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

Okay, here we go. In this video, I'm going to take the time to explain exactly how Warren Buffett calculates the intrinsic value of a stock. We'll hear him explain it, and then we'll run through a full example in the second half of the video so you can follow along as well.

But before we jump into the clips, I wanted to start at a high level. So when it comes to valuation, what are we trying to do? Well, we're trying to look at a business as a machine that prints money each year. We have to figure out how much to pay for the money printing machine now so that we get a good return on investment as it prints money out into the future.

So, following that analogy, we look at the business in its entirety, and then we figure out how much we'd pay to own the whole thing considering it makes X amount of cash each year. Once we figure out how much we'd be willing to pay for the business, we can then compare that intrinsic value to the current market capitalization of the business.

And the market cap, for those that don't know, is the total stock market value of a company. So, it's equal to the amount of shares the business is divided up into multiplied by the current share price. If the market capitalization ends up being higher than our intrinsic value, then the business is overvalued; and if the market cap is lower than our intrinsic value, well, that's a good sign for us because it means that the business is undervalued.

So, that's what we're trying to do, and now I wanted to play this clip of Warren Buffett explaining exactly this process. Now, warning, this is a long clip; it's three minutes long. But really listen to it, and also don't worry if you don't understand it immediately. We'll come back after, and we'll run through a full example of the method he's about to explain. Over to you, Warren.

"It's how do you find intrinsic value in a company? Well, intrinsic value is what is the number that if you were all knowing about the future and could predict all the cash that the business would give you between now and judgment day, discounted at the proper discount rate, that number is what the intrinsic value of businesses. In other words, the only reason for making investment and laying out money now is to get more money later on, right? That's what investing is all about.

Now when you look at the stock, when you look at a bond, say a United States government bond, it’s very easy to tell them what you’re going to get back. It says it right on the bond; it says when you get the interest payments, it says when you get the principal. So it's very easy to figure out the value of a bond. It can change tomorrow if interest rates change, but the cash flows are printed on the bond. The cash flows aren't printed on a stock certificate.

That's the job of the analyst is to print out, change that stock certificate which represents an interest in the business, and change that into a bond and say this is what I think it's going to pay out in the future. When we buy, you know, some new machine for Shaw to make carpet, that's what we're thinking about, obviously; and you all learn that in business school. But it’s the same thing for a big business.

If you buy Coca-Cola today, the company is selling for about 110 to 115 billion dollars in the market. The question is, if you had 110 or 115 billion, you wouldn't be listening to me, but I'd be listening to you instantly. But the question is, would you lay it out today to get what the Coca-Cola company is going to deliver to you over the next two or three hundred years? Discount rate doesn't make much difference after you get further out.

But that is the question: how much cash are they going to give you? This isn't a question of, you know, isn’t the question about how many analysts are going to recommend it or what the volume in the stock is or what the chart looks like or anything; it's a question of how much cash it's going to give you. That's your only reason. It's true if you're buying a farm, it's true if you're buying an apartment house, any financial asset, oil in the ground. You're laying out cash now to get more cash back later on, and the question is how much you're going to get, when are you going to get it, and how sure are you?

And when I calculate the intrinsic value of a business when we buy businesses, and whether we're buying all of a business or a little piece of the business, I always think we're buying the whole business because that's my approach to it. I look at it and say, 'What will come out of this business and when?' And what you really like, of course, is them to be able to use the money they earn and earn higher returns on it as you go along. I mean, Berkshire has never distributed anything to its shareholders, but its ability to distribute goes up as the value of the businesses we own increases.

We can compound it internally, but the real question is: Berkshire is selling for, we'll say, 105 or so billion now. What can we distribute from that 100? If you're going to buy the whole company for 105 billion now, can we distribute enough cash to you soon enough to make it sensible at present interest rates to lay out that cash now? And that's what it gets down to. If you can't answer that question, you can't buy the stock.

So if your company was selling for a market cap of 105 billion, can that business deliver enough cash to you soon enough to make it a sensible investment? That's what it boils down to. And the process we're going to go through to figure that out is called the discounted cash flow analysis. The long way of saying it, as Warren Buffett does, is the discounted present value of all future cash flows. Now, that will make more sense in a minute, trust me.

So with that said, let's begin. Here's what we're going to do: we're going to figure out what to buy the business for right now, then we're going to hold the business for 10 years. Now, we're going to sell it, so we'll have to outlay some cash right now to buy it. Then we'll receive 10 years of juicy profit from the business's operations, and then we'll get a big one-time check when we sell this thing in 10 years' time.

So what do we pay for it now? That is the question. So, the first step is to find the amount of cash this money printing machine makes for its owner every year. That is the free cash flow. So the business makes money and spends money, and the free cash flow is what the business owners could potentially keep each year.

This number is calculated from two numbers on the cash flow statement: it is the cash flow from operations, or sometimes just the operating cash flow, minus the capital expenditure, alternatively known as the purchase of property, plant, and equipment. Now, if you wanted to get more precise, we would prefer to eliminate the part of the capital expenditure that's related to growth and expansion. So it would really be the cash flow from operations minus the capital expenditure needed just for maintenance.

But unfortunately, this is very rarely reported by companies, and you kind of just have to figure it out yourself. So we'll just use free cash flow for this example, and don't worry because using free cash flow is more conservative anyway. More conservative, but obviously slightly less accurate, so step one complete, we have the business's free cash flow.

Then the next step is to figure out how well they're going to be able to grow their cash flow each year for the next 10 years. Now, this growth rate is down to you and your research, and it will be different for every single company. And a quick word of warning here, the growth rate you use will have a big impact on the result of your intrinsic value calculations.

So please don't go off into la-la land while you predict how much this business will grow in the next 10 years. Don't convince yourself they're going to grow at 200% annually for 10 years straight. I mean, even 25% growth per year is a very high growth rate to use.

So overall, a few ways to stay grounded: number one, look at the prior 10 years of free cash flow growth and equity growth—how quickly have they grown on average in the past? Then, two: what is the typical growth rate of the industry—you know, what are other companies managing to achieve in the same industry? And then three: actually understand the future growth drivers for your business and how they will likely impact the cash flows.

For example, Tesla right now has two new factories that will be coming online across the next five years, in fact, across the next year, and they'll be ramping up. So how will those factories impact the amount of vehicle deliveries, and what will that mean for Tesla's free cash flow considering their current margins?

So, overall, there's a bit to think about, but these three pointers should help you come to a solid idea of an annual growth rate for your business. Let's just run for this example with 10% per year as a growth rate. So, let's now grow the free cash flow out by 10% per year for the next 10 years. It's pretty easy; just multiply the previous year's free cash flow by 1.1.

And then after that, now we're going to sell this thing. Now, of course, you don't actually have to sell it in real life, but for the calculation, we imagine we're going to sell the business in 10 years. This is called our terminal value. So what can we sell it for? Well, let's look at what multiple of free cash flow the business has been selling for over the past five years. If we take the average, let's say we could probably sell the business for that free cash flow multiple in say 10 years’ time.

Now, honestly, 25 and a half is probably quite a high multiple for this business that I'm modeling the numbers off. So, of course, you have to use your own judgment a little bit as well, but let's just run with 25 and a half for the sake of this example.

So now what we need to do is multiply the 10th year of free cash flow by our free cash flow multiple to get our terminal value. And there you have it; we have all of our future cash flows. But remember, this process is finding the sum of all the discounted future cash flows. So what's that all about?

Well, remember Buffett said can the business deliver the cash to you soon enough to justify buying the business at its current price? This time factor is very important. Remember one dollar today is worth more than one dollar in five years because we don't have to wait five years to get it. If we get that dollar now, we could maybe invest it and turn it into, who knows, two dollars or three dollars by that five-year mark. So you have to think about the opportunity costs.

So what do we do? Well, say we want to achieve 15% annual returns in our stock portfolio. All we have to do is discount the future cash flows by 15% per year. And watch this: as you go further out in time, even though the company is growing its cash flows at 10%, the present value of that future cash flow is actually getting lower and lower year by year because of that opportunity cost. It's very interesting, and that's why Buffett in that clip said the further out in time you go, the less consequential it is to your intrinsic value.

But anyway, so we've discounted the 10 years of future cash flows 15% per year, and then don't forget we also discount the terminal value at the 10th year as well. So what we've just done is we've calculated what we'd pay today for the annual future cash flows we'll get from owning the business, and we've figured out what the big one-time check is worth to us today from selling the business in 10 years' time.

Now simply add all the discounted future cash flows together, and that's the intrinsic value of the business today. If it grows its cash flows at 10% per year, you can sell the business in 10 years at 25 and a half times free cash flow, and you want to achieve 15% returns per year, $595.97 billion in this instance. There you go, we did it! That is the sum of the discounted future cash flows. That is the discounted cash flow model.

It makes sense, right? Then, if the market cap is below the intrinsic value, then it suggests we could buy the business at its current stock market value, and we'd likely make 15% returns per year. However, there is one more step after this point; we have to add a margin of safety to our intrinsic value because all the stuff we've just done is technically trying to predict the future, and you can't predict the future with 100% accuracy.

You just can't, so we're going to be wrong at least in part, and because of this, we add a margin of safety to our intrinsic value—maybe 20%, maybe 30%, maybe 50%. That bit's up to you, but if you can snag the business not at intrinsic value but substantially below intrinsic value, then that really de-risks your investment. It protects you if the future doesn't quite turn out as we predicted.

However, also by doing this, if you are actually pretty correct in your future estimates, then the margin of safety will also help you achieve a higher rate of return than your calculated 15% per year. So, overall, margin of safety really is a key concept.

But that's it, guys! That is how Warren Buffett calculates the intrinsic value of a business, and that's how you can do it as well. So give it a try on your favorite company and let me know how you go. You know, chances are honestly in this environment most businesses will be trading above intrinsic value, but you never know.

So anyway, guys, that will do us for today. Leave a like if you enjoyed. The introduction to stock analysis is linked in the description if you want a more comprehensive step-by-step walkthrough of this entire approach. Also, new Money Patreon is linked in the description if you wanted to support the channel financially. But that's it for today, guys. Thank you very much for watching, hope you enjoyed it, and I'll see you guys in the next video.