Warren Buffett: How to Calculate the Instrinsic Value of a Stock

Introduction

In this tutorial, we will explore how to calculate the intrinsic value of a stock, a method famously advocated by Warren Buffett. Understanding intrinsic value is crucial for making informed investment decisions and identifying stocks that are undervalued. We will focus on the discounted cash flow model, a fundamental technique used to estimate a company's worth based on its expected future cash flows.

Step 1: Understand the Intrinsic Value Concept

• Intrinsic value represents the true, inherent worth of a company, independent of its market price.
• It can be determined by analyzing expected future cash flows and discounting them back to their present value.
• The goal is to find stocks that are trading below their intrinsic value to ensure a margin of safety in your investments.

Step 2: Gather Financial Data

• Collect essential financial statements:
  • Income Statement
  • Balance Sheet
  • Cash Flow Statement
• Look for key metrics such as:
  • Revenue growth
  • Earnings before interest and taxes (EBIT)
  • Free Cash Flow (FCF)

Step 3: Project Future Cash Flows

• Estimate future cash flows for the next five to ten years:
  • Use historical data to identify growth trends.
  • Consider industry conditions and economic factors.
• Make conservative estimates to accommodate for uncertainties.

Step 4: Determine Discount Rate

• The discount rate is used to convert future cash flows to their present value.
• Commonly, the Weighted Average Cost of Capital (WACC) is used:
  • Calculate WACC using the formula:

    WACC = (E/V * Re) + (D/V * Rd * (1 - Tc))
    

    Where:
    • E = market value of equity
    • D = market value of debt
    • V = E + D
    • Re = cost of equity
    • Rd = cost of debt
    • Tc = corporate tax rate

Step 5: Calculate Present Value of Cash Flows

• Use the formula for present value:

  PV = CF / (1 + r)^n
  

  Where:
  • PV = Present Value
  • CF = Cash Flow in year n
  • r = discount rate
  • n = year number
• Sum the present values of all projected cash flows to get the total present value.

Step 6: Estimate Terminal Value

• Terminal value represents the value of the company beyond the projection period:
  • Use the Gordon Growth Model:

    Terminal Value = (Final Year Cash Flow * (1 + g)) / (r - g)
    

    Where:
    • g = growth rate of cash flows after the projection period
• Discount the terminal value back to present value and add it to the total present value of cash flows.

Step 7: Calculate Intrinsic Value Per Share

• To find the intrinsic value per share:
  • Subtract total liabilities from total assets to find equity value.
  • Divide equity value by the number of outstanding shares:

    Intrinsic Value Per Share = Equity Value / Outstanding Shares
    

Conclusion

Calculating the intrinsic value of a stock allows investors to make informed decisions based on a company's actual worth rather than market speculation. By gathering financial data, projecting future cash flows, determining an appropriate discount rate, and calculating present values, you can identify undervalued stocks. Remember to always conduct thorough research and consider seeking advice from financial professionals before investing. Start applying these steps to your investment analysis for smarter decision-making!