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

Warren Buffett says the three most important words in investing are "margin of safety." It's no doubt the margin of safety is an integral concept used extensively by value investors, both past and present. We're talking people like Charlie Munger, Warren Buffett, Benjamin Graham, Monish Pabrai, Guy Spear, Peter Lynch, Phil Town; heck, Seth Klarman's book is literally called "Margin of Safety."

So for us aspiring value investors, it's probably a good idea for us to learn about the concepts of margin of safety and make sure we're actually using that in our investing approach. However, I find the problem is most investors out there, most aspiring investors, have never learned, firstly, how to calculate intrinsic value for a certain business, and thus don't understand how to apply the principles of margin of safety in their own investing.

So I want to fix that. By the end of this video, I hope that you have all the skills you need to be able to calculate the intrinsic value of any company you look at and thus work out what a fair margin of safety price is for that business. So let's get started.

Alright, so firstly, to be able to talk about the margin of safety, which is so integral to Warren Buffett's investing approach and so integral to his ongoing success as an investor, we first need to be able to understand how to find the intrinsic value of a business. The intrinsic value is simply the fair value of the business; it's what the business is actually worth.

Now, a quote that Warren Buffett commonly uses, that he pulls from the theory of investment value by American economist John Burr Williams, is: "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," where in this case, the asset is the business.

So the intrinsic value of a business is quite simply the present value of all the future cash flows of that business added together. So if you imagine you are the entire owner of this business—you are the only owner, okay? You own the whole thing. Then to work out the business's intrinsic value, you need two pieces of information. You need to know how much cash is that business going to make for you in the future, and you need to know what those future cash flows are worth to you standing here today.

So firstly, the amount of cash that a business makes for its owners is called the owner's earnings. The way you actually calculate what the owner's earnings is for a business in a particular year is you turn to the cash flow statement. You take the operating cash flow and then you subtract the maintenance capital expenditure.

The operating cash flow, sometimes called cash flow from operating activities, is quite simply the amount of cash that the business operations of this particular company produced in that time period. The maintenance capital expenditure is quite simply the amount of money going out simply to maintain and keep the business in its current competitive position.

Now, the owner's earnings is the most accurate number to use for these calculations. However, the annoying thing is that while companies don't have to report their maintenance capital expenditure—some do, some great companies do report that, which is very helpful—but most don't. So a lot of investors, instead of using maintenance capital expenditure, they just use total capital expenditure, which is the purchase of property, plant, and equipment on the cash flow statement.

That just includes, yes, the maintenance capital expenditure, but it also includes all the capital expenditure used for growing the business. For the simplicity of the calculations, we'll also use free cash flow for these calculations. Technically, using free cash flow is more conservative; however, in being more conservative, it's also slightly less accurate.

However, another advantage of using free cash flow, as I was just talking about before, is that you can work it out from any cash flow statement. So it's a very easy number to find within the financial statements. It's simply operating cash flow minus purchase of property, plant, and equipment.

So with all that said, how do we actually find the intrinsic value of a business? Well, for this example, we're going to imagine we're going to try and buy the local corner store, which just sells snacks and drinks. Now, over the past 10 years, this is what the free cash flow has looked like each and every year for this corner store business. If you happen to notice, well, it just perfectly happens that each and every year the free cash flow of this business grows by 10%. How's that for consistency?

So now what we're going to do is we're going to take the most recent free cash flow number and take that growth rate, which is proving to be very consistent 10% growth, and we're going to grow that free cash flow again by 10% each and every year for 10 years out into the future. Then we're going to assume that after that 10th year, we're going to be able to sell the business for 10 times its free cash flow.

So if we put all those numbers into a spreadsheet, this is what it looks like. Surely the intrinsic value of the business to us is just us adding together all of these cash flows; we just add them all together and then that's the value of the business to us. That's the cash flow that we're going to receive as the owners.

Not quite. If we're looking to make this purchase right now, here and today, the reason that it's not quite the intrinsic value is because the cash flows that we're going to receive in, say, the seventh year of ownership, or the eighth year, or the ninth year of ownership, those cash flows are not as valuable to us as the cash flows that we're going to receive, say, next year or the year after that.

The reason they're not as valuable to us is because it's going to take a long time before we actually receive those cash flows. Those cash flows are going to happen far out into the future and, of course, there's a time value of money. If you ask me whether I wanted ten dollars now or ten dollars in a year from now, I'm always going to take the ten dollars now because what I can do is I can take that ten dollars, put it to work, and in a year's time, I can make that ten dollars into eleven dollars. Right? So I'm one dollar better off; so I'm always going to take the money sooner.

So with that idea, we have to take the future cash flows of this business and discount them to what they're actually worth to us today. We're going to discount it by 15% annually because that's what we want to achieve with our investing.

If we go ahead and discount all of these future cash flows by 15% annually, this is what the table now looks like. Now, we also discount that one-time cash flow that we're going to get by selling the business in ten years for ten times its free cash flow, and then after that, we've now got the present value of all the future cash flows of this investment.

So the intrinsic value of the business to us today is all of these cash flows simply added together. In this case, the corner store has an intrinsic value of about $306,000. So if we were to go and meet with the owners and make them an offer for $306,000 for their business, it is likely that we're going to get 15% returns running that business, assuming it grows as free cash flow 10% annually when you get 15% returns every year for ten years.

However, if the business owners turned around and said, "No, no, we want $500,000 for the business," obviously, our return is going to be much lower. If the business owners are just desperate to move on and get rid of this business, they say, "Look, just take it for $200,000, seriously, I want it gone," then obviously we're going to make a much higher return.

But overall, for 15% returns each year, $306,000 is the intrinsic value for that business. Now, here's the thing: the stock market each and every day gives us the price of thousands and thousands of businesses, right? We can look at the market capitalization of each business and work out what that whole business is currently being sold for.

Now that's a really big advantage to us because what it means is we can go into these companies' financial statements, calculate the intrinsic value for that business, and then compare it to that company's current market capitalization to see whether it's trading at its intrinsic value, whether it's trading at a premium to its intrinsic value, or whether it's trading under its intrinsic value.

But the thing is, all of the calculations that we've done to try and work out intrinsic value—it's just guesswork. It's taking an educated guess. Yes, we can minimize the risk of our guessing being incorrect by finding businesses with an economic moat or a very predictable, consistent history of financial data, but we have to acknowledge that there's always going to be things that could potentially happen to any old business in the future that we simply can't foresee and that we simply can't control.

I mean, what if there was, say, a fire in the corner store and it meant that the business just had to stay closed for a year as it got repaired? Or, you know, what if a juice bar opened up right next door to our business and that decreased our drink sales by 50%? Now these situations might be unlikely, but it shows that all of our estimations can't be a hundred percent relied upon.

Okay, it's kind of like Travis Cloak lining up for a set shot 10 meters out directly in front. It's probably going to go through, but you're not a hundred percent certain. And because our estimations of future cash flows can't be a hundred percent certain, then our estimates of intrinsic value also aren't a hundred percent certain.

So to account for this, we need a margin of safety. We don't buy our business at our calculated intrinsic value because then even if we're slightly wrong in our intrinsic value calculations, that's going to have a real impact on our returns.

So what we need to do is we need to give ourselves a buffer, a safety buffer, a margin for error or a margin of safety. Benjamin Graham writes this about the margin of safety: "The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future." Seth Klarman says a margin of safety is necessary because valuation is an imprecise art.

The future is unpredictable, and investors are human and do make mistakes. So what we do is we take our intrinsic value and then we shave a little bit off of it just to give ourselves a margin of safety, a buffer for being wrong in our estimations. So if we calculated the intrinsic value of that corner store to be $306,000, we might only offer the owners, say, $200,000 or $250,000.

So we only buy a business once it's being offered to us below its intrinsic value. But how far below intrinsic value? Well, this is where it's kind of up to you. For example, experienced investors, which are highly confident in the predictability of future cash flows of a business, they might opt for, say, a 20% or 30% margin of safety.

But potentially if you're a new investor or you're investing in a company that's maybe a little bit more risky, a little bit less predictable, then you might opt for, say, a 50% margin of safety. Now, don’t get me wrong, a 50% margin of safety is very difficult to come by, and if you’re looking in the current market, it’s unlikely that you’re going to find any businesses at a 50% margin of safety.

However, that's the mentality that we have to go in as investors. We sit patiently, we wait our turn until the businesses that we’ve been analyzing do get presented to us by the market at a price that is well below intrinsic value and that does give us that margin of safety. Because if you invest in a business at a 50% margin of safety, you can be very, very wrong in your predictions of the future for this business and you'll probably still end up with, say, a 15% return annually.

So that’s an absolute gold mine opportunity if you can find it. So that is how you take a lot of the risk away when you’re buying into a business. You take a lot of the risk of downside away by making sure you’re only buying at a margin of safety share price.

Now lastly, I wanted to flick over and have a look at this illustration. Now as I put this illustration up on the screen, from what we’ve spoken about in this video, you should now be confident in being able to interpret this chart and explain exactly what it means.

So what this chart is showing is, firstly, here is the price of the business—this is what the stock market offers the business to us at. And of course, that fluctuates every single day; there's a new price. There’s a new price that the market is offering to us for the shares of that company.

Then here we have the intrinsic value of the business, which is what we calculated from our discounted cash flow analysis where we added together the sum of all future cash flows to figure out what the business is worth to us as the sole owner. Then, as we can see in this chart, the price of the business eventually cuts down and touches the intrinsic value. But of course, that's not our buy trigger.

It's good to see that the price has now equaled the intrinsic value, but that doesn't necessarily mean we buy just yet because, of course, what we're talking about is we need that buffer, that buffer for us potentially being a little bit wrong in our predictions of the future and our predictions of what intrinsic value actually is.

So as you can see, when the share price—or the market price for the business—continues to fall, let’s say this line is, you know, 30% under the intrinsic value, then once it crosses down underneath that line, then that is our sweet spot. That is our gold mine opportunity, and that is when we decide we want to buy into this business.

We've done our due diligence—we firstly understand the company; we know the company has a great competitive advantage. We've checked out the management team; they're running the company with skill and integrity. Okay? The management of the company has really low debts. And then we’ve finally got that last key ingredient: we are now able to buy this company at a discount to its intrinsic value, and we've got the margin of safety, and that protects our downside risk quite substantially.

And this is really the key ingredient as to why all of those notable investing names that I mentioned earlier have proven themselves to be great investors decade after decade after decade. It’s because, quite simply, they don't get frazzled by the current market situation and, "Oh, don’t want to miss out on this hot stock" or anything like that. They stay perfectly rational, and they wait for opportunities where they buy great businesses at this situation, where they are at that margin of safety share price, where there's a lot of upside and there's very little downside.

So overall, guys, I hope that has helped you. I hope that you’ve learned something from this video. If you did, I’d really appreciate it if you left a like on the video. If you’d like more examples and full run-throughs of the discounted cash flow analysis as well as some other valuation methods, then definitely check out Profitful. Links are down in the description.

This is actually going to be the last day of our New Year’s sale, so if you want to get started with your investing and you want to hop on board, check out "Introduction to Stock Analysis." That’ll be the course for you. It's on a great discount at the moment. If you wanted to pick it up, that discount will probably be gone tomorrow, so act quickly if you want it. This will be the last time we do a big sale on Profitful for a fair while, so if you want to get in, get in now.

But apart from that, guys, thank you very much for watching; I really appreciate it. I hope you enjoyed the video; I hope you learned something from it, and I’ll see you guys next time.