If you love finances and investing, whenever you hear the terms ”intrinsic value” or ”stock valuation” Warren Buffet’s name inevitably comes to mind. He is, if not, one of the greatest investors of all times, and in today’s article we would like to address one of the basic methods Buffet uses when picking undervalued stocks.
So What is Intrinsic Value?
It is basically the “real” or “fare” value of an asset, in this case, a company stock price. This type of study goes by the name of Quantitative Analysis or most commonly known as “Fundamental Analysis” of a company. For example, if you want to buy a stock priced at $20, you’ll be better off by knowing what is the “fare” value of that stock, in the case that stock intrinsic value was $25, it means that the stock has potential to increase it’s price in the future, however, it does not mean the stock is going to do so for sure because there are many factors involved, but it is certain that the stock is undervalued.
To put it in Buffet’s words, the intrinsic value of a company is the value of all the cash that can be taken out of a company and be returned to investors during its remaining life. So basically, it is picking an undervalued stock with the potential to increase in price in the future. The question is, how do I calculate the intrinsic value of a company? Well, there are many ways to do it, but for the sake of this article, we are going to review the Buffet’s method for calculating a stock “fair” value.
Before understanding how to calculate the intrinsic value, first it is important to review 3 key concepts that are used to value a company stock price.
What are dividends?
The amount of cash the management of the company distributes to the shareholders of the company (after profits). Although, not all companies pay dividends. When understanding dividends you have to pay attention to payout ratio, which is the percentage paid per share. It is important that the payout ratio is not higher than what the company is making, because it wouldn’t be sustainable on the long term.
What is Book Value?
Book value refers to the total amount a company would be worth if it liquidated it’s assets and paid back all its liabilities. Book value can also represent the value of a particular asset on the company’s balance sheet after taking accumulated depreciation into account.
What is EPS?
It is a company’s net income divided by the number of shares the company has outstanding. It gives you an idea of how fast the company is growing. Also how much the company is paying you per share. The EPS comes from book value growth and dividends.
How to Calculate the Intrinsic Value of Stock?
The Cash that can be taken out of a company during its remaining time – Warren Buffet
We are going to use the 3 concepts explained above to calculate the intrinsic value of XYZ stock in the following example:
The example shows XYZ stock EPS, Book Value, and Dividend for a period of 10 years. The total cash at the end is just the sum of the total book value plus the total dividends. These are the numbers we need in order to create an estimated intrinsic value for this stock.
In order to calculate the intrinsic value in this example, we are going to use an intrinsic value calculator. Link Here! This calculator is going to help us simplified all the steps needed to estimate the intrinsic value of the stock.
In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value – Warren Buffet
First, we have to calculate how much the book value is growing annually through that 10-year period. To do this you need to use the current book value, the old book value, and the number of years between the book values. With these numbers, you are going to get the average book value change per year, which for this case is 7.61%. What that means is that the book value for that 10-year period was growing 7.61% per year.
In the second step, using the second part of the calculator you have two blank spaces to add different values. The first space asks you to add the cash taken out of business, which in other words is the dividend that the company pays (0.35$). It also asks you for the current book value which is $25 and the average percentage charge which we calculated to be 7.61%. And finally, the current 10-year federal note (%) which is 0.72% right at the moment.
That gives us an intrinsic value of $51.81 for this hypothetical example. However, always remember this is an estimate of the “fare” value of a company, this does not mean that this stock can get to that value or that it will not surpass that value. It is simply an estimate which can be supported with other types of analyses.
Then again this is a basic example of how to calculate the intrinsic value of a stock. There are other methods that work in conjunction with this one, in order for the estimated stock valuation to be more accurate. Buffet also does what is called Discounted Cash Flow Intrinsic Value Calculation, this method has a different approach to valuating a stock when compared to the one explained in this article. The DCF calculation uses cash flows for valuation. This calculation usually compute the cash flows for the coming 10 years, and then in addition it estimates the value of the stock if you hold it forever, which might as well be called “perpetuity”. This method focuses on looking at the projected earnings to ensure if your estimated cash flows in the future are realistic.
I also wanted to point out that when you are doing your stock valuation, there are 4 signs that might tell you why a company is a risky investment.
4 Signs to be aware of:
- High Payout Ratio
- Declining earnings
- Taking on more debt
- Selling off assets
After reviewing one of the methods Warren Buffet uses to look for undervalued stocks, we can conclude that carrying out a fundamental analysis of a company before buying it, is one of the most important things for any long-term investor. Remember that the main goal of an investor is trying to figure out what businesses are going to be worth 10, 20 or 30 years from now.
However, it is not always good to start valuating stocks and investing by yourself, because as I mentioned before there are many variables that can affect a company’s price movement along the way. That’s why it is important to leave the investing to a professional that has to spend all their life researching, studying, and analyzing the market. For that, we encourage you to contact a Certified Financial Planner, that can really help you redirect your financial objectives with a good long-term strategy that can be the most beneficial for your future retirement.
Nonetheless, it is important for you to educate yourself and so when is the time to choose your financial planner you’re not lost and you have a clear, informed idea of what you want and what to look for. For this, we recommend you to check out these books below, which are simply tools for you to understand better this concept of valuating stocks.