It makes no sense to buy a stock when its intrinsic value is smaller than the current price.
Buffett cautions: "The calculation of intrinsic value, though, is not so simple .... intrinsic value is an estimate rather than a precise figure."
Computing Intrinsic Value
Individuals differ from one another in assessing companies' future prospects. They also differ in their risk tolerance. Hence, it should be no great leap to accept that there is no unique intrinsic value that can be assigned to a common stock upon which everyone will agree. In computing intrinsic value, you should start by examining a company's balance sheet.
- Some assets, such as cash and investments in marketable securities, are reported at market value. As a first approximation, the intrinsic value of such items can be taken to be the same as their market values.
- For most companies, however, the major component of intrinsic value comes from their future earnings.
Valuation of future earnings
For valuation of future earnings, you can
- Start with estimating a growth rate based on your evaluation of the company's past performance.
- Then you can apply the estimated growth rate to current earnings to approximate expected earnings for a future year, say, 10 years from the current year.
- Finally, apply a P/E multiple to the future earnings per share to estimate the value of those earnings in the future and discount them to their present value.
- In addition, dividends should be properly accounted for.
While it is a simple approach, it requires many assumptions.
- For example, you may have to adjust reported earnings in an attempt to obtain underlying or sustainable earnings.
- You also need to assume a growth rate, a P/E multiple, and a discount rate.
It is important to learn a lot about the company so that you may consider the appropriate method for computing its intrinsic value. You should invest only when the margin of safety is high.
Company A: This is easy to evaluate because most of its assets are in marketable securities. Earnings play a limited role in this company's intrinsic value.
Company B: This company's value is driven primarily by its earnings.