The Intrinsic Value of a stock is an estimate of a stock’s value without regard for the stock market’s valuation. We uncover how Warren Buffet calculates Intrinsic Value
Value investors try to determine the Intrinsic Value in order to learn how much money a stock could make without market forces. In contrast, dividend investors look at the intrinsic value to estimate future dividends. Dividend investors want to know the Intrinsic Value, because it can them a rough idea of the amount of future dividends.
In addition, growth investors will use Intrinsic Value to estimate a company’s potential for future growth. For instance, a retailer’s plans for expansion, or new products management is planning.
Intrinsic Value is a Matter of Opinion
There are many formulas for calculating Intrinsic Value, because Intrinsic Value is a matter of opinion.
To clarify, analysts and investors disagree on what Intrinsic Value is and how to calculate it. For example, value investors look at cash, assets, and cash flows. However, growth investors may examine intangible assets like patents, intellectual properties, strategies, business plans, brand names, reputations, and copyrights.
For example, many people regard copyrighted fictional characters; like Luke Skywalker, Darth Vader, Spider-Man, Iron Man, and Captain America, as part of the Walt Disney Company’s (NYSE: DIS) Intangible Value. In addition, most of Procter & Gamble’s (NYSE: PG) potential value comes from popular brands like Tide.
Intrinsic Value vs. Book Value
The Book Value of a company is the value of all the business’s physical, financial, and legal assets. For example, the money in the company’s accounts, accounts receivable, inventory, real estate, patents, assets, equipment, etc.
A good way to think of Book Value is the amount of money creditors could receive if a bankruptcy court liquidates the company. However, Book Value does not take such factors as management, corporate, culture, business plans, and consumer loyalty into account. In addition, Market Capitalization is not part of book value.
The easiest way to estimate Book Value is to subtract a company’s liabilities from its assets. For instance, Apple (NASDAQ: AAPL) had assets of $341.998 billion and liabilities of $93.772 billion in March 2019. Consequently, you can estimate Apple’s Book Value at $248.226 billion.
Comparing Book Value to your estimates for Intrinsic Value can give you an idea of how other people are pricing a company.
Price to Earnings Ratio vs. Intrinsic Value
Many people use the Price to Earnings (P/E) Ratio or Price Multiple but is not an estimate of stock value. Instead, the PE Ratio is an estimate of the value of a stock’s earnings.
Generally, analysts use the P/E Ratio to compare the earnings of different stocks. In addition, you can compare present and historic P/E Ratios to learn the consistency of a stock’s earnings.
A classic P/E Formula is the stock price divided by the Earnings Per Share (EPS). You must pay attention to the P/E Ratio because it is the most popular stock analysis formula.
However, the P/E Ratio is a short-term analysis tool that has little effect on Intrinsic Value. On the other hand, speculators watch the P/E Ratio because it can affect short-term market prices. Hence, the P/E Ratio can be an indicator of a stock’s future market performance.
Formulas for Calculating Intrinsic Value
However, there are several formulas that can give you a rough estimate of Intrinsic Formula. Understanding, and utilizing these formulas can make it easier to value and understand stocks.
1. The Dividend Discount Model
The simple idea behind the Dividend Discount formula for estimating Intrinsic Value is that cash is king.
A simple means of calculating the Dividend Discount is to use the Time Value of Money method. To calculate the Time Value add the amount of future dividends to the present stock price.
To determine Walmart’s (NYSE: WMT) Intrinsic Value next year you would add four quarters of dividends to Walmart’s stock price ($100.04 on May 15, 2019). Since Walmart will pay a 53₵ divided on June 3, 2019, its Intrinsic Value could be $102.28.
Hence, a dividend investor will spend $100.04 to get $2.24 in dividends. Thus, you can determine if $2.24 is worth $100.04 if you purchase Walmart stock for the dividend.
The Problems with the Dividend Discount Model
The problem with the Dividend Discount Model is that a company’s management can end the dividend; or change it, any time. For instance, a company that pays a quarterly dividend could switch to annual dividends. Moreover, some companies will occasionally issue big bonus dividends.
Unfortunately, the Dividend Discount Model only works with stocks that pay dividends. Hence, the Dividend Discount Model is useless with companies; such as Alphabet (NASDAQ: GOOG); Amazon (NASDAQ: AMZN), and Berkshire Hathaway (NYSE: BRK.B), which refuse to pay dividends.
2. Discounted Value of Cash – How Warren Buffett calculates Intrinsic Value.
Interestingly, Warren Buffett bases his Intrinsic Value calculations on future free cash flows. To explain, Buffett thinks cash is a company’s most important asset, so he tries to project how much future cash a business will generate.
The usual formula for estimating future Free Cash Flows is the Discounted Cash Flow Method. Here is an example of a simple Discounted Cash flow Method
- Take the free cash flow of the first year and multiply it with the expected growth rate.
- Then calculate the NPV of these cash flows by dividing it by the discount rate.
Note: the NPV refers to the Net Present Value or the present value of money. You calculate the Net Present Value by subtracting the discount rate from the future value of the money and multiplying it by the number of years you are measuring.
- Project the cash flows 10 years into the future, and repeat steps one and two for all those years.
- Add up all the NPV’s of the free cash flows.
- Multiply the 10th year with 12 to get the sell-off value.
- Add up the values from steps four, five, and Cash & short-term investments to arrive at the intrinsic value for the entire company.
- Divide this number with the number of shares outstanding to arrive at the intrinsic value per share.
The advantage to the Discounted Cash Flow Method is that it is simple. The problem with this method is that Free Cash flows can vary dramatically over from year-to-year. Thus, the final figure from this method is guesswork.
A Warren Buffett Spreadsheet
The website Warren Buffett Spreadsheet claims to offer free spreadsheets the designers base on Buffett’s formulas.
In addition, the website offers YouTube videos that will explain its use. Note: since Buffett famously only uses computers to play Bridge, Warren himself has nothing to do with this site. However, the tools offered could help you learn basic value investing formulas.
Intrinsic Value for Math Haters
If you are not good at math; hate math, or get scared by all the numbers, there are many excellent financial calculators online that will estimate Intrinsic Value.
In addition, you can see examples of these calculations at YouTube. In fact, watching a YouTube video of a calculation is one of the best ways to learn it. To find such videos search YouTube by entering the words “Intrinsic Value Formula” or “Intrinsic Value Spreadsheet.”
Moreover, you can cheat by using a formula in an Excel Spreadsheet. You can locate many such spreadsheets by typing the words “Intrinsic Value Spreadsheet” into your search engine. In addition, this New York University webpage gives you access to vast numbers of Excel Spreadsheets you can download.
The Limits of Intrinsic Value
In the final analysis, Intrinsic Value is nothing but an estimate because there is no guarantee that future numbers will match the ones you use.
Intrinsic Value estimates are often wrong, because they exclude outside factors that can change a company’s price. For instance, the price of oil determines the value of an oil company like Exxon-Mobil (NYSE: XOM).
Consequently, any change in oil prices can cause Exxon-Mobil’s free cash flow to go up and down. Thus, calculating the Intrinsic Value of oil companies is tough.
Therefore, Intrinsic Value is just one of many tools you should use to analyze stocks. Over-reliance on Intrinsic Value can cost you money by giving you an unrealistic picture of stock values.