In this video, Preston says at 11:30 mark to pause the video and evaluate how much money you are willing to pay for this ice cream business:
I will look at following points to estimate what price am I willing to pay for the ice cream business:
# First of all, I will look what return am I getting risk-free. The State Bank of India gives 6.4% per year. You can check on its website here. So, if I am taking any little amount of risk, I will only invest if I get more than 6.4%. Hence, in no case, I should pay more than 16 times of net income (100/6.4~16)
# I will also look at the growth opportunity. Is there any possibility that, that 20,000$ per year could become 25,000$ per year. If that happens I would be willing to pay more for the business since my return on investment will increase in future.
On the contrary, I will also be willing to pay less if there is any risk of that 20,000$ becoming 18,000 or 15000$ per year.
#I will look at the Industry structure, competition and company’s moat or unique selling proposition. How are they different from their competitors
# I will look at the simplicity and longevity of the business. Means people are going to need it for a long long time.
These two points ensure the revenue will keep coming from customers
Cost of revenue
#I will look at the employees, management and owners. Are the employees happy to work there? How likely are they to leave the company? Are they part of any union? What is the background of promoters? What is their lifestyle like? Are they extravagant or penny pinchers? What is the shareholding of promoters? What is the skill set of management as well as promoters? How competent are they?
#I will look at the raw material supply. Is it sustainable? Can they face problems in future on the supply side?
The first point ensures that the employees are capable to run the business and not quit. The second ensures the sustained availability of raw materials.
# I will look at the government interference in that industry, The tax structures. Is the industry heavily regulated?
This ensures that government lets the businessman run his business peacefully and not tax and regulate him to death.
#In a nutshell, I will look at all the parameters which will ensure that I indeed will be getting the promised net income with very little risk over a very long period of time.
Now, let’s say I went through all my assessment and after considering all the risk associated and everything, I want to earn 10% on my money. So, I would pay 10 times (100/10=10) of net income or 200,000$ for owning the whole business. If I am, willing to earn only 8% then I could even pay more than 12 times the earnings.
That is how Warren Buffett evaluates the business. Once you evaluate the price of whole business, divide it by no. of shares outstanding and you get the price per share.This will be the intrinsic value of that business. The value that you think is fair for the business. Then, look price of that share in the stock market, if it is below your price you buy it if not, you don’t buy it and wait for a better price.
That is exactly what Warren Buffett does.