One of the most sought after calculations in all investments is Warren Buffett’s intrinsic value formula. Although it may seem elusive to most, for anyone who has studied Buffett’s Columbia business professor Benjamin Graham, the calculation becomes more obvious. Remember that the intrinsic value formula that Buffett uses is an adornment of Graham’s ideas and fundamentals.
One of the most amazing things about Benjamin Graham is that he actually felt that bonds were safer and more investment likely than stocks. Buffett would totally disagree with that today due to high inflation rates (a completely different topic), but it is important to understand this in order to understand Buffett’s method of valuing stocks (stocks).
When we look at Buffett’s definition of intrinsic value, we know that he is quoted as saying that intrinsic value is simply the discounted value of a company’s future cash flows. So what the heck does that mean?
Well, before we can understand that definition, we must first understand how a bond is valued. When a bond is issued, it is placed on the market at a face value (or face value). In most cases, this value is $ 1,000. Once that bond is on the market, the issuer pays a semi-annual coupon (in most cases) to the bondholder. These coupon payments are based on a rate that was established when the bond was initially issued. For example, if the coupon rate were 5%, a bondholder would receive two coupon payments of $ 25 per year, for a total of $ 50 per year. These coupon payments will continue to be paid until the bond expires. Some bonds mature in one year while others mature in 30 years. Regardless of the term, once the bond matures, the face value is repaid to the bondholder. If you value this security, the value is based entirely on those key factors. For example, what is the coupon rate, how long will I receive those coupons, and how much of the face value will I receive when the bond matures.
Now, you might be wondering why I described all that information about bonds when I wrote an article on calculating the intrinsic value of Warren Buffett. Well the answer is quite simple. Buffet values stocks the same way he values bonds!
You see, if you were to calculate the market value of a bond, you would simply plug in the inputs for the terms listed above in the market value of a bond calculator and process the numbers. When it comes to stocks, it is no different. Think about it. When Buffett says that he discounts the future value of cash flows, what he is actually doing is adding up the dividends he expects to receive (like coupons on a bond), and estimating the future book value of the company (like than the par value of a bond). By estimating these future cash flows from the key terms mentioned in the previous sentence, you can discount that money to present value using a respectable rate of return.
Now this is the part that often confuses people: discounting future cash flows. To understand this step, you must understand the time value of money. We know that the money paid in the future has a different value than the money in our hands today. As a result, a discount (like a bonus) must be applied. The discount rate is often a hotly debated topic for investors, but for Buffett it is quite simple. For starters, it discounts your future cash flows on a 10-year federal note because it provides you with a relative comparison to a zero-risk investment. You do this to get started to see how much risk you are taking with the potential pick. Once that figure is established, Buffett discounts future cash flows at a rate that forces the intrinsic value to equal the current market price of the stock. This is the part of the process that may confuse many, but it is the most important part. By doing this, Buffett can immediately see the performance he can expect from any given stock selection.
Although many of the future cash flows that Buffett estimates are not hard figures, he often mitigates this risk by choosing nice and stable companies.