One of the most sought after calculations in all investing is Warren Buffett’s intrinsic value formula. Although it may seem elusive to most, to anyone who has studied Buffett’s Columbia business professor Benjamin Graham, the calculus becomes more obvious. Remember that the intrinsic value formula that Buffett uses is an embellishment of Graham’s ideas and rationale.
One of the most surprising things about Benjamin Graham is that he actually felt that bonds were safer and more likely as an investment than stocks. Buffett would strongly disagree with that today due to high inflation rates (an entirely different topic), but this is important to understand 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 hell 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 par (or nominal) 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 first issued. For example, if the coupon rate were 5%, a bondholder would receive two annual coupon payments of $25, for a total of $50 per year. These coupon payments will continue to be paid until the bond matures. Some bonds mature in one year while others mature in 30 years. Regardless of the term, once the bond matures, the face value is refunded to the bondholder. If you were to rate 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 may be wondering why I describe all that information about bonds when I’m writing an article on Warren Buffett’s calculation of intrinsic value. Well the answer is quite simple. Buffett 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 into the market value of a bond calculator and crunch the numbers. When it comes to stock, it’s no different. Think about it. When Buffett says he discounts the future value of cash flows, what he is really doing is adding up the dividends he expects to receive (just like coupons on a bond), and estimating the future book value of the business (just like the par value of a bond). By estimating these future cash flows from the key terms mentioned in the previous award, he can discount that money at 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 need to understand the time value of money. We know that money paid in the future has a different value than money in our hands today. As a result, a discount must be applied (just like a bonus). The discount rate is often a hotly debated topic for investors, but for Buffett it’s pretty simple. To begin with, he discounts his future cash flows with a ten-year federal note because it gives him a relative comparison to a zero-risk investment. He does this to start with, so he knows how much risk he is taking with the potential selection. After setting that figure, Buffett discounts future cash flows at a rate that forces intrinsic value to equal the stock’s current market price. This is the part of the process that can confuse many, but it is the most important part. By doing this, Buffett can immediately see the return he can expect from any stock selection.
Although many of the future cash flows that Buffett estimates are not hard numbers, he often mitigates this risk by choosing nice, stable companies.