POST OF THE DAY
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A Value Story

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By invertirmenor
September 29, 2005

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Yesterday I started typing this story and my computer just randomly turned off in the middle on my typing, I was typing in the post message thing, so all the pages were erased, anyway this story is kind of from How to Think Like Benjamin Graham and Invest Like Warren Buffet. I know most of the prices are way off, but I'm just using them because it's easier to compute, and I really have no idea what the real numbers would be :-)

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 an 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 today is worth less than a dollar tomorrow, 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 gat 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."

Here we looked at a number of ways people attempt to value businesses, in the next post the old man will talk to the broker about cash flow instead of earnings.

-Mike


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