Warren Buffett's 4 Rules:
1. Vigilant Leaders
2. Long Term Prospects
3. Stock Stability
4. Undervalued
Non-Predictable Company (Andrew :-) )
- Lots of Debt
- No Long Term Prospects
- Not Stable
- Price ? - Can't be determined due to stability
- Manageable Debt
- Long-term Prospects
- Stable
- Market Price = $44.33 Intrinsic Value = ?
Lesson Objective 1: How do we calculate the intrinsic value of a stock
Lesson Objective 2: How do we use the BuffettsBooks.com intrinsic value calculator
Summary of this lesson
In this lesson, students learned that the intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during it's remaining life. For us, we've defined the life as the next ten years. This way, we can discount that cash by the 10 year federal note. The Cash that we are taking out of the business is simply the dividends and the book value growth during the next 10 years. Since these numbers need to be estimated, it's very important to ensure that Warren Buffett's third rule (a stock must be stable and understandable) is met.
When a company doesn't have a history of linear growth, estimating the cash that they will produce for the next ten years becomes more speculative. When we look at the root of the intrinsic value calculator, it operates off of the same principals as a bond calculator. Instead of using coupons, we substitute dividends. And instead of using par value (or value at maturity) we estimate the book value of the business in 10 years. The value that we use to discount the summation of the cash is simply the 10 year federal note.
Although the previous paragraph might sound confusing to some, it's application is fairly straight forward. The reason Buffett says, "Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures," is due to a difference in opinion of the future cash flows. Since some investors are more conservative than others, their estimates of book value growth or dividend payments may be lower. This will immediately change the intrinsic value. Your job as an intelligent investor is to determine your own tolerance for risk and conservative estimates on how much money you will receive while owning the stock for a 10 year period.
Intrinsic Value Calculator
Source of Quotes: http://www.berkshirehathaway.com/owners.html
"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." - Warren Buffett
Therefore, the sum of cash that can be taken out of the business over the next ten years is going to be the dividends plus the equity growth. The discounted value is the current value of the 10 year federal note. To start, we'll determine how much a company's book value is growing.
"In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value."- Warren Buffett
Click here for the Intrinsic Value Calculator:
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