BUFFETTS BOOKS ACADEMY: INTERMEDIATE COURSE

LESSON 21: WARREN BUFFETT’S 4TH RULE – INTRINSIC VALUE CALCULATOR

LESSON 20
COURSE OUTLINE
LESSON 22

INTRINSIC VALUE CALCULATOR

Source of Quotes: www.BerskshireHathaway.com

“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 we can start with is the current value of the 10 year federal note – this will act as our ruler for risk. 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 ($):

TEACH ME!

LESSON OBJECTIVES

  1. Learn how we calculate the intrinsic value of a stock.
  2. Learn how we use the BuffettsBooks.com intrinsic value calculator.

LESSON SUMMARY

In this lesson the fourth and final rule of Warren Buffett is presented. It is important to remember that all four rules need to be met, before buying a stock.

In essence the question about price and value (often called intrinsic value) is quite simple. “Is the intrinsic value of the stock you are buying lower than the price”? A company might have great properties, but no stock is worth an infinity amount of dollars.

This lesson presents direct quotes from Warren Buffett. First he teaches us that the intrinsic value is simple nothing more than the discounted cash flow from that company. In other words: “The value of any stock is dependent on how much money it is making, the risk, and when the money is made”. In investment terms he is looking at the how the earnings for the stocks are applied. Some is paid directly out as dividend, and some of the money is retained in the company either to grow income producing assets or pay of debt. When the money is retained it is growing the book value correspondingly. He looks 10 year into the future thereby comparing his valuation to a 10-years note (bond).

He also teaches us that the intrinsic value is an estimate rather than a precise figure. That means that even if two people are looking at the same stock with the same information, they would inevitable come up with different valuations.

When Warren Buffett is talking about cash taken out of the business he is referring to EPS. This is the source of dividends and increase in book value. If the dividend and book value is growing linearly or staying stable in any direction, you can use that slope as a predictor. Stability is really everything here.

One word of caution: Remember to look at the projected earnings for the coming year to make sure that your cash flows projections are realistic. There might have been something in the near future that you have overlooked.

Berkshire Hathaway’s owner manual explains to us why the growth in book value is so important when valuing stock. It states that the change in book value is reasonable close in any given year to the change in intrinsic value. This is also why Warren Buffett is comparing his own growth in book value to the S&P500.

In this lesson we also learn that the BuffettsBooks.com calculator is built on the very quotes from Warren Buffett and the Berkshire Hathaway owner’s manual. Using the book value growth from the past 10 year, given the stability and the outlook, we would apply a similar rate for the next 10 years. This book value growth represents more income producing assets to the investor, or a lower debt. In other words this is money that is distributed indirectly back to the investor.

Dividend from the past 10 years is also used as a predictor for the next 10 years. If you want to be conservative you might want to take the average from that period, and use that as a predictor. For most companies that would be very conservative estimate, but just as for the book value growth, you exact calculation is up to your risk of appetite. Based on your knowledge of the company you would either choose a number higher, lower or similar to the past 10 years.

BuffettsBooks.com recommends using a 10 year period for your calculation. It is a time period that often captures both depression and boom in the economy. At the same time it is not a time period that is too long in terms of using data that is of no relevance any longer.

The discount rate is a very important concept to fully understand. The way to look at discounting is to ask yourself if you would rather have $50 today or $50 in 10 years? It would make no economic sense to wait to get your $50. You could use that money to invest and grow your money over the next 10 years, and even if you were to spend it, $50 would be worth more today, because inflation would dilute the value over time. In short: Discounting means that money you have today is worth more than the same amount in the future.

The reason why Warren Buffett uses the 10 federal note as his discounting rate, is foremost because the 10 years matches the time period for our valuation. Another thing is because it can be considered risk free. He knows for sure that he can always get this yield, as the government in practice can simply print more money. We learned more about that in lesson 6. So imagine that you could get a 10% risk free return every year. Would it change the value of a stock where you might hope you would get a 10-12% return, but also knowing that you could lose that investment? Of course! If you could only get 1% risk free return would you think that the same stock perhaps yielding 10-12% would be more appealing? Of course!

  • High 10 year federal note: More discounting -> Lower value of a stock
  • Low 10 year federal note: Less discounting -> Higher value of a stock

Remember always to look up the current 10 year federal note. It changes every day.

Using these inputs, the BuffettBooks.com calculator can estimate the intrinsic value of stocks. It is important to emphasis that it is only stocks that are stable you can valuate. If you see the book value growth and dividends all over the place, your estimates would be very uncertain.

When you arrive at an intrinsic value it does necessarily matches the market value. In most cases you will find that there is a vast difference. You should be pleased when that happens. If you find that the intrinsic value is much higher than the market price it is great. You have potential found a great company at a margin. If the market price is much higher than the intrinsic value, it is also great. You have just omitted the common mistake of overpaying for a stock.

Knowing the value of a stock is perhaps the most desired skill in Security Analysis. Perhaps the only person who can challenge Warren Buffett’s ranking on top of that list, is his mentor and professor from Columbia Benjamin Graham. His book Security Analysis is an all-time best seller, and Warren Buffett has repeatedly hailed his investment success and valuation skills to this book.

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 on YouTube.

NEW VOCABULARY

Market Value
The current price of the stock that is traded on the exchange. You can find this price on a simple Google search on the name of the company.

Intrinsic Value
The value of the stock according to your estimates. It is most likely that other another investor have another estimate for the same company that you are looking at. You want the biggest difference between the intrinsic value (high as possible) and the market price (low as possible).

Discounted Cash Flow
Cask taken out of a business in the future is not worth the same as it is today. If you had the money today you could invest them. Money in the future is partly eaten up by inflation, but more importantly more uncertain if it is there at all.

EPS
The earnings of a company dividend out to each individual shares. If the company has $500 in earnings and has 100 shares outstanding the EPS is $5.

S&P 500
500 of the biggest listed companies in the US. There are detailed selection processes, but the way to think about S&P500 for the investor is ‘as the market’.

LESSON TRANSCRIPT

This last rule is the most complicated – determining whether a stock is undervalued or not.

In the three previous lessons, we compared Sirius and Disney. Sirius failed the first rule – a company must be managed by vigilant leaders. Sirius had a lot of debt. Again, all 4 rules must be met in order for Buffett to invest, so automatically, Sirius is not qualified. On the other hand, Disney’s debt was manageable for the past 10 years, so it is considerable. With the second rule, Sirius is not anticipated to having long-term prospects 30 years from now, while it’s the other way around For Disney. Buffett proves that Sirius is not stable. Their debt, book value, and debt to equity were all over the place. Disney was stable and predictable. That is absolutely essential as we move into this lesson where we’re trying to calculate the intrinsic value. Without a stable company, we can’t make a good estimate of how much growth the company will have in the next 10 years. For the third rule, Sirius isn’t even worth the attempt to calculate, because they are unstable. Disney is.

Let’s learn how the intrinsic value calculator works. If you get lost in this portion, that’s fine; I have a couple of practical exercises where you can work on.

How do we determine the intrinsic value of a company?

If you read Berkshire Hathway’s manual, Buffett said, “The 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. As our definition suggests, intrinsic value is an estimate rather than a price figure. And it is definitely an estimate that must be changed as interest rates move or forecast or future cash flows are revised. Two people looking at the same set of facts for almost inevitably come up with slightly different intrinsic value figures.”

Keep in mind that the calculator itself isn’t different, but you might take it to a more conservative approach than what I will show you. When you do that, you’re going to get a different interest value.

If you want to use a different interest rate in the 10-year federal note, you’re going to get a different intrinsic value. As we start using the calculator, you’ll understand why Buffett said quote above. He might look at a company a little bit different the way you viewed it.

What does it mean by “Cash that can be taken out of the business during its remaining life”? When Buffett was assessing, he was referring to this: “If I could take out all the profit the company’s going to make over X number of years I’d own it, how much would that add up to?” He did it for 10 years into the future to co