1. How to derive the intrinsic value of an asset?
Discounted cash flow DCF analysis can be used to value any asset, including stocks, bonds and real estate.
The present value PV of an asset is the discounted value of all its future cash flows.
This PV is also the intrinsic value of the asset.
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2. What are the steps in DCF analysis to derive intrinsic value of a stock?
DCF analysis is predicated on the premise that a share of stock must be worth the present value of all the future cash flows it is expected to generate for the investors.
This begins by estimating what those future cash flows will be. There is tremendous potential for error here.
Once the projected cash flows are estimated, they have to be discounted back to the present in order to determine what they are worth in current dollars.
The discount rate itself is a function of the general level of interest rates in the economy and the risk of an investment.
Those who are willing to apply themselves and learn how to conduct a proper DCF analysis give themselves a distinct advantage over those who do not want to bother to learn the technique.
----
3. What cash flows projections are used in a DCF analysis to calculate intrinsic value of a stock?
There is more to cash flows than dividends. The cash flows do not actually have to be paid out to the investors to be included in a DCF analysis.
The shareholders have rights to the cash flows whether or not they actually receive them. These cash flow might be reinvested in the company, but technically they belong to the shareholders. Therefore, a proper DCF analysis must include all the cash flows, whether they are paid out to investors or retained within the company and reinvested.
----
4. Why is the DCF analysis the preferred method Buffett uses to calculate the intrinsic values of his stocks?
Conducting a proper DCF analysis is as much art as it is science.
However, Buffett relies on this methodology because he knows that it is the only theoretically correct way to determine what a stock is worth.
The ability to make good projections is what distinguishes Buffett from other investors. Buffett excels at this game.
Buffett finds undervalued stocks using the DCF approach. Fortunately, conducting a DCF analysis is not easy. It is also one of Buffett's favorite ways to spot undervalued stocks.
-----
5. What is the difference between value stocks (low price multiple e.g.low PE, low P/B, low P/CF, or P/S) and undervalued stocks?
Buffett may have a general preference for value stocks over growth stocks, but only because value stocks are more likely than growth stocks to be undervalued. It would really be more accurate to call Buffett an "undervalued" investor.
The point is that when he says he likes to buy cheap stocks, he is not talking about price multiples. Instead, he is talking about discounting cash flows to find stocks with intrinsic values that are greater than what he would ahve to pay for them in the market.
Thus, Buffett is not really looking to buy cheap stocks at all. Instead, he is looking to buy stocks cheap.
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Buffett likes to control risk. He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows.
Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it.
-----
A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk. Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.
Analysts and academics have criticized Buffett for this. They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued. Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities. Buffett stands guilty as charged, yet his track record speaks for itself.
-----
10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock
Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.
For many businesses, it is difficult to calculate this with a level of precision that has much utility.
Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.
Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.
The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.
In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.
A no-growth business also earning $1 million would be worth about 10 times earnings.
Business 1: $1 million / (10%-6%) = $25 million
Business 2: $ 1 million / (10%) = $10 million
As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.
Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.
You should carefully think about each of these and add them to your checklists for evaluating a business.
I’ve put Gurley’s characteristics in the form of a question.
1. Does the business have a sustainable competitive advantage (Buffett’s moat)?
2. Does the business benefit from any network effects?
3. Are the business’s revenue and earning visible and predictable?
4. Are customers locked in? Are there high switching costs?
5. Are gross margins high?
6. Is marginal profitability expected to increase or decline?
7. Is a material part of sales concentrated in a few powerful customers?
8. Is the business dependent on one or more major partners?
9. Is the business growing organically or is heavy marketing spending required for growth?
10. How fast and how much is the business expected to grow?
Written by Greg Speicher
Discounted cash flow DCF analysis can be used to value any asset, including stocks, bonds and real estate.
The present value PV of an asset is the discounted value of all its future cash flows.
This PV is also the intrinsic value of the asset.
----
2. What are the steps in DCF analysis to derive intrinsic value of a stock?
DCF analysis is predicated on the premise that a share of stock must be worth the present value of all the future cash flows it is expected to generate for the investors.
This begins by estimating what those future cash flows will be. There is tremendous potential for error here.
Once the projected cash flows are estimated, they have to be discounted back to the present in order to determine what they are worth in current dollars.
The discount rate itself is a function of the general level of interest rates in the economy and the risk of an investment.
Those who are willing to apply themselves and learn how to conduct a proper DCF analysis give themselves a distinct advantage over those who do not want to bother to learn the technique.
----
3. What cash flows projections are used in a DCF analysis to calculate intrinsic value of a stock?
There is more to cash flows than dividends. The cash flows do not actually have to be paid out to the investors to be included in a DCF analysis.
The shareholders have rights to the cash flows whether or not they actually receive them. These cash flow might be reinvested in the company, but technically they belong to the shareholders. Therefore, a proper DCF analysis must include all the cash flows, whether they are paid out to investors or retained within the company and reinvested.
----
4. Why is the DCF analysis the preferred method Buffett uses to calculate the intrinsic values of his stocks?
Conducting a proper DCF analysis is as much art as it is science.
However, Buffett relies on this methodology because he knows that it is the only theoretically correct way to determine what a stock is worth.
The ability to make good projections is what distinguishes Buffett from other investors. Buffett excels at this game.
Buffett finds undervalued stocks using the DCF approach. Fortunately, conducting a DCF analysis is not easy. It is also one of Buffett's favorite ways to spot undervalued stocks.
-----
5. What is the difference between value stocks (low price multiple e.g.low PE, low P/B, low P/CF, or P/S) and undervalued stocks?
Buffett may have a general preference for value stocks over growth stocks, but only because value stocks are more likely than growth stocks to be undervalued. It would really be more accurate to call Buffett an "undervalued" investor.
The point is that when he says he likes to buy cheap stocks, he is not talking about price multiples. Instead, he is talking about discounting cash flows to find stocks with intrinsic values that are greater than what he would ahve to pay for them in the market.
Thus, Buffett is not really looking to buy cheap stocks at all. Instead, he is looking to buy stocks cheap.
-----
Buffett likes to control risk. He does this primarily by avoiding companies if he thinks there is too much uncertainty about their future cash flows.
Furthermore, because he believes there is little risk in buying companies that have predictable cash flows, he feels comfortable using the so-called risk-free rate to discount their projected cash flows. More specifically, he starts with the yield on U.S. Treasury bonds and makes some adjustments to it.
-----
A more conservative approach would argue for the use of a higher rate - in particular, one that properly reflects the stock's market-related risk. Buffett believes he does not need to account for risk in the discount rate since he consciously avoids stocks that he considers too risky.
Analysts and academics have criticized Buffett for this. They say that by using a discount rate that does not properly reflect risk, he is more likely to erroneously conclude that an overvalued stock is undervalued. Furthermore, by ignoring companies whose cash flows are difficult to understand, he is likely to miss out on great investment opportunities. Buffett stands guilty as charged, yet his track record speaks for itself.
-----
10 Essential Questions to Ask When Deciding What Multiple to Pay For a Stock
Buffett has correctly pointed out that the correct way to value a business is to calculate the discounted value of all its future cash flows. The concept is simple. The application is not.
For many businesses, it is difficult to calculate this with a level of precision that has much utility.
Some businesses are sufficiently predictable that a careful business analyst can make a reasonable and useful calculation of its DCF, or what Buffett calls its intrinsic value.
Also, sometimes in periods of extreme dislocation, a business will sell at such a depressed price that you can reasonably conclude that the market price is below intrinsic value, even if the range of possible DCFs is large.
The multiple at which a stock trades is nothing more than a shorthand proxy for its DCF.
In Buffett’s 1991 letter to shareholders, he concluded that, assuming a discount rate of 10%, a business earning $1 million of free-cash and with long-term growth prospects of 6% would be worth $25 million or 25 times earnings.
A no-growth business also earning $1 million would be worth about 10 times earnings.
Business 1: $1 million / (10%-6%) = $25 million
Business 2: $ 1 million / (10%) = $10 million
As a practical matter, what types of things should you be thinking about when deciding if you are dealing with a company that deserves a multiple of 25 times earnings versus one that only deserves a multiple of ten times earnings. There are many factors to consider.
Venture capitalist Bill Gurley has written an excellent list of characteristics to consider when evaluating a company and determining what multiple to use when valuing its earnings.
You should carefully think about each of these and add them to your checklists for evaluating a business.
I’ve put Gurley’s characteristics in the form of a question.
1. Does the business have a sustainable competitive advantage (Buffett’s moat)?
2. Does the business benefit from any network effects?
3. Are the business’s revenue and earning visible and predictable?
4. Are customers locked in? Are there high switching costs?
5. Are gross margins high?
6. Is marginal profitability expected to increase or decline?
7. Is a material part of sales concentrated in a few powerful customers?
8. Is the business dependent on one or more major partners?
9. Is the business growing organically or is heavy marketing spending required for growth?
10. How fast and how much is the business expected to grow?
Written by Greg Speicher
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