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.