In Berkshire Hathaway Inc’s Annual Report 2016, Warren Buffett had shared the definition of “Intrinsic Value” and it is as follows:
It is the discounted value of the cash that can be taken out of a business during its remaining life.
There are 3 components to calculating intrinsic value:
- Discounted Value
- Cash that can be “taken out”
- Remaining life
Let’s examine each component in detail.
1. Discounted Value
What’s the meaning of “discount”? Why is there such a need for “discount”?
Simple. Let me ask you a question. Is there a difference between receiving:
- US$ 10k in cash today.
- US$ 10k in cash one year later?
It is obvious that most prefer to have the US$ 10k today than one year later. The reason is cash is valued more now than later. US$ 10k in a year’s time is lesser in value than today. But, by how much?
That “how much” is subjective. For instance, if one places US$ 9,708.74 into FDs that pay 3% a year today, he would collect US$ 10k in one year’s time. So if 3% a year is his benchmark, the value of US$ 10k in a year’s time is US$ 9,708.74 now.
US$ 9,708.74 (today) x 1.03 = US$ 10k (one year’s time)
If the benchmark is 5%, the value of US$ 10k in a year’s time is US$ 9,523.81. So, the greater the benchmark, the less valuable the US$ 10k in a year’s time. So, as an investor, this benchmark is also known as “discount”. Hence, our question is: “What discount rate do we use?” Is it 3%, 5%, 10% … etc?
The discount rate chosen will impact our intrinsic value calculation.
2. Cash That Can Be “Taken Out” of a Business
So, what’s that? Is it a stock’s:
- Operating cash flows?
- Free cash flows?
There is no right answer to this as many use both. As such, they could cause the calculation of intrinsic value to be different. For instance, if a stock generated as much as US$ 100 million in operating cash flows in a year and has expended US$ 20 million in CAPEX (free cash flows = US$ 80 million), which figure do we use to calculate intrinsic value?
- Operating cash flows = US$ 100 million?
- Free cash flows = US$ 80 million?
Anyhow, both have their limitations:
1. It doesn’t work for banks and financing companies as their business nature in general is different. For instance, when bank customers withdraw / transfer out cash for their own uses, it is a cash outflow but it is not reflective of its business performance.
2. A stock that brings in huge operating cash flows can utilise them for CAPEX in expanding its operations for 2-3 years. In that case, it would significantly reduce its free cash flows for that 2-3 years. So, an investor who uses free cash flows to calculate intrinsic value shall obtain a figure significantly lower than an investor who uses operating cash flows.
In addition, as investors, we like to invest in businesses which could continue to grow their annual operating cash flows. If a stock has generated US$ 100 million in operating cash flows in Year 0, it is ideal for it to grow this to:
Year 1 – US$ 110 million
Year 2 – US$ 120 million
Year 3 – US$ 130 million … etc
But, what would be the ideal growth rate to use to project these figures? Could it be 3%, 5%, 10% … etc? What’s its basis?
Once again, it is subjective.
3. Remaining Life
How long is “remaining life”?
The other is: who knows. Sure, there are stocks which stood the test of time. As investors, the question is: “What’s the time period that we take?”. Is it 10 years, 20 years, 50 years or eternity?
Here, let us take a 10-year horizon for our investments. Thus, the formula for us to calculate a stock’s intrinsic value would be:
Intrinsic Value = DCF (Year 1) + DCF (Year 2) + DCF (Year 3) + … + DCF (Year 8) + DCF (Year 9) + DCF (Year 10) + Projected Stock Price @ Year 10
The question is: “How do we make a projection of its stock price at that time?”.
Even if I know how to do so, there’s no guarantee that my projection is accurate and will eventually hit the mark.
Conclusion: Assumptions in Intrinsic Value Calculation
In conclusion, I don’t calculate a stock’s intrinsic value when investing. Although it is sound in theory, in practice, it involves multiple assumptions when it comes to calculating this figure. As a result, each investor will obtain “different figures” of intrinsic value of the same stock despite the stock reporting the same figures in its annual and quarterly reports.
To sum it up, such assumptions would include choosing:
- Discount rate.
- Operating cash flows (OCF) / free cash flows (FCF)
- Growth rate of either OCF or FCF
- Time horizon: 10 years, 20 years or eternity
Even if you come out with a figure, that figure may not necessarily be correct. It is possible for that figure to be higher or lower than the current stock price. If a stock’s intrinsic value is higher than its stock price, does it necessarily mean this stock is a good investment? Likewise if it is in the opposite direction, could such mean that the stock is overvalued?
The answer is not quite.
Instead of using intrinsic value calculation, I keep it simple by using:
- P/E Ratio
- PEG Ratio (Growth Stocks)
- P/OCF Ratio
- Dividend Yields
As long as these ratios make sense, that’s good enough for me.
If you intend to earn growing and recurring dividends from your stock portfolio, you can check out the processes I use to build my own portfolio by our 1-Hour free training session as follows:
Link: How to Build a Stock Portfolio That Pays Increasing Dividends?
