Calculate Intrinsic Value

How Warren Buffett Values A Stock By Calculating Its Intrinsic Value

Publish Date: 25 Feb 2020

Intrinsic value is one of those terms that everyone talks about on YouTube but no one really has one answer on how to figure it out. There is a lot of speculation around whether intrinsic value is the correct way to value a stock, it’s not perfect, but as Warren Buffet has said before… “It’s better to be approximately right, than precisely wrong”.

A basic definition of intrinsic value is: Intrinsic value is a measure of what an asset is worth.  This figure is arrived at by means of an objective calculation or financial modelling of the company's future cash flows.

The concepts below and the 4 step calculation has helped Warren Buffett gain an average 21% return on his investments over a 50 year career.

The basic equation for intrinsic value is:

Intrinsic Value Calculation

To find out what the components are and how to find them read below.

You can see how Chris Calculates Intrinsic Value using his Free Excel Calculator

 

Intrinsic value explained

There is no universal way of calculating the intrinsic value of a company, but analysts have built valuation models based on aspects of businesses in different industries that include quantitative, qualitative, and perceptual factors.

Quantitative factors are those found in fundamental analysis of a company. They include such things as debt to equity ratios, financial statement analysis, and balance sheet figures. Whereas qualitative factors look more towards the running of the business, such as the business model, board member changes, target demographic or industry competition. Perceptual factors are largely based on individual analysis and the investors personal view opinion of the company.

Creating a mathematical method for weighing these factors has led to the 5 ways I use to calculate the intrinsic value of a business. You must be aware that you can’t completely get rid of assumptions and subjective measures like market volatility. After all this is an estimation, and your opinion of the estimate value should give you more confidence in the investment.

Just to add to this explanation… Options trading looks at intrinsic value as the difference between the current price of an asset and the strike price of the option. To learn more check out our article: What Are Stock Options And How Do They Work!

 

Discounted cash flow & Risk free rate of return explained

Discounted cash flow is often used when calculating intrinsic value. Warren Buffett generally uses a company’s free cash flow and weighted average cost of capital (WACC). WACC accounts for the time value of money and then discounts all its future cash flow back to the present day.

The WACC is the expected rate of return that an investor wants to earn that is above the company’s cost of capital. A company will raise its cost of capital by issuing shares, bonds, or debt.

The future cash flows are discounted so the risk free rate of return that could be earned is factored into the equation instead of the single investment. In simpler words, the return on investment must be greater than the risk free rate.

The risk free rate of return is a theoretical concept that shows the return of your investment with zero risk. To calculate the risk free rate subtract the inflation rate from the yield of the treasury bond matching your investment duration.

So with the jargon taken care of, there are 4 steps Warren Buffet takes to calculate the intrinsic value of a company:

  1. Estimate future cash flows
  2. Discount the cash flows to the present
  3. Calculate the terminal value
  4. Calculate the intrinsic value

 

We will be basing this case study & tutorial on the company Microsoft.

 

How does Warren Buffett estimate future cash flows?

There are a few ways you can estimate cash flows. You could rely on analyst estimates, or you could calculate the historic growth in cash flow from data reports, then predict if the company is likely to uphold the growth.

Obviously now Warren Buffett has people to calculate things like future cash flows for him. But when he was just starting he thought it better to work it out himself, rather than trust the analysts.

So first things first… You need to grab a balance sheet for the company you want to invest in. I use Morning Star for my financial research, it’s very easy to navigate, just search for a company in the search tab. You’ll then need to click on the ‘Financial’ tab then scroll down a bit, then you’ll be met with a page like this:

Morning Star Screenshot

 

 

You can choose between tables or charts, I would choose tables as they give you exact figures. 

You need to find the ‘Free Cash Flow’ figures for at least 3 years (the further back you go the better), which as you will see I’ve highlighted in the above image. Another thing you will notice in the image is that in 2017 Microsoft's free cash flow was $31.38B, and as of 2020 it was $40.58B. We will take these figures to estimate the future cash flows.

The equation we use is:

Annual Growth Rate Equation

Annual Growth Rate Equation

Where:

  • AGR: Annual Growth Rate
  • F1: Most recent figure
  • F2: Earliest figure
  • Years: Number of years between the 2 figures

 

Our example using Microsoft would be:

Microsoft AGR calculation

So we worked out that Microsoft has an annual increase in cash flow of 8.94%. Now the question is… In your opinion, will Microsoft maintain this level of growth for the next 5 years?

Personally for a tech giant like Microsoft I think 8% growth is more than likely, but just to manage our risk we’ll round it down to 8%. To work out the future cash flows based on our estimated growth rate you would do some calculation like this:

Microsoft Growth 5 Years

 

That is our first step to finding the intrinsic value of Microsoft stock!

 

How does Warren Buffett discount cash flows?

Ok… You’ve got your projected cash flows, but because of inflation the money isn’t worth the same in the future as it is now. We now need to discount the cash flows and add them together. To do this we need to calculate another number which will be our discount rate.

Just keep in mind, the higher the discount rate, the lower the cash flow, meaning a lower intrinsic value.

The big question that faces most value investors is, what discount rate should I use? Well… it’s up to you. I use 10% as my discount rate, which is considered conservative because the average return for major assets on the S&P 500 is around the same value. But when it comes to long term investment any rate between 8-12% would be reasonable.

Before we go onto the calculations, don’t think you want a return of 50% and use that number, because you most likely won’t find a stock where the intrinsic value is above the market price. It’s just not attainable.

Onto the fun formula. Below is a calculation based on our example of Microsoft and a discount rate of 10%.

Discounted Cash Flow Equation

 

Notes: CF1 = Cash Flow of the first future year (2021), CF2 = Cash Flow of the second future year (2022) and etcetera. DR = Discount Rate expressed as a decimal. DCF = Discounted Cash Flow.

For our example it would be 10% = 1.1

Microsoft DCF Calculation

 

We come to a Discounted Cash Flow for Microsoft of $206.1… That’s all for this section of the method.

 

How does Warren Buffett calculate the terminal value of a stock?

The terminal value of a stock is the present value at a future point in time of all future cash flows when we expect stable growth. In better words, it is the estimated value of a company if the company were to survive forever. Terminal value plays a vital role in calculating intrinsic value of a stock.

The value we are talking about is an infinite growth rate, so it’s rather hypothetical. The number should reflect the growth rate at which a company would grow infinitely.

The average GDP growth rate is most commonly used to calculate the terminal value of companies because a company is most likely to grow as fast, if not faster than the economy. The GDP growth rate sits at 3%, but you should choose a percentage between 2-5% based on personal preference.

We have our infinite growth rate… Now let's dive into the equation to get your terminal value:

 

Terminal Value Equation

Terminal Value Equation

Notes:

  • CF5 = The most recent Free Cash Figure
  • DR = Discount rate
  • IG = Infinite growth rate.

 

Now let’s calculate the terminal value for Microsoft:

TV = (40.58*1.02) / (0.1 - 0.02) = $517.40

So you take the free cash flow figure from 2020, multiple it by the infinite growth rate which we discovered in the prior section (You can choose any growth rate that fits your goal). Then we divide it by the discount rate minus the growth rate.

You should notice 2 things in this calculation:

  1. The IG & DR are both decimals, this is because we want to calculate the increase, so take the percentage and convert it to a decimal, you can Google the answer if you can’t work it out.
  2. The infinite growth rate must be lower than your discount rate otherwise the terminal value will be negative.

 

Finally, onto the next step.

 

How does Warren Buffett calculate the intrinsic value of stock?

This is the easiest step in the entire method. In order to come to a final intrinsic value we have to smash all the values we’ve calculated together. Into one nice formula.

Intrinsic Value Calculation

Intrinsic Value Calculation

Notes: We use 10 as our power over the Discount Rate because this is a long term investment, and we want to forecast the investment for the next 10 years.

 

So the intrinsic value for Microsoft as of the 1st of February 2020 is:

(517.40 + 206.1) / (1.1^10) = $252.65

Given that the share price of Microsoft on the 1st of February 2020 was $188.70, you can see that the intrinsic value is showing that the stock is undervalued.

However, like I mentioned this does not always mean it is a good investment...Recently Bill Gates told the world he was stepping down from the board at Microsoft, this could have massive implications of future earnings. Also with the advances Google is making in online office software, it is likely Microsoft will lose some customers.

If you want to know how to find a good investment, check out my last article: How To Find A Good Stock Market Investment!

You can get your own Free Cash Flow Intrinsic Value Calculator from PainFreeInvesting (our sister site)! Chris uses this himself and is giving it away for FREE!

 

A few more examples

Apple:

  • Intrinsic Value = $213.90
  • Market Price = $288.08
  • Verdict = Apple has been an overpriced stock since early 2018, this is because, like many of the massive tech companies in America they are benefitting from a bull market which is driven by consumers. Apple/Amazon/Samsung etc all excel when the economy is good.. Because people are buying!

 

IBM:

  • Intrinsic Value = $151.49
  • Market Price = $143.72
  • Verdict = IBM has been stagnant for about 5 years now, this is because the hardware they supply has come up against some strong competition. They are no longer market leaders in computer hardware development. But they are strengthening their software development which will diversify their income, making them a good pick for the next 5 years. Also their dividend yield is among the highest in the tech industry.

 

Tesla

  • Intrinsic Value = $282.00
  • Market Price = $650.57
  • Verdict = Tesla is a great company but they are going through a massive switch, Elon Musk is developing a massive factory in the US that focuses on long use batteries. This is what has cut their intrinsic value in half, because it is forecasted to take upto 7 years before they see a return on investment from this factory, while also accruing a lot of debt in the process. The future of Tesla is exciting because I think they will move away from the automotive industry and more towards the energy sector.

 

Intrinsic value isn’t everything

Even Warren Buffett realises that intrinsic value isn’t everything. A company with a great intrinsic value could go bust just as fast as a bad company. Once you have the intrinsic value of a company, then you look at the news, projects the company is completing, and any major changes to the business model, plan, or politics.

Intrinsic value is a good guide to what a well structured business looks like. But just because they have great cash flows, a good track record of growth, and a strong market presence, it doesn’t mean they are going to make good decisions forever. Projects go bad, sales go down, and leadership changes affect output. These are factors that you have to consider after finding in intrinsic value.

 

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