Unit 1 - How Intelligent Investors manage risk
Unit 2 - How Intelligent Investors pick bonds
Unit 3 - How Intelligent Investors pick stocks
Unit 4 - How Intelligent Investors pick preferred shares
Unit 5 - How Intelligent Investors pick manage cash flow×
Unit 1 - When does Warren Buffett Sell
Unit 2 - Understanding the importance of Return on Equity
Unit 3 - Understanding the importance of Volume
Unit 4 - How to calculate and find financial terms
Unit 5 - How to use stock screeners
Unit 6 - What is Goodwill
Unit 7 - What is Owner's Earnings×
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
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.
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.
"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
Although Facebook is a terrible example of a stable company, I use it in this practical exercise to demonstrate how estimations become speculative when looking at future cash flows of an unstable business.
Click here to view the Practical Exercise Video
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