A Series Of Equal Cash Flows Is A N How to Calculate the Intrinsic Value of Stocks Like Warren Buffett

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How to Calculate the Intrinsic Value of Stocks Like Warren Buffett

One of the most sought after calculations in all of investing is Warren Buffett’s Intrinsic Value Formula. While this may seem elusive to most, the calculations become clearer to anyone who studies Buffett’s Columbia business professor, Benjamin Graham. Note that the intrinsic value formula that Buffett uses is an embellishment of Graham’s ideas and fundamentals.

One of the most surprising things about Benjamin Graham is that he thought bonds were a safer and more viable investment than stocks. Buffett strongly disagrees with it today due to high inflation rates (an entirely different topic), but it is important to understand Buffett’s approach to valuing equities (stocks).

When we look at Buffett’s definition of intrinsic value, we know that he said that intrinsic value is simply the discounted value of a company’s future cash flows. So what does this mean?

Well, before we understand that definition, we must first understand how bonds are valued. When a bond is issued, it is marketed at par (or face value). In most cases this equal value is $1,000. Once that bond is on the market, the issuer then pays the bondholder a coupon semiannually (in most cases). These coupon payments are based on the rate established when the bond is initially issued. For example, if the coupon rate is 5%, the bondholder will receive two annual coupon payments of $25 – a total of $50 per year. These coupon payments will be made until the bond matures. Some bonds mature in one year while others mature in 30 years. Regardless of maturity, once the bond matures, the bondholder is repaid equal value. If you value this security, the value is purely based on those key factors. For example, what is the coupon rate, how long will I receive those coupons, and how much par value will I receive when the bond matures?

Now you may be wondering why I covered all the information about bonds when I was writing about Warren Buffet’s intrinsic value calculation? Well, the answer is quite simple. Buffets value stocks the same way they value bonds!

You see, if you’re going to calculate the market value of a bond, you simply plug the inputs of the terms listed above into a bond market value calculator and crunch the numbers. When dealing with stocks, it is no different. Think about it. When Buffett says he discounts the future value of cash flows, what he is actually doing is adding up the dividends he receives (like a bond’s coupons), and he estimates the future book value of the business (like the value of a similar bond). By estimating these future cash flows from the key terms mentioned in the previous sentence, he is able to return that money to its present value using a respectable rate of return.

Now here’s the part that often confuses people – discounting future cash flows. To understand this step, you must understand the time value of money. We know that money paid in the future has a different value than the money we have in our hands today. Consequently, a discount must be applied (just like a bond). The discount rate is often a hot topic for investors, but it’s pretty simple for Buffett. To begin with, he discounts his future cash flows with a ten-year federal note because it compares to a zero-risk investment. He does this to begin with so he knows how much risk he is taking with a potential selection. Once that figure is established, Buffett discounts future cash flows at a rate that forces the intrinsic value to equal the stock’s current market price. This is the part of the process that can confuse many people, but it is the most important part. By doing so, Buffett is able to instantly see the expected return from any stock pick.

While many of Buffett’s projections of future cash flows aren’t concrete numbers, he often mitigates this risk by choosing good, stable companies.

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