When Is Formula Going To Be Back In Stock 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. Although it seems difficult to many, to anyone who has studied Buffett’s Columbia Business Professor, Benjamin Graham, the calculation will be more obvious. Remember the intrinsic value formula that Buffett uses is an embellishment of Graham’s ideas and principles.

One of the most amazing things about Benjamin Graham is that he felt bonds were a safer and more likely investment than stocks. Buffett would not agree much with that today because of the high rate of inflation (a whole different topic), but this is important to understand in order to understand Buffett’s approach to valuing equities (stocks).

Looking at Buffett’s definition of intrinsic value, we know that he is quoted as saying that intrinsic value is the discounted value of a company’s future cash flows. So what does that mean?

Well, before we can understand that information, we must first understand how a bond is valued. When a bond is issued, it is placed on the market at par value (or face value). In most cases this amount is $1,000. Once that bond is on the market, the issuer then pays semi-annually (in most cases) to the bondholder. These coupon payments are based on the rate determined when the bond was originally issued. For example, if the coupon rate is 5%, then the bondholder will receive two annual coupon payments of $25 – a total of $50 per year. These coupon payments will continue to be paid until the bond matures. Some bonds mature annually while others mature in 30 years. Regardless of the term, when the bond matures, the par value is returned to the bondholder. If you were to value this security, the value is based entirely on those important factors. For example, what is the coupon rate, how long will I get the bonds, and how much cash value will I get when the bond matures.

Now you might be wondering why I mentioned all that information about bonds when I wrote an article about Warren Buffett’s insider valuation? Well the answer is very simple. Buffet values ​​stocks the same way he values ​​bonds!

You see, if you were to calculate the market value of a bond, you could simply plug the input of the names listed above into the bond market value calculator and crunch the numbers. When dealing with stocks, it’s no different. Think about it. When Buffett is discounting future cash flows, what he is doing is summing up the dividends he expects to receive (like coupons from a bond), and estimating the future book value of the business (like the bond’s par value). By predicting these future cash flows from the key terms mentioned in the previous sentence, you are able to discount those cash flows back to present value using a reasonable rate of return.

Now this is the part that often confuses people – discounting future cash flows. To understand this step, you need to understand the time value of money. We know that money paid in the future has a different value than money in our hands today. Therefore, a discount (like a bond) must be used. Discount pricing is often a hot topic for investors, but for Buffett it’s pretty simple. For starters, he’s discounting his future cash flows with a ten-year bond because it gives him a relative comparison with risky investments. He does this to begin with so he knows how much risk he is taking with a possible choice. Once that number is established, Buffett then discounts future cash flows at a rate that forces the intrinsic value to equal the stock’s current market value. This is the part of the process that can be confusing to many, but it is the most important part. By doing this, Buffett is able to immediately see the expected return on any given stock option.

Although many of the future cash flows that Buffett predicts are not realistic numbers, he often mitigates this risk by choosing good and stable companies.

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