A Beginners Guide to Stock Valuation (Intrinsic Value and Margin of Safety)

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So when it comes to stock market investing, there are a lot of things that we as investors need to remember. For example, we need to understand the business. We need to make sure the business has a long-term durable competitive advantage. We need to make sure the business's debts are manageable. We need to make sure the management team is growing the business very well.

But arguably the most important thing that we need to know is we need to understand how to value that business. So we know what price we should be paying for the shares. And in my experience running the channel, hearing from you guys, and reading all the comments, very frequently this is brought up as the trickiest part of investing. It's the part that people struggle with the most.

I just want to say that at the top of this video, this is going to be, if you're someone that's already up to speed with stock valuation and you've been investing for a fair while, this video might seem a little bit basic. But what I wanted this video to be is really a beginner's guide to understanding the concepts of stock valuation and margin of safety.

So, if you're someone that's already up to speed and you just want to get into some maybe nitty-gritty examples, then I've already made an in-depth video on intrinsic value in the past. I'll leave it linked in the description and it should be coming up on the screen right now as well. But yeah, this video is going to be all about the foundational principles of valuation and margin of safety.

So where do we even start? Well, firstly, what does it mean when we say we value a stock at, say, a hundred dollars, or we value that stock to be worth a thousand dollars? First, we need to remember that these companies we're looking to invest in are essentially like machines. They are machines that are made up of factories, robots, employees, and shop fronts.

The objective of these machines is to make as much money as possible for the owners of the machine. Because this machine has the capacity to produce a finite amount of cash each year, that also means that the price we are willing to pay for this machine is also finite. It stands to reason that the more money a machine is able to make for us in any given year, the higher the price we would be willing to pay for it.

For example, we'd be willing to pay a much higher price for a machine that can make a million dollars a year versus a machine that can only make a thousand dollars per year. So stock valuation is all about figuring out how much you're willing to pay for any given machine based on two factors: how much money that machine makes for its owners every single year and also how the money-making capabilities of that machine are changing over time.

That's what we're doing. It might surprise you, investors, that this process doesn't have anything to do with the stock price. In fact, just looking at the stock price alone, you cannot make any calculations around what that business is actually worth because the stock price is simply what the next person is willing to pay for the shares of that business. It doesn't actually tell you anything about the value of that business.

As Warren Buffett says, "Price is what you pay, but value is what you get." So if we buy shares in this company, then we are becoming the owner of the business. But we're not the sole owner of that business; we are the owner alongside all of the other people that are also shareholders in that business.

What happens is a company divides itself up into millions or billions of equal portions, each one of those portions being shares. If you own more shares, you start to own a higher percentage of that company. Now in reality, with our investing, we're only going to own very, very, very small slivers of companies, but we are shareholders; we are part owners nonetheless.

However, when it comes to the valuation process, it is always easier to value a company by imagining you just have bought the entire business. Now, without getting too complicated, to find the intrinsic value of the business we're looking at, this is what we do: First of all, we find how much money this machine is printing for its owners every year.

Then after that, we're going to look at the historical growth rate trend—historically, how much is this company growing by each year? We're going to grow that cash flow number out for a 10-year period based on the historically proven growth rate of the company. That is going to give us an estimate of how much money this machine is going to print for the owners across the next 10 years.

We also imagine we're going to sell the business after 10 years, which is going to give us a big fat one-time cash flow after that 10-year period. Then the next thing we do is we're going to discount all of these future cash flows by whatever we would like to achieve per year. I always use 15%, but really you can use whatever you would like to achieve from your own investing.

So, we're going to discount these future cash flows by what we'd like to achieve every year back to what they're worth to us sitting here right now. Then we simply add all of these discounted cash flows together, and that gives us the total intrinsic value of the business, what the business is worth to us sitting here right now if we are going to get that desired rate of return—in this case, I said 15%.

From there, if you wanted to figure out the intrinsic value as a share price, then all you would do is you would take that really big number and you would divide it by the total number of shares that exist within the business. That is called the company's shares outstanding.

Now, before I go any further, if the last minute or so of this video was quite confusing—and granted this is discounted cash flow; it takes a little while to wrap your head around how it works—if you found it confusing, go back and check out that video that I referenced at the start of this video, the one that is linked down in the description, because that is an in-depth example of how this discounted cash flow process actually works.

But what we just did, if I had to summarize it down into one sentence, is we predicted what the future cash flows of our business are going to be across the next 10 years. Then we used that information to figure out what we would be willing to pay for the business today if we wanted to achieve a 15% rate of return every year.

We looked at the performance of the business right now, how much cash it's generating for its owners right now, we predicted the future performance based on the historically proven past performance, the historical growth rate, and we used that to figure out what we'd be willing to pay for the business today.

What we'd be willing to pay for the business today is what we call the business's intrinsic value. But it's definitely worth focusing on the fact that what we just did is we did a whole lot of guesswork. We're essentially predicting the future. If you ask me, there's not a person on this planet that can accurately predict what the future holds, right? So we have to remember that.

And that's when our next key valuation concept comes in, which is the margin of safety. Investopedia puts it pretty well; they say "margin of safety" is a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. What we're looking to do is we are looking to buy the shares of the business we're analyzing when the share price is significantly below that intrinsic value that we just calculated.

The lower it goes below intrinsic value, the better. If we can find high-quality businesses that are trading substantially below their intrinsic value, that is great for us because it means that even if we've made some level of error in predicting the future of this company, then we're still probably going to make money. We're still probably going to make that 15% return that we wanted.

That's why Benjamin Graham said that the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future. Now, the size of the margin of safety that you go for, that's completely up to you. Some investors want to see the share price drop 20% below intrinsic value. Some investors want to see it drop 30% or 50% below intrinsic value. That's totally up to you, and it could even change based on what industry you're looking into and different volatility of every industry.

There's a lot of things, but ultimately that's up to you. However, what I would say is that, particularly for someone that is new to the valuation process and new to investing—and this is still something that I aim to achieve as well—I always try and look for a 50% margin of safety.

Now in reality, when you actually start doing the discounted cash flow analysis on lots of good quality businesses out there, you're going to find that in current market conditions, finding a 50% margin of safety is basically impossible. But that's kind of where we are right now with the stock market. It's definitely not always like that; it's just the fact that the stock market is incredibly overvalued at the moment.

But I still think it's a smart idea, particularly if you're a new investor, to just wait on the sidelines unless you can find a high-quality business at a 50% margin of safety. But overall, that's the video today. That's kind of the difference; they're the two key concepts when it comes to stock evaluation—two key concepts that people often struggle with and don't entirely understand.

Firstly, you have to use the discounted cash flow analysis to find the intrinsic value of the business. That intrinsic value is calculated based on the actual business performance, the cash flow generating capabilities, and the growth of that business. It's not related to share price at all.

And then once you've found that intrinsic value, then we have to admit that there's going to be some level of error in trying to predict the future. We are not going to predict the future with 100% accuracy, so we give ourselves that margin of safety to account for any potential errors we've made so that we make sure that we're still going to make money through buying this business.

So overall, guys, that is intrinsic value and margin of safety. I hope you really enjoyed this video. If these concepts are kind of making sense for you now, I would definitely recommend you check out the video that I've left linked in the description. That is kind of the next step, actually going into this discounted cash flow method and looking at how it actually works with the whole growth rate, cash flows in the future, discounting back to what they're worth today, adding it together, terminal value, all that sort of thing.

So if you're interested in taking that next step, definitely check out that video. But that will do us for today. If you enjoyed the video or if you found it useful in any way, please leave a like on the video and share it with somebody. If there's somebody that you know that would benefit from understanding these two key investing concepts, please link them this video, link them into it, share it around, and I would definitely appreciate that because it helps get this video and this message out to more potential investors.

So I'd really appreciate that. I will say just quickly at the end here, if you do want a full step-by-step walkthrough of this whole investing strategy, understanding the business, modes, management teams, and also you want a full kind of a full walkthrough of three different valuation methods of how to calculate the intrinsic value of a stock, then you can check out "Introduction to Stock Analysis."

That is an 8-hour in-depth course that I made last year, and in doing so, that's hosted on my own business, which is called Profitful. So if you would like to check out that course and if you picked it up, then that would also actually financially support all of my efforts here on YouTube as well. So if you're interested in that, that is linked down in the description.

But hopefully, this video was still handy. Check out that other video, the free video that I've left linked in the description. That will do me for today, guys. Thank you very much for watching, and I'll see you guys in the next video. [Music]

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