(#Warren Buffett #Valueinvesting)
How do you calculate the intrinsic value of a stock? This may be the single most important question in all of investing. Everyone knows that the secret to good investing is finding undervalued stocks, but how exactly do you determine if a stock is undervalued? To do this, you have to find the true value of a stock, referred to as its intrinsic value, and compare that to what the stock is currently selling for. Let’s listen to this clip of Warren Buffett explaining the theory behind calculating the intrinsic value of a stock. Then, we will use an example company to demonstrate the concept Warren Buffett laid out with a tangible demonstration. But first, make sure to like this video and subscribe to the channel if you aren't already because it is my goal to help you better understand investing by studying the greatest investors.
While Warren Buffett did a great job explaining the theory behind calculating intrinsic value, this tangible example I am about to provide should help explain the concept even further. Keep in mind this example is simplified, but it demonstrates the concepts Warren Buffett laid out in the clip in a way that may make more sense for you. This is the general framework that I personally use in my job as a professional investor at a large investment fund to think about valuing any type of cash flow producing asset: whether it is a stock, bond, or an apartment building. Now, let’s take a hypothetical company, called ABC Corp. ABC Corp stock is selling at 75 dollars per share and we want to know if the stock is undervalued compared to its intrinsic value. Let's say ABC Corp will operate over a 10 year period and make 10 dollars per share in the first year, growing its annual earnings by 1 dollar every year, all the way to 19 dollars per share at the end of year 10, in which it will stop operating. The next important variable is the interest rate in which you discount the cash flows back by. Let’s use 5% in this example. In the clip, Warren Buffett mentioned that he uses the long term risk free rate as his discount rate. In the US, the risk free rate is the interest rate on long-term government bonds.
With the variables that we laid out, that means ABC corp stocks intrinsic value is about 109 dollars per share. In this example ABC Corp stock is selling at a roughly 30% percent discount to its intrinsic value. Meaning that it is undervalued and a savvy, value-oriented investor would want to make this purchase. It is important to note and as Warren Buffett and Charlie Munger point out in the clip, that there needs to be a significant discount between the intrinsic value and what the stock is selling for to account for the uncertainty involved in predicting the future cash flows of the business and potentially using the wrong interest rate. This is known in value investing as the Margin of Safety. So there we have it. I hope you found this video helpful in your understanding of investing. Talk to you soon!
