Warren Buffett: How to Know if a Stock is Undervalued

How do you calculate the intrinsic value of a stock? This may be the single most important question in all of investing. Everyone knows that the secret to good investing is finding undervalued stocks, but how exactly do you determine if a stock is undervalued? To do this, you have to find the true value of a stock, referred to as its intrinsic value, and compare that to what the stock is currently selling for.

Let's listen to this clip of Warren Buffett explain the theory behind calculating the intrinsic value of a stock. Then we will use an example company to demonstrate the concept Warren Buffett laid out with a tangible demonstration. But first, make sure to like this video and subscribe to the channel if you aren't already, because it is my goal to help you better understand investing by studying the great investors. Enjoy the video!

"Charlie has promised to stop tapping the Coke can during this session. I only did that when somebody else was talking. Number two, okay? I used to have a friend that was a stock salesman many years ago, and when you'd have lunch with him, he would just keep going like this, and finally it would get you, and say, 'What's that?' And he said, 'That's opportunity.' He was pretty good."

"Okay, let's uh Kelly tells me we should start with, uh with number two, um zone two. So we're gonna start with zone two. Yes, I'm Fred Cooker from Boulder, Colorado, and this is a question about intrinsic value, and it's a question for both of you because you have written that perhaps you would come up with different answers. You write and speak a great deal about intrinsic value, and you indicate that you try to give shareholders the tools in the annual report so they can come to their own determination. What I'd like you to do is expand upon that a little bit."

"First of all, what do you believe to be the important tools, either in the Berkshire annual report or other annual reports that you review in determining intrinsic value? Secondly, what rules or principles or standards do you use in applying those tools? And lastly, how does that process, that is, the use of the tools and the application of the standards relate to what you have previously described as the filters you use in determining your valuation of a company?"

"If we could see, in looking at any business, what its future cash inflows or outflows from the business to the owners or from the owners would be over the next, we'll call it a hundred years, or until the business is extinct, and then could discount that back at the appropriate interest rate, which I'll get to in a second, that would give us a number for intrinsic value. In other words, it would be like looking at a bond that had a whole bunch of coupons on it that was due in 100 years. If you could see what those coupons are, you can figure the value of that bond compared to government bonds if you want to stick an appropriate risk trade in, or you can compare one government bond with five percent coupons to another government bond with seven percent coupons."

"Each one of those bonds has a different value because they have different coupons printed on them. Businesses have coupons that are going to develop in the future too. The only problem is they aren't printed on the instrument, and it's up to the investor to try to estimate what those coupons are going to be over time. As we have said in high-tech businesses or something like that, we don't have a faintest idea what the coupons are going to be."

"When we get into businesses where we think we can understand them reasonably well, we are trying to print the coupons out. We are trying to figure out what businesses are going to be worth in 10 or 20 years when we bought See's Candy in 1972. We had to come to the judgment as to whether we could figure out the competitive forces that would operate, the strengths and weaknesses of the company, and how that would look over a 10 or 20 or 30 year period."

"And if you attempt to assess intrinsic value, it all relates to cash flows. The only reason for putting cash into any kind of an investment now is because you expect to take cash out, not by selling it to somebody else, because that's just a game of who beats who, but in a sense by what the asset itself produces. That's true if you're buying a farm, it's true if you're buying a business."

"And the filters you described were there, their number filters which say to us we don't know what that business is going to be worth in 10 or 20 years, and we can't even make an educated guess. Obviously, we don't think we know the three decimal places or two decimal places or anything like that, what precisely what's going to be produced, but we have a high degree of confidence that we're in the ballpark with certain kinds of businesses."

"The fillers are designed to make sure we're in those kinds of businesses. We basically use long-term risk-free, let's call it government bond type interest rates to think back in terms of what we should discount at. And you know, that's what the game of investment is all about. Investment is putting out money to get more money back later on from the asset, and not by selling it to somebody else, but by what the asset itself will produce."

"If you're an investor, you're looking at what the asset is going to do. In our case, businesses. If you're a speculator, you're primarily focusing on what the price of the object is going to do independent of the business, and that's not our game. So we figure if we're right about the business, we're going to make a lot of money. And if we're wrong about the business, we don't have any hopes. We don't expect to make money."

"And in looking at Berkshire, we try to tell you as much as possible as we can about our business of the key factors. Those are the things that Charlie and I, well, the things we put in our report about those businesses are the things that we look at ourselves. So if Charlie had nothing to do with Berkshire but he looked at our report, he would probably, in my view, he would come to pretty much the same idea of intrinsic value that he would come to from being around it for X number of years."

"The information should be there. We give you the information that if the positions were reversed, we would want to get from you. And in companies like Coca-Cola or Gillette or Disney or those kinds of businesses, you will see the information in the reports. You have to have some understanding of what they're doing, but you have that in your everyday activities. You'll get that kind of knowledge, and you won't get it, you know, in terms of some high-tech company, but you'll get it with those kinds of companies. And then you sit down and you try to print out the future."

"Charlie, I would argue that one filter that's useful in investing is the simple idea of opportunity cost. If you have one opportunity that you already have available in large quantity and you like it better than 98% of the other things you see, well, you can just screen out the other 98% because you already know something better. So that people who have a lot of opportunities tend to make better investments than people that don't have a lot of opportunities."

"And people have very good opportunities, and using the concept of opportunity costs, they can make better decisions about what to buy. With this attitude, you get a concentrated portfolio which we don't mind. That practice of ours, which is so simple, is not widely copied. I do not know why. Now it's copied among the Berkshire shareholders. I mean, all you people have learned it, but it's not the standard in investment management, even at great universities and other intellectual institutions."

"Very interesting question. If we're right, why are so many imminent places so wrong? There are several possible answers to that question. Yeah, the attitude though, I mean, if somebody shows us a business, you know, the first thing goes through our head is would we rather own this business and more Coca-Cola? Would we rather own it than more Gillette?"

"Now, it's crazy not to compare it to things that you're very certain of. There's very few businesses that we'll find that we're certain of the future about as companies such as that, and therefore we will want companies where the certainty gets close to that. And then we'll want to figure that we're better off than just buying more of those."

"If every management, before they bought a business in some unrelated field that they might not have even heard of, you know, more than a short time before that being promoted to them, but they said is this better than buying in our own stock? You know, is this better than even buying, you know, buying Coca-Cola stock? Or something that there'd be a lot fewer deals done."

"But they don't, they tend not to measure against what we regard as close to perfection as we can get. Charlie?"

"Well, I will say this: that the concept of intrinsic value used to be a lot easier, because there were all kinds of stocks that were selling for 50% or less of the amount at which you could have easily liquidated the whole corporation if you owned the whole corporation."

"Indeed, in the history of Berkshire Hathaway, we've bought things at 20% of then liquidating value. And in the old days, the Ben Graham followers could run their Geiger counters over corporate America, and they could spell out a few things, and you could easily see if you were at all familiar with the market prices of whole corporations that you were buying at a huge discount."

"Well, no matter how bad the management, if you're buying it fifty percent of asset value or thirty percent or so on down, you have a lot going for you. And as the world has wised up, and as stocks have behaved so well for people, that stocks generally have gone to higher and higher prices, that game gets much harder now to find something at a discount from intrinsic value."

"Those simple systems ordinarily don't work. You've got to get into Warren's kind of thinking and that is a lot harder. I think you can predict the future in a few places best if you understand a few basic ideas that come from a good general education, and that's what I was talking about in that talk I gave at the USC business school."

"In other words, Coca-Cola is a simple company if it's stripped down and analyzed in terms of some elemental forces. But generally, it's hard to understand Costco either. You know, I mean, there's certain fundamental models out there that do not take, you don't have the kind of ability that quantum mechanics requires, you just have to know a few simple things and really know them."

"Charlie talks about liquidation. I talked about closing up the enterprise, but he's talking about what somebody else would pay for that stream of cash too. I mean, yeah, if you could have looked at a collection of television stations owned by a Cap Cities for example in the early, well, 1974, and it would have been worth, we'll say, four times what the company was selling for—not because you'd close the stations, but just their stream of income was worth that to somebody else."

"It's just that the marketplace was very distressed, depressed. Although, like I say, on a negotiated basis, you've gone and sold the properties for four times what the company was selling for, and you got wonderful management. I mean, those things happen in markets; they will happen again. But part of investing and calculating intrinsic values is if you get the wrong answer when you get through—in other words, if it says don't buy, you can't buy just because somebody else thinks it's going to go up or because your friends have made a lot of easy money lately or anything of the sort. You just—you have to be able to walk away from anything that doesn't work."

"And very few things work these days. You also have to walk away from anything you don't understand, which in my case is a big handicap, but you would agree with Jordan that it's much harder now?"

"Yeah, but I would also agree that almost at any time over the last 40 years that we've been up on a podium, we would have said it was much harder in the past, but it is harder now. It's way harder. The part of it being harder now too is the amount of capital we run. I mean, if we were running a hundred thousand dollars, our prospects for returns would be—and we really needed the money—our prospects for return would be considerably better than they are running Berkshire."

"It's just—it's very simple. Our universe of possible ideas would expand by a huge factor. We are looking at things today that, by their nature, a lot of people have to, are looking at, and there were times in the past when we were looking at things that very few people were looking at, but there were other times in the past when we were looking at things where the whole world was just looking at them kind of crazy, and that, that's a decided help."

While Warren Buffett did a great job explaining the theory behind calculating intrinsic value, this tangible example I'm about to provide should help explain the concept even farther. Keep in mind this example is simplified, but it demonstrates the concept Warren Buffett laid out in the clip in a way that may make more sense for you.

This is the general framework that I personally use in my job as a professional investor at a large investment fund to think about valuing any type of cash flow producing asset, whether it is a stock, bond, or an apartment building.

Now, let's take a hypothetical company called ABC Corp. ABC Corp's stock is selling at 75 dollars per share, and we want to know if the stock is undervalued compared to its intrinsic value. Let's say ABC Corp will operate over a 10-year period and make 10 dollars per share in the first year, growing its annual earnings by one dollar every year all the way to nineteen dollars per share at the end of year ten, in which it will stop operating.

The next important variable is the interest rate in which you discount the cash flows back by. Let's use five percent in this example. In the clip, Warren Buffett mentioned that he uses the long-term risk-free rate as his discount rate. In the U.S., the risk-free rate is the interest rate on long-term government bonds.

With the variables that we laid out, that means ABC Corp’s stock's intrinsic value is about 109 dollars per share in this example. ABC Corp's stock is selling at a roughly 30 percent discount to its intrinsic value, meaning that it is undervalued, and a savvy value-oriented investor would want to make this purchase.

As Warren Buffett and Charlie Munger point out in the clip, that there needs to be a significant discount between the intrinsic value and what the stock is selling for to account for the uncertainty involved in predicting the future cash flows of the business and potentially using the wrong interest rate. This is known in value investing as the margin of safety.

So there we have it. I hope you found this video helpful in your understanding of investing. Talk to you soon!