One of the most sought after calculations in all of investing is Warren Buffett’s intrinsic value formula. Although it may seem elusive to most, for anyone that’s studied Buffett’s Columbia Business Professor, Benjamin Graham, the calculation becomes more obvious. Remember the intrinsic value formula that Buffett uses is an embellishment of Graham’s ideas and fundamentals.
One of the most amazing things about Benjamin Graham is that he actually felt bonds where safer and more probable of an investments than stocks. Buffett would strongly disagree with that today due to high inflation rates (a whole different topic), but this is important to understand in order to understanding Buffett’s method for valuing equities (stocks).
When we look at Buffett’s definition of intrinsic value, we know he’s quoted as saying that the intrinsic value is simply the discounted value of the future cash flows of a company. So what the heck does that mean?
Well, before we can understand that definition, we must first understand how a bond is valued. When a bond is issued, it is placed on the market at a par value (or face value). In most cases this par value is $1,000. Once that bond is on the market, the issuer then pays a semi annual (in most cases) coupon to the bond holder. These coupon payments are based on a rate that was established when the bond was initially issued. For example, if the coupon rate was 5%, then a bond holder would receive two annual coupon payments of $25 – totaling $50 a year. These coupon payments will continue to be paid until the bond matures. Some bonds mature in a year while other mature in 30 years. Regardless of the term, once the bond matures, the par value is repaid to the holder of the bond. If you were to value this security, the value is completely based on those key factors. For example, what is the coupon rate, how long will I receive those coupons, and how much of a par value will I receive when the bond matures.
Now you might be wondering why I described all that information about bonds when I’m writing an article about Warren Buffett’s intrinsic Value Calculation? Well the answer is quite simple. Buffet values stocks the same way he values bonds!
You see, if you were going to calculate the market value of a bond, you’d simply plug the inputs of the terms listed above into a bond’s market value calculator and crunch the numbers. When dealing with a stock, it’s no different. Think about it. When Buffett says he discounts the future value of the cash flows, what he’s actually doing is summing the dividends he expects to receive (just like the coupons from a bond), and he estimates the future book value of the business (just like the par value of a bond). By estimating these future cash flows from the key terms mentioned in the previous sentence, he’s able to discount that money back to …