How to Calculate the Intrinsic Value of a Stock (Full Example)

warren buffett says the three most important words in investing are margin of safety and it's no doubt the margin of safety is an integral concept used extensively by value investors both past and present we're talking people like charlie munger warren buffett benjamin graham monish prabrai guy spear peter lynch phil town heck seth clarman's book is literally called margin of safety so for us aspiring value investors it's probably a good idea for us to learn about the concepts of marginal safety make sure we're actually using that in our investing approach however i find the problem is most investors out there most aspiring investors have never learned firstly how to calculate intrinsic value for a certain business and thus don't understand how to apply the principles of margin of safety in their own investing so i want to fix that by the end of this video i hope that you have all the skills you need to be able to calculate the intrinsic value of any company you look at and thus work out what a fair margin of safety price is for that business so let's get started [Music] all right so firstly to be able to talk about the margin of safety which is so integral to warren buffett's investing approach and so integral to his ongoing success as an investor we first need to be able to understand how to find the intrinsic value of a business the intrinsic value is simply the fair value of the business it's what the business is actually worth now a quote that warren buffett commonly uses that he pulls from the theory of investment value by american economist john burr williams is the intrinsic value of any stock bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset where in this case the asset is the business so the intrinsic value of a business is quite simply the present value of all the future cash flows of that business added together so if you imagine you are the entire you're the whole owner of this business you are the only owner okay you own the whole thing then to work out the businesses intrinsic value then you need two pieces of information you need to know how much cash is that business going to make for you in the future you need to know what are those future cash flows worth to you standing here today so firstly the amount of cash that a business makes for its owners is called the owner's earnings and the way you actually calculate what the owner's earnings is for a business in a particular year is you turn to the cash flow statement you take the operating cash flow and then you subtract the maintenance capital expenditure the operating cash flow sometimes called cash flow from operating activities is quite simply the amount of cash that the business operations of this particular company produced in that time period and then the maintenance capital expenditure is quite simply the amount of money going out simply to maintain and keep the business in its current competitive position now the owners earnings is the most accurate number to use for these calculations however the annoying thing is that while companies don't have to report their maintenance capital expenditure some do some great companies do report that which is very helpful but most don't so a lot of investors instead of using maintenance capital expenditure they just use total capital expenditure so that is the purchase of property plant and equipment on the cash flow statement and that just includes yes the maintenance capital expenditure but it also includes all the capital expenditure used for growing the business and for the simplicity of the calculations we'll also use free cash flow for these calculations technically using free cash flow is more conservative however in being more conservative it's also slightly less accurate however another advantage of using free cash flow as i was just talking about before is that you can work it out from any cash flow statement so it's very it's a very easy number to find within the financial statements it's simply operating cash flow minus purchase of property plant and equipment so with all that said how do we actually find the intrinsic value of a business well for this example we're going to imagine we're going to try and buy the local corner store which just sells snacks and drinks now over the past 10 years this is what the free cash flow has looked like each and every year for this corner store business and if you happen to notice well just perfectly happens that each and every year the free cash flow of this business grows by 10 how's that for consistency so now what we're going to do is we're going to take the most recent free cash flow number and take that growth rate which is proving to be very consistent 10 growth and we're going to grow that free cash flow again by 10 each and every year for 10 years out into the future then we're going to assume that after that 10th year we're going to be able to sell the business for 10 times its free cash flow so if we put all those numbers into a spreadsheet this is what it looks like so surely the intrinsic value of the business to us is just us adding together all of these cash flows we just add them all together and then that's the value of the business to us that's the cash flow that we're going to receive as the owners not quite if we're looking to make this purchase right now here and today the reason that it's not quite the intrinsic value is because the cash flows that we're going to receive in say the seventh year of ownership or the eighth year or the ninth year of ownership those cash flows are not as valuable to us as the cash flows that we're going to receive say next year or the year after that and the reason they're not as valuable to us is because it's going to take a long time before we actually receive those cash flows there those cash flows are going to happen far out into the future and of course there's a time value of money if you ask me whether i wanted ten dollars now or ten dollars in a year from now i'm always going to take the ten dollars now because what i can do is i can take that ten dollars put it to work and in a year's time i can make that ten dollars into eleven dollars right so i'm one dollar better off so i'm always going to take the money sooner so with that idea we have to take the future cash flows of this business and discount them to what they're actually worth to us today and we're going to discount it by 15 annually because that's what we want to achieve with our investing so if we go ahead and we discount all of these future cash flows by 15 annually this is what the table now looks like now we also discount that one-time cash flow that we're going to get by selling the business in 10 years for 10 times its free cash flow and then after that we've now got the present value of all the future cash flows of this investment so the intrinsic value of the business to us today is all of these cash flows simply added together so in this case the corner store has an intrinsic value of about 306 000 so if we were to go and meet with the owners and make them an offer for three hundred and six thousand dollars for their business it is likely that we're going to get 15 returns running that business assuming it grows as free cash flow 10 annually when you get 15 returns every year for 10 years however if the business owners turned around and said no no we don't we want 500 000 for the business obviously our return is going to be much lower if the business owners are just desperate to move on and get rid of this business they say look just take it for 200 000 seriously i want it gone then obviously we're going to make a much higher return but overall for 15 returns each year 306 000 is the intrinsic value for that business now here's the thing the stock market each and every day gives us the price of thousands and thousands of businesses right we can look at the market capitalization of each business and work out what that whole business is currently being sold for now that's a really big advantage to us because what it means is it means we can go into these companies financial statements calculate the intrinsic value for that business and then compare it to that company's current market capitalization to see whether it's trading at its intrinsic value whether it's trading at a premium to its intrinsic value or whether it's trading under its intrinsic value but the thing is all of the calculations that we've done to try and work out intrinsic value it's just guesswork it's taking an educated guess yes we can minimize the risk of our guessing being incorrect by finding you know businesses with an economic moat or you know a very predictable consistent history of financial data but we have to acknowledge that there's always going to be things that could potentially happen to any old business in the future that we simply can't foresee and that we simply can't control i mean what if there was say a fire in the corner store and it meant that the business just had to stay closed for a year as it got repaired or you know what if a juice bar opened up right next door to our business and that decreased our drink sales by 50 percent now these situations might be unlikely but it shows that all of our estimations can't be a hundred percent relied upon okay it's kind of like travis cloak lining up for a set shot 10 meters out directly in front it's probably going to go through but you're not a hundred percent certain and because our estimations of future cash flows can't be a hundred percent certain then our estimates of intrinsic value also isn't a hundred percent certain so to account for this we need a margin of safety so we don't buy our business at our calculated intrinsic value because then even if we're slightly wrong in our intrinsic value calculations that's going to have a real impact on our returns so what we need to do is we need to give ourselves a buffer a safety buffer a margin for error or a margin of safety benjamin graham writes this about the margin of safety the function of the margin of safety is in essence that of rendering unnecessary and accurate estimate of the future seth clarkman says a margin of safety is necessary because valuation is an imprecise art the future is unpredictable and investors are human and do make mistakes so what we do is we take our intrinsic value and then we shave a little bit off of it just to give ourselves a margin of safety a buffer for being wrong in our estimations so if we calculated the intrinsic value of that corner store to be 306 000 we might only offer the owners say 200 000 or 250 000. so we only buy a business once it's being offered to us below its intrinsic value but how far below intrinsic value well this is where it's kind of up to you for example experienced investors which are highly confident in the predictability of future cash flows of business they might opt for say a 20 or 30 percent margin of safety but potentially if you're a new investor or you're investing in a company that's maybe a little bit more risky a little bit less predictable then you might opt for say a 50 margin of safety now don't get me wrong a 50 margin of safety is very difficult to come by and if you're looking in the current market it's unlikely that you're going to find any businesses at a 50 margin of safety however that's the mentality that we have to go in as investors we sit patiently we wait our turn until the businesses that we've been analyzing do get presented to us by the market at a price that is well below intrinsic value that does give us that margin of safety because if you invest in a business at a 50 margin of safety you can be very very wrong in your predictions of the future for this business and you'll probably still end up with say a 15 return annually so that's an absolute gold mine opportunity if you can find it so that is how you take a lot of the risk away when you're buying into a business you take a lot of the risk of downside away by making sure you're only buying at a margin of safety share price now lastly i wanted to flick over and have a look at this illustration now as i put this illustration up on the screen from what we've spoken about in this video you should now be confident in being able to interpret this chart and explain exactly what it means so what this chart is showing is firstly here is the price of the business this is what the stock market offers the business to us at and of course that fluctuates every single day there's a new price there's a new price that the market is offering to us for the shares of that company then here we have the intrinsic value of the business which is what we calculated from our discounted cash flow analysis where we added together the sum of all future cash flows to figure out what the business is worth to us as the sole owner then as we can see in this chart the price of the business eventually cuts down and touches the intrinsic value but of course that's not our buy trigger it's good to see that the price has now equaled the intrinsic value but that doesn't necessarily mean we buy just yet because of course what we're talking about we need that buffer that buffer for us potentially being a little bit wrong in our predictions of the future and our predictions of what intrinsic value actually is so as you can see when the share price or the the market price for the business continues to fall let's say this line is you know 30 percent under the intrinsic value then once it crosses down underneath that line then that is our sweet spot that is our gold mine opportunity and that is when we decide we want to buy into this business we've done our due diligence we firstly understand the company we know the company has a great competitive advantage we've checked out the management team they're running the company with skill and integrity okay the management of the company has really low debts and then we've finally got that last key ingredient we are now able to buy this company at a discount to its intrinsic value and we've got the margin of safety and that protects our downside risk quite substantially and this is really the key ingredient as to why all of those notable investing names that i mentioned earlier have proven themselves to be great investors decade after decade after decade it's because quite simply they don't get frazzled by the current market situation and oh don't want to miss out on this hot stock or anything like that they stay perfectly rational and they wait for opportunities where they buy great businesses at this situation where they are at that margin of safety share price where there's a lot of upside and there's very little downside so overall guys i hope that has helped you i hope that you've learned something from this video if you did i'd really appreciate it if you left a like on the video if you'd like more examples and full run throughs of the discounted cash flow analysis as well as some other valuation methods then definitely check out profitful links are down in the description this is actually going to be the last day of our new year's sale so if you want to get started with your investing and you want to hop on board check out introduction to stock analysis that'll be the course for you it's on a great discount at the moment if you wanted to pick it up and that discount will probably be gone tomorrow so act quickly if you want it this will be the last time we do a big sale on profitable for a fair while so if you want to get in get in now but apart from that guys thank you very much for watching i really appreciate it i hope you enjoyed the video i hope you learned something from it and i'll see you guys next time [Music] [Applause] [Music] [Applause] [Music] [Applause] [Music] [Applause] you

Channel: New Money

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Keywords: stock market, intrinsic value, how to calculate intrinsic value, margin of safety, warren buffett, peter lynch, benjamin graham, discounted cash flow, stock valuation, intrinsic value calculator, investing for beginners, value investing, intrinsic value formula, intrinsic value of a stock, how to value stock, how to value a stock, how to find intrinsic value, intrinsic value explained, when to buy a stock, intrinsic value calculation, value investing warren buffett

Id: l-T-Vyk2txc

Length: 16min 46sec (1006 seconds)

Published: Wed Jan 13 2021