HOW WARREN BUFFET DETERMINES A FAIR PRICE

The real secret of Warren Buffett is the methods that he uses, some of which are known from his remarks, and some of which are not, that allow him to predict cash flows with some probability.

Various books about Warren Buffett give their explanations as to how he calculates the price that he is prepared to pay for a share with the desired margin of safety.

• Mary Buffett and David Clarke pose a series of tests, based on past growth rates, returns on equity, book value and government bond price averages.
• Robert G Hagstrom Jnr in The Warren Buffet Way gives explanatory tables of past Berkshire Hathaway purchases using a DCF model and owner earnings.

Ultimately, the investor must decide upon their own methods of arriving at the intrinsic value of a share and the margin of error that they want for themselves.

Should investors worry about the possibility that business value may decline? Absolutely.

The possibility of sustained decreases in business value is a dagger at the heart of value investing (and is not a barrel of laughs for other investment approaches either). Value investors place great faith in the principle of assessing value and then buying at a discount. If value is subject to considerable erosion, then how large a discount is sufficient?

Should investors worry about the possibility that business value may decline? Absolutely. Should they do anything about it? There are three responses that might be effective.

• First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. 
• Second, investors fearing deflation could demand a greater than usual discount between price and underlying value in order to make new investments or to hold current positions. This means that normally selective investors would probably let even more pitches than usual go by. 
• Finally, the prospect of asset deflation places a heightened importance on the time frame of investments and on the presence of a catalyst for the realization of underlying value. In a deflationary environment, if you cannot tell whether or when you will realize underlying value, you may not want to get involved at all. If underlying value is realized in the near-term directly for the benefit of shareholders, however, the longer-term forces that could cause value to diminish become moot.

Ref:  Margin of Safety by Seth Klarman

Intrinsic Value Calculator and Spreadsheet Template

http://www.intrinsicvaluecalc.com/

Intrinsic Value Calculator  Value investors actively seek stocks of companies that they believe the market has  undervalued.  They believe the market overreacts to good and bad news, resulting  in stock price movements that do not correspond with the company's long-term  fundamentals. The result is an opportunity for value investors to profit by buying  when the price is deflated. (courtesy of Investopedia.com) Want to estimate the value of a stock? Try this top-rated Intrinsic Value Calculator! Simply enter your stock symbol and click "Submit" to get started. Read more about Value Investing

Enter Stock Symbol and click Submit Enter Stock Symbol  Terms of Use STEP 1:   Input values and click "Calculate Intrinsic Value" Input or Adjust values: Current EPS (TTM) : Where to find EPS(ttm)? Estimated Growth Rate to use: % Where to find growth rate? Future PE To use: View current PE  View historic PEs Current Price $: Where to find current quote? STEP 2:   Review Results Review Results Estimated Intrinsic Value Price: $ Estimated Margin of Safety Value Price: $ 5-Year Return on Investment Capital (ROIC): (A strong business will have a 5-Year ROIC of 10% or greater)    Review Technical Chart View Technical Chart for ; trade on momentum [MACD(17,8,9) and 10-day MA]  Other useful research links: View Key Statistics for  View Historic Equity Growth (Book Value / Share) for  View Historic EPS and Sales Growth for

How is the Estimated Intrinsic Value calculated?
The software determines an estimated growth rate based on the historic EPS and Equity growth rates. It then applies FV (future value) calculations to determine the expected EPS and stock price at some point in the future. It then reverses the calculation using a minimum acceptable rate of return (15%) to determine the intrinsic value in today’s dollars. The MOS price is half of that estimated intrinsic value price. Value investors
believe that risk can be minimized by only investing when the current price falls below the MOS price.




http://www.valuestockmoves.com/spreadsheetinfo.php

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Intrinsic Value Excel Spreadsheet Template

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Calculates the intrinsic value and MOS (margin of safety) for your stocks

Additional notes:

If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.

The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. 

Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar.  The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.

Finance for Managers - Discounted Cash Flow Valuation Method

One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year.  And as the oft-heard saying goes, past performance is no assurance of future results.  If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead.   Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.

We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method:  discounted cash flow (DCF).  The DCF valuation method is based on the same time-value-of-money concepts.  DCF determines value by calculating the present value of a business's future cash flows, including its terminal value.  Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.

For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:

1.  The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow.  They would use EBITDA and make some adjustment for taxes and for changes in working capital.  Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.

2.  Your analysts would then estimate future annual cash flows - a tricky business to be sure.

3.  Next, you would estimate the terminal value.  You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows).  That net figure after taxes will fall into the final year's cash flow.  Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:

Present value = Cash Flow / Discount Rate

Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity).  This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.

4.  Compute the present value of each year's cash flow.

5.  Total the present values to determine the value fo the enterprise as a whole.

We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2).  Our calculated value there is $4,380,100.  (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)

In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business.  All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager.  Such determinations are best left to the experts.  What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.

Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)

               Present Value                  Cash Flows
              (in $1,000, Rounded)       (in $1,000)

Year 1    446.5                               500
Year 2    418.5                               525
Year 3    398.7                               500
Year 4    381.6+2,734.8                 600+4,300

   Total    4,380.1



The strength of the method are numerous:

-  It recognises the time value of future cash flows.
-  It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
-  It accounts for the buyer's cost of capital.
-  It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
-  It is based on real cash flows instead of accounting values.

The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.

When to Buy Any Stock: Consider Margin of Safety

Having computed intrinsic value of a stock, we know that a stock should be purchased only if the market price is below the stock's intrinsic value.

"How MUCH lower should the price be relative to the intrinsic value?"

Think of the margin of safety for any stock as the difference between a stock's intrinsic value and its market price.

If you buy a stock at its intrinsic value, you will have no margin of safety.  

• If everything goes as you assume in your calculations, you will earn an annual rate of return equivalent to the discount rate assumed.
• For example, if you assume a discount rate of 7 percent and purchase the stock at intrinsic value, your annual rate of return will be 7 percent.  

If the same stock is purchased at 25 percent below the intrinsic value, 

• the calculations show that the rate of return will be about 10 percent per year.  

And if the stock is at half the intrinsic value, 

• the rate of return will be about 15 percent.  

So it seems logical that you should buy a stock with a large margin of safety.

An alternate way of thinking about looking for a large margin of safety is to require a large discount rate.

Related posts:

Intelligent Investor Chapter 20: Margin of Safety as the Central Concept of Investment

The Intelligent Investor: “Margin of Safety” as the Central Concept of Investment

Value Investing: Provide a Margin of Safety

Everything Buffett Needs to Know, He Learned Right Here

****Price to Earnings Growth Ratio (PEG) Explanation

A great company can be a lousy investment. Always incorporate a margin of safety.

Buying when the price is right.