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Warren Buffett is known by many as being the most influential and successful investor of our times. And that’s true — his track record shows you that he has achieved an annual return of 21% over the last 52 years(!).
Buffett is a value investor, which means that he doesn’t agree with the efficient market hypothesis and searches for undervalued stocks by the market. To find those promising investments he uses a financial number or estimate called the intrinsic value.
To arrive at the intrinsic value i.e. the true worth of a stock (or investment in general) like Warren Buffett you have to follow five simple steps.
First, I want to explain to you what the intrinsic value is and what it means in regard to stock investments. You can say that the intrinsic value is an estimated number that represents the true worth of an investment due to its fundamental financial numbers — the technique you will learn in this article (which may be the technique Warren Buffett uses) is looking on a company’s or investment’s future cashflows and estimates a worth based on those cashflow estimates.
Cashflow is basically the number at which you arrive when you take all the cash outflows and you add all the cash inflows. Without further details all you have to know is that cashflow is the “actual hard cash amount” i.e. the actual positive cash which flows into a company.
A quick note: Warren Buffett never showed his formulas and technique to arrive at the intrinsic value to the public, but through mentioning this method that we will discuss in detail now several times and through “reverse engineering” some of Buffett’s principles it is safe to say that he uses some kind or variation of the DCF analysis.
The DCF analysis is the approach that is used to arrive at the intrinsic value of an investment (there are many more approaches, but the DCF analysis is one of the most effective and most probable approach that may be used by Buffett himself). DCF analysis stands for Discounted Cash Flow Analysis. You’ve probably already noticed that the name contains “discounted” and “cash flow” and that’s also the primary concept of arriving at the intrinsic value. Don’t panic when you don’t understand what discounting, terminal value, etc. is. We will go through it in detail and we are going to calculate the intrinsic value of an example stock (in our case Apple, Inc.).
As I’ve written in the beginning of this article there are five steps in determining the intrinsic value like Warren Buffett:
1. Estimate future cash flows
The first step of the DCF analysis is to estimate or predict the future cash flows of the company (or investment in general). To do this you could either rely on analyst estimates, calculate the historic growth rate and decide whether the company is able to grow at its historic rate or estimate and predict those future cash flows by yourself (be cautious when predicting them by yourself!).
I prefer to calculate the historic growth rate and decide whether the company is able to grow at that rate in the future (or whether I have to adjust the number a little bit). Another good (but not always reliable) way is to use analyst numbers and estimates. The third option is to predict them by yourself, which should be your last option (especially when you are a beginner in investing). Many people think they can predict better than analysts, but that’s mostly not the case. Analysts are actually pretty good predictors, which makes sense when think about how many years of experience the most financial analysts have. So please do not think that you can predict financials better without any experience than an analyst with many years of experience doing exactly this.
By how many years should we predict the cash flows? Well, I use always five years. You can use ten years when you think of long-term investments, but you have to consider that it gets harder and harder to predict cash flows farther in the future. Predicting the next five years cash flow is easier than predicting the next ten or even twenty years.
Because I mainly use the historic growth rate as an indicator of future cash flows we have to calculate the historic annual growth rate of our example Apple. To do this we have to go to a major financial site (my favorite is www.morningstar.com ; just type into Google: “Apple stock ratios morningstar” and click on the first result).
You’ll get to a page that looks like this.
As you can see in the image above Apple’s free cash flow of 2018 was approximately $64.1 billion. And you can also see that below the free cash flow number there is the free cash flow per share number (11.5$).
Having this per-share number is very handy, because when we would use the free cash flow number and arrive at our intrinsic value we have to divide it by the shares outstanding number to compare it to the stock pricec (or we use the intrinsic value and compare it to the market capitalization without having to divide the intrinsic value). So I’ll use the per-share number and stick to it from now on.
2018 free cash flow per share = 11.5$
2013 free cash flow per share = 6.5$
(I mostly use the last five years to calculate the historic growth rate, sometimes the last three years when there was a misleading high or low number in one year).
Now, we need to calculate the historic annual growth number between 2013 and 2018 for Apple. To do this we have to insert the historic cash flow per share numbers into this formula:
CAGR (annual growth rate) = [(last number / first number) ^1/years]-1
In words: The result of cashflow of the end year divided by the cashflow of the start year to the power of (1 divided by the years between the start cashflow value and end cashflow value). The result minus 1.
Let’s plug in the numbers from our Apple example:
[(11.5$ / 6.5$)] ^1/5]-1 = 0.12 = 12%
In our example we get 0.12 i.e 12% as the result of our historic growth rate. That means that Apple’s cash flow grew 12% annually in the past five years.
Now we have to decide whether Apple is able to grow its cash flows at 12% annually over the next five years. Due to iPhone sales growth declining and the overall saturation of the laptop, tablet and smartphone market I would rather use a growth rate of about 8% annually for the next five years. Sometimes this decision can be just your gut feeling and your individual number can be different from mine, but make sure that the number stays around the historic growth rate and is not to optimistic or pessimistic — but staying conservative here is safer than being too optimistic.
Having our estimated future cash flow growth rate of 8% we can now calculate the future cash flow per share numbers for the next five years (2019–2023):
2019: 12.4$ (= 11.5$ * 1.08)
2020: 13.4$ (=11.5$ * 1.08²)
2021: 14.5$ (=11.5$ * 1.08³)
2022: 15.7$ (=11.5$ * 1.08⁴)
2023: 16.9$ (=11.5$ * 1.08⁵)
That’s all we need to do in the first step of arriving at the intrinsic value.
2. Discount the cash flows to the present
As of now we’ve calculated and predicted the future cashflows. But because they aren’t worth the same in future as they are know, we have to discount the cashflows and add them together. To do this we need another number, called the discount rate.
This rate is used to discount the cashflows — the higher the discount rate the lower the cash flow number and eventually the lower the intrinsic value.
What number should we use as the discount rate? Well, it’s basically up to you, but I always use 10% as my discount rate. Many people advise that the discount rate should be the risk free rate or rather the minimum return you want from your investments. So the discount rate could be the bond yield, because bonds are basically risk free and you want your stocks to at least return the risk free rate.
Many business schools teach you a CAPM model and other models to calculate the discount rate, but that leaves you a different discount rate for different companies due to increased risk of for example tech stocks. But I use always the same 10% as my discount rate, because I can only compare many companies from different industries when the discount rate stays always the same (and as I’ve read and interpret Buffett’s statements, he also thinks like this).
You may ask why exactly 10%? Well, I’ve tried some numbers and I generally realized that I get the best and most accurate results with the 10% number. Also, I think that stocks should at least return 10% or more, because the long-term average return of the major indexes like the S&P500 is around 10–12%.
But don’t go in and say that you want a minimal return of 80% and use that number, because you probably won’t find a stock where the intrinsic value is above the market price and taking a 10% number doesn’t mean that the stocks will return 10%, but they will rather (if the predictions are correct) return above 10%. So even though I take the 10% number I have stocks in my portfolio returning up to 180% per year.
So what we have to do now with our forecasted future cash flow numbers is to discount them and add them together.
The formula looks like this:
Discounted cash flows = (CF1/DR¹) + (CF2/DR²) + (CF3/DR³) + (CF4/DR⁴) + (CF5/DR⁵)
Note: CF1 = Cashflow of the first future year (i.e. 2019), CF2 = Cashflow second year in future, etc. ; DR= discount rate
For our example Apple it should look like this:
(12.4$ / 1.10) + (13.4$ / 1.1²) + (14.5$ / 1.1³) + (15.7$ / 1.1⁴) + (16.9$ / 1.1⁵) ≈ 54.5$
We arrive at a value of approximately 54.5$ for Apple. That’s all we had to do in this second step.
3. Calculate terminal value
In order to calculate the terminal value of a stock we need another number. But first, what is the terminal value? The terminal value is an estimated value for the worth of a company when the company would survive forever. Because you know that no company can survive infinitely, you have to understand that the terminal value is just a concept or model that helps us determine the intrinsic value and future worth of a company more accurately.
The number we need I’ve talked about is the infinite growth rate. So that’s a rather hypothetical number, but it’s important for long-term investors. The number should represent the growth rate at which the company would growinfinitely.
I take normally the average GDP growth rate. That’s because a company is probably able to grow as fast as the economy itself. The average GDP growth rate is around 3%.
I have my own simple way to determine the infinite growth rate: I use 2% for very large companies that aren’t growing as much (consumer companies, oil companies, etc.). I use 3% for around 80% of the stocks that I analyze, because I think they’re all able to grow at the GDP growth rate. I use 4% for fast growing future-oriented companies (mainly tech companies).
You can either use my way to determine the infinite growth rate or use your own. But make sure that you don’t choose a high number, because it is very unlikely that a company can grow at let’s say 15% forever. I would advise you to not go over 6% — and that should be your absolute maximum.
I’ve been mostly in the 2–4% range, there may be very very few companies that I think would be able to grow at 5% infinitely. So please stay in the 1–6% range.
Now that we’ve determined our infinite growth rate, let’s look at the general formula for the terminal value.
Note: CF5 = Cashflow from last year in the future (in our example the fifth year); DR = discount rate; IG = infinite growth rate
TV (Terminal Value) = (CF5 * IG) / (DR — IG)
Note: The first IG should be the percentage as a decimal number + 1, so f.ex. 26% is equal to 1.26; The DR and second/last IG number are the percentages as a decimal number without 1, so f.ex. 56% would be equal to 0.56!
Let’s calculate the terminal value of Apple:
TV (Apple) = (16.9$ * 1.03) / (0.10–0.03) = 248.6$
From the calculation above you can notice two things:
That’s all we need. The next step is to calculate the intrinsic value.
4. Calculate intrinsic value
In order to arrive at the final intrinsic value we have to add the discounted cash flows from step two and the terminal value from step three together and discount the result.
Adding the terminal value and the discounted future cash flows from our example stock Apple gives us a value of about 303.1$ (= 248.6$ + 54.5$).
To arrive at the final intrinsic value we have to discount those 303$ to the present. Doing this will get us an intrinsic value of 188$ for the Apple stock.
Formula used: (TV + discounted cash flows) / (discount rate⁵)
Note: We use five in the exponent of the discount rate (=1.10), because we forecasted the cash flows five years into the future.
5. Compare intrinsic value to the price
To use the intrinsic value for our buying decision we have to compare it to the investment’s price (which in our case is the stock price of Apple).
When the intrinsic value is above the stock price that means the stock is undervalued by the market and has upside potential. When the intrinsic value is below the price it means that the stock is overvalued and will sooner or later fall. When the intrinsic value is near or equal to the price that means that the stock is valued fair by the stock market.
This interpretation is only true and fully correct when our estimates and calculations are approximately correct. Whether that is the case will only the future tell us.
*(The article is from April 2019, so the numbers may not be correct anymore)
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