Welcome to Unit 3: How Intelligent Investors find the intrinsic value of stocks

 

Warren Buffett Intrinsic Value Calculator
Lesson 5: Buffett's 4th Rule

Lesson Objectives

Lesson Objective 1: How do we calculate the intrinsic value of a stock

Lesson Objective 2: How do we use the BuffettsBooks.com intrinsic value calculator

Summary of this lesson

In this lesson, students learned that the intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during it's remaining life. For us, we've defined the life as the next ten years. This way, we can discount that cash by the 10 year federal note. The Cash that we are taking out of the business is simply the dividends and the book value growth during the next 10 years. Since these numbers need to be estimated, it's very important to ensure that Warren Buffett's third rule (a stock must be stable and understandable) is met.

When a company doesn't have a history of linear growth, estimating the cash that they will produce for the next ten years becomes more speculative. When we look at the root of the intrinsic value calculator, it operates off of the same principals as a bond calculator. Instead of using coupons, we substitute dividends. And instead of using par value (or value at maturity) we estimate the book value of the business in 10 years. The value that we use to discount the summation of the cash is simply the 10 year federal note.

Although the previous paragraph might sound confusing to some, it's application is fairly straight forward. The reason Buffett says, "Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures," is due to a difference in opinion of the future cash flows. Since some investors are more conservative than others, their estimates of book value growth or dividend payments may be lower. This will immediately change the intrinsic value. Your job as an intelligent investor is to determine your own tolerance for risk and conservative estimates on how much money you will receive while owning the stock for a 10 year period.

If you ever have difficulty understanding the material, simply click on the link for the forum above. Be sure to sign-up for an account and ask any questions you might have. Just because you didn't understand something in this lesson, doesn't mean you have to simply give up on the process.

Intrinsic Value Calculator

Source of Quotes: http://www.berkshirehathaway.com/owners.html

"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." - Warren Buffett

Therefore, the sum of cash that can be taken out of the business over the next ten years is going to be the dividends plus the equity growth. The discounted value is the current value of the 10 year federal note. To start, we'll determine how much a company's book value is growing.

"In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value."- Warren Buffett

Make sure you DO NOT use % or $ signs when using the calculators.

Current Book Value ($):
Old Book Value ($):
# of Years between Book Values:

Average Book Value change (%):

"As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover - and this would apply even to Charlie and me - will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value." - Warren Buffett

Cash Taken out of business ($): *This is dividends recieved for 1 year
Current Book Value ($): *We need to know this so we can determine the base value that's changing
Average Percent Change in book value per year (%): *This will determine the estimate BV at the end of the next 10 years
Years: *This will most likely be 10 (if you're comparing a 10 year federal note)
(Discount Rate) 10 year federal note (%): *Look up the ten year treasury note by clicking on this text

Intrinsic Value: $

 

Lesson 5 Practical Exercise

If you're ever trying to determine the value of a company that experienced a stock split, simply assessing the Book Value growth over a ten year period may prove difficult. If you owned 1 share, the value of that 1 share actually changed in value because you would assume control of an additional share at no expense. In order to account for this difference, investors will need to assess the growth during these two periods separately; pre-stock split and post-stock split.

Click here to view the Practical Exercise Video

Got Questions about this Lesson?

Ask your question at the BuffettsBook money forum (no sign-up or e-mail required)

  • C2 U1
  • C2 U3 L1
  • C2 U3 L2
  • Debt/Equity

    Debt/Equity

    This ratio is the total debt divided by the equity. A company with manageable amounts of debt will have a debt/equity ratio below 0.50

    ×
  • Current Ratio

    Current Ratio

    This ratio is the current assets divided by the current liabilities. A company that is well managed will have a current ratio above 1.50

    ×
  • C2 U3 L3
  • Capital Gains Tax

    Capital Gains Tax

    This is the tax paid to the federal and state government for the sale of stock when a profit is made from a change in the market price.

    ×
  • C2 U3 L4