How to Calculate the Intrinsic Value of a Stock in 2023 (Full Example)

All right guys, today we are going to be tackling a very big topic that I'm sure a lot of you guys are very interested in, and that is how to value a stock. So, at the end of this video, you'll understand the step-by-step process to find the intrinsic value of a stock and also understand why we do it the way we do.

But first, why do we do this and what is valuation all about? Well, the easy answer is it's about figuring out what a stock is worth, so we don't overpay for the shares of the business. But the longer and more accurate answer is we're trying to estimate the future cash flows a business will generate for its owners, so that we can then figure out what we'd be willing to pay today for those future cash flows to ensure that we achieve a high rate of return over time.

So, that's what we're doing. To help visualize this process, we imagine that the business we're looking to buy is a money printing machine. Imagine it like literally just like a robot that creates dollars. It can print a certain amount of money per year. Then we can maybe tinker with the robot during the year and find a way to say, increase its printing speed by 10%, or maybe its current owners have neglected it, so maybe it's all rusty and it's printing less and less every year.

The point is, it's a machine that can print a certain amount of cash each year, and it's our job to figure out what we'd be willing to pay for that money printing robot. For example, the Microsoft robot is currently selling for 1.85 trillion dollars total. That's a lot of money, but would you pay that price if the robot could only print a million dollars a year? Of course not.

But would you or should you pay 1.85 trillion dollars if the robot could generate, say, a hundred billion dollars per year? That's perhaps a trickier question, and we'll get to that in a second. But overall, the first thing to visualize is that these businesses are just money printing machines, and it's our job to assess how much cash they can make for us in the future to determine a price we'd be willing to pay to own them now.

So next, let's learn how to find a business's intrinsic value. Warren Buffett likes to quote a famous American economist by the name of John Burr Williams, who said, "The intrinsic value of any stock, bond, or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset."

Now that line sounds obviously quite confusing, but all it's doing is explaining a valuation process called a discounted cash flow analysis, and it's what we're going to do in this video. But essentially what this quote is saying is the intrinsic value of a business is the present value of all the business's future cash flows added together.

So with that in mind, it becomes clear that we, as potential new owners of this money printing machine, need two big pieces of information. We need to know firstly how much cash will the business make for us in the future, and then secondly, we need to know what those future cash flows are actually worth to us sitting here today.

So step one: finding out how much cash the business will make for us in the future. To understand that, first we have to start by understanding how much money the business is making for its owners right now, also known as the owner's earnings. So what is the owner's earnings? Operating cash flow minus maintenance capital expenditure.

Operating cash flow is the amount of cash the business's operations actually generate, and it can be found as the last line of the first section of the cash flow statement. However, maintenance capital expenditure, which is the amount of cash a business needs to spend to maintain its earnings, can oftentimes be a lot harder to figure out.

The reason for that is because businesses do have to report their total capital expenditure, which is the purchase of property, plant, and equipment, but they don't have to tease that out into how much is for growth and how much is simply for maintenance. Some companies do report maintenance capital expenditure, but honestly, most don't.

So if you're looking at a company that doesn't report it, instead of using, say, owner's earnings for your calculation, you can simply start with free cash flow, which is operating cash flow minus total capital expenditure, or as I said before, purchase of property, plant, and equipment. Overall, that will be more conservative for our calculation; however, technically, it will be slightly less accurate.

All right, so let's now put that into practice, and here I'm doing a historical example of buying Apple stock back in 2016. Back then, Apple's operating cash flow was 65.824 billion dollars, and their total capex was 12.734 billion, leaving us with free cash flow of 53.09 billion.

Okay, we have our starting point, but what do we do next? Well, with this discounted cash flow scenario, what we're imagining is that we're going to buy the business today, hold the company for 10 years, and then sell it. So we'll have to spend a certain amount of cash to buy it today, and then we'll receive the business's cash flows for 10 years, and then at the end of the 10 years, we'll sell it and receive a one-time big payout from that sale.

So we now know that the business is producing the owners 53.09 billion dollars per year, and the next step is to assess how quickly the business is growing year by year to then estimate the future owner's earnings for the next 10 years. So for our historical Apple example, I had a look at the 10 years running up to 2016, and it looks like Apple's business had grown at roughly 20% to 30% annually for those previous 10 years.

But am I going to use that in my future calculation? Probably not. And this is where the discounted cash flow analysis gets really tricky. You need to be really honest with yourself as to how quickly you realistically think your business can grow across the next 10 years.

Because by using different growth rates, you can basically get the discounted cash flow analysis to say whatever you want. If you let your emotions run wild and say that Tesla can grow at 50% per year for the next 10 years, you can basically make Tesla look cheap at any market cap.

So, the main things to note when selecting a growth rate are to base it off of your own in-depth research into this specific business, and when in doubt, go conservative. So for me, the past performance of Apple is saying use, you know, 20%, 30%, or 40% annual growth in our model.

But I'm looking at Apple as one of the biggest, you know, most mature technology companies in the world, and I'm saying, you know, if it does, say, 10% growth per year over the next 10 years, I'm happy. And if it hits 15% growth, then that's just amazing. You know, I'll definitely, definitely take that.

But having said that, let's go with the 10% just to be conservative. So then from there, the next step of the process is now to grow the free cash flow by our 10% growth rate for the next 10 years. And once we've done that, we also have to figure out a terminal value for the business—that's what we're likely going to be able to sell the whole company for in 10 years' time.

Now, remembering that this is a historical example of Apple in 2016, we can see that around that time, the price to free cash flow multiple that Apple had been selling for for quite a few years was about 10. So we can then take that number and say, you know what? In 10 years, we'll probably be able to sell Apple for 10 times free cash flow.

So what do we do? We take the 10th year of free cash flow, and we simply multiply it by 10. So year 10, we estimated that Apple's free cash flow would be 137.7 billion. If we sell the business thereafter at 10 times free cash flow, the terminal value, or our sale price, would be 1.377 trillion dollars. That's pretty cool!

Now, the next step is we've estimated what the business's future cash flows will be, and we've estimated what we'll be able to sell the business for in 10 years' time, but those cash flows are not actually worth that amount to us sitting here today.

The reason being is we have to wait several years to actually get them. As they say, one dollar today is worth more than one dollar tomorrow. You know, if we have those cash flows today, we could put that money to work in the stock market and turn it into a lot more money by the year that we're actually expected to genuinely receive those cash flows.

So we need to account for the fact that the further away these cash flows are, the longer we'll have to wait, and thus the less that that money is actually worth to us today. Now, the way I do it is I discount based on the annual return that I want to achieve—which is 15%.

Now, you could do 10%, but if you're doing 10%, you may as well just settle for an index fund, because that's historically what they tend to produce every year. You may as well just save yourself a lot of effort.

So anyway, to do this step, we take our estimated free cash flow and then we divide it by 1.15 for out 15—that's where the 1.15 comes from—and then we take that to the power of how many years have passed. Then finally, we also do this to our terminal value as well, and with that step done, we actually have the present value of all future cash flows. That's pretty cool!

And then from there, to work out the intrinsic value, well, that's simply all of those cash flows added together, which comes to 759.53 billion. AKA, if we looked at the latest data at the end of 2016 for Apple and assume that the business was going to grow at 10% annually, then for Apple, we would calculate the intrinsic value to be 759.53 billion dollars.

I actually ran the numbers on a 15% growth rate as well, and it comes out to an intrinsic value of 1.062 trillion. So doing this method back in 2016, you would have known Apple's intrinsic value was somewhere between those two numbers.

But wait, wait! There's actually two more things to do in this process when not done. Firstly, think about this: if you're buying a house that you thought was worth 500,000 dollars, but then you knew there was a hundred thousand dollars buried in the backyard, that obviously changes the amount of money you'd be willing to pay for the house.

Obviously, now you'd be willing to pay up to six hundred thousand dollars. It's the exact same thing with businesses as well—they have a treasure chest full of cash too, which when you buy it, you get. So you need to just quickly turn to the balance sheet and see what the size of that treasure chest is and add that onto the amount you'd be willing to pay.

So if we look at Apple's 2016 10K, we see that they had 20.484 billion in cash and 46.671 in short-term marketable securities. So if we add that 67 billion dollars back onto the intrinsic value range, we'd get somewhere between 826.7 billion and 1.129 trillion as a fair value.

So that's the second last factor to consider. But then the last thing is then at a margin of safety. So tell me honestly, you know, with all of our estimations and guessing in this formula plus the inevitability of change in the future, what are the chances you think our little constructed scenario is actually going to play out perfectly? In reality, it's zero, right?

It's not going to happen like that. We have to acknowledge that it's just a guess—it is our best guess. So because it's a guess, what we do is we add a margin of safety. If you're a beginner, you'd probably want to see a 50% margin of safety. Maybe if you're more experienced in investing and you're well within your circle of competence, maybe you can settle for a 30% margin of safety.

Maybe if you're Warren Buffett, you could settle for less—I don't know. But the point is, if intrinsic value is somewhere between 826 billion and 1.13 trillion, acknowledge that your guess will probably be wrong and give yourself a buffer.

For example, a 30% margin of safety brings that range down to, you know, roughly between 580 and 790 billion. So if you had the opportunity to buy Apple shares at the end of 2016, somewhere in that range, you probably would have been fairly safely locking in about a 15% annual return.

So the question is, what was Apple's market cap back then? Well, guess what? At the end of 2016, Apple was worth a total of 609 billion dollars. It's actually quite low in that range for a 30% margin of safety. That's pretty cool!

But do you know what's even cooler? Who was buying Apple stock back in 2016? Warren Buffett himself—the granddaddy of this investing approach, the oracle of Omaha, the best investor to have ever lived—was buying Apple stock hand over fist.

Why? Because this process, this discounted cash flow analysis, is what all the great value investors go through when valuing companies. And now you know how this process works.

So hopefully, this helps you find some great undervalued stocks. You know, please leave a like in this video if it helped you; I would really appreciate it. Consider subscribing if you want to see more. But with that said, I'll see you guys in the next video.