 What Is Intrinsic Value Of A Stock

In An Owner’s Manual that Warren Buffett sends to all new Berkshire Hathaway investors, he wrote that the intrinsic value of a stock is “the discounted value of the cash that can be taken out of a business during its remaining life.

Question 1. What do we mean by the cash that can be taken out of a business?

Question 2. How fast is this cash growing and for how long?

Question 3. What discount rate should we use?

The simplest answer to Question 1 is that “cash” refers to dividends. Obviously this does not work for companies that are expected to pay low or no dividends. Berkshire Hathaway is an excellent example of such a company. It has never paid dividends and, so long as Warren Buffett is in charge, it is unlikely that it will.

A better interpretation of cash is earnings, or earnings per share if we are working at the level of individual shares. But even this has drawbacks since earnings are the result of much accountancy processing such as making adjustments for depreciation.

The Usual Meaning of Cash Is Free Cash Flow

Free cash flow is defined as earnings plus depreciation and amortization less capital expenses. If necessary further adjustments are made for increases in working capital and tax allowances.

Note that we do not assume that the free cash flow actually gets paid directly to the investors. Rather, it is assumed that the free cash flow eventually ends up in the pockets of the investors through dividends and capital gains.

Determine The Intrinsic Value Of A Stock

Estimating the rate and duration of growth of the free cash flow is the heart of successfully determining the intrinsic value of a stock.

The three main approaches are the stable growth model, the two-stage model and the three-stage model.

The stable model assumes that the free cash flow grows at a constant rate. For how long? The standard answer is for the long term which, when inserted into the formulas, means running out to infinity. A little weird, but the formulas are simpler this way.

The two-stage model assumes that the company grows at a fast rate in an initial period and then at a stable rate after that. The three-stage model adds a transition period where the growth rate tapers from the initial rate to the long-term stable rate.

Estimating the size and duration of these growth rates uses past earnings, analyst forecasts and fundamental data. The third question concerns the discount rate. For Buffett it is very simple. He says that he only invests when there is no risk so he discounts using the risk-free rate. The more standard approach is to use the Capital Asset Pricing Model. For the average U.S. stock the CAPM gives a discount rate of around 4-5% above the risk-free rate.

The goal of a value investor like Buffett, is to determine the intrinsic value of a stock and then buy stocks that are undervalued and sell them when they are overvalued.