below this arrived
intrinsic value this means you wouldn't pay more than $29.15 per share. But
in this case it does not apply because the stock is currently overvalued. 

So to conclude our Walmart valuation: If you want to buy a company like
Walmart with all the stores, employees, inventory and so on, you would need
to pay $72.5 per share today and the company is not worth more than $41.64
or $29.15 per share with your margin of safety. 

Have fun investing.