Value investors prefer to estimate the intrinsic value of a company by looking first at the assets and then at the current earnings power of the company.

At the core of most investment approaches lies the practice of valuations, the techniques by which the real or intrinsic value of a company can be estimated.

Most investors want to buy securities whose true worth is not reflected in the current market price of the shares.

There is general agreement that the value of a company is the sum of the cash flows it will produce for the investors over the life of the company, discounted back to the present.  

In many cases, however, this approach depends on estimating cash flows far into the future, well beyond the horizon of event he most pro-phetic analyst.

Value investors since Graham have always preferred a bird in the hand - cash in the bank or some close equivalent - to the rosiest projection of future riches.

Therefore, instead of relying on techniques that must make assumptions about events and conditions far into the future, value investors prefer to estimate the intrinsic value of a company by looking:
1.  first at the assets and 
2.  then at the current earnings power of a company.  

Only in exceptional cases are they willing to factor in the value of potential growth.  

The market prices reflect the sentiment of the investors. To protect oneself from the volatilities of the market prices, the smart investor needs to understand the value of the business he is investing into.

It is the nature of the market that prices of a stock can be pushed to very low level when the crowd is pessimistic.  On the other hand, the prices of these same stock can be pushed to very high level when the crowd is optimistic.  The reasons maybe fundamental or sentimental.

The market prices reflect thus the sentiment of the investors.  However, the value of a stock is unlikely to change very much during these short periods when the market prices may change drastically.

To protect oneself from the volatilities of the market prices, the smart investor needs to understand the value of the business he is investing into.

More investors lose money when they overpay for the stocks when the crowd is overoptimistic.  Many hold onto losses in unbelievable denial.  This is evident whenever the price of a stock falls.  Why does the price of a stock fall?  Often these investors blame many external factors for the fall, when in fact, the single most important reason is themselves, they overpaid for the stock during period of over-optimism.

How is market value of common stock determined?

Market value is basically determined by investor expectations of future earnings and dividend payments, although the value of assets is also important.

Prices may also be affected temporarily by large transactions creating bid-offer imbalances, by rumours of various sorts, and by public tender offers.

Price target - this information is helpful for getting a sense of what others are thinking about the stock's price.

Price target is a share price analysts say the stock will achieve at some future date.

Analysts often attach a period to the price, such as a one-year price target of $ 18.

The information is more suggestive than quantifiable.

It is helpful for getting a sense of what others are thinking about the stock's price.

Secrets to successful investing

Secrets to successful investing.

1. Know the business well. Do you understand the business?
2. Know the intrinsic value of the business. Is it increasing its intrinsic value consistently?
3. Know the management. Are they with integrity?
4. Know the price. Is the company's price attractive, that is, undervalued?

It is just so simple, everyone can adopt these.

Graham’s basic principles of value investing

Value investing

Value investing is a much used phrase and means, in general terms, buying something for less than it is worth. It can apply to just about anything. You can value invest in shares, in bonds, in property, in postage stamps, in vintage cars. The difficulty is in calculating the value of the thing in which you are investing. In many things (postage stamps, collectible cars etc), the only way that value can be determined at any given time is the price that someone is prepared to pay for the item at at that time. The investor in that asset is, as a result, subject to the opinion of others.

Benjamin Graham proposed a method of calculating the value of a stock and Warren Buffett has both applied and enhanced Graham’s approach.

Benjamin Graham: the ‘father of value investing’

It was Benjamin Graham who applied to the theory of investing the concept ofintrinsic value. According to Graham, if you can determine the intrinsic value of a share, then you can ascribe to that share a real value that is not dependent upon the opinion of others (the whims of Mr Market). If you can then buy that share at a price less than its intrinsic value, giving yourself a satisfactory margin of safety, you have made a prudent and rational investment. An investor who holds a diverse portfolio of stocks acquired by this process should, over time, finish ahead.

Benjamin Graham did not apply the term value investment to this investment approach; that has been done by others. He did however called this intelligent investing, indeed the only real form of investing. Buying shares on the basis of value is investing. Buying shares on other bases such as the belief that the market will rise generally, or that a particular industry is good, or that others will bid the price up, is not investment but speculation.

Graham’s basic principles of value investing

In The Intelligent Investor, Graham sets out his strategies for making investments based on value for various types of investor – passive and active, defensive and enterprising – but each approach rests on these basic principles:

• When you buy a stock, you are buying a share in a business.
• The market price of a stock is only an opinion of the value of the stock and does not necessarily reflect the real value of that stock.
• The future value of a stock is a reflection of its current price.
• An investor must always build a margin of safety into the decision to buy a stock.
• Intelligent investing requires a detached and long term approach, based on careful research and reason, and not on the opinions of others or the prospects of short term gains.

Warren Buffett Intrinsic Value Calculation

How do we determine the intrinsic value of a company?

"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

"As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures." - Warren Buffett

Benjamin Graham and his profound investment principles

Graham had become well known during the 1920's.  At a time when the rest of the world was approaching the investment arena as a giant game of roulette, he searched for stocks that were so inexpensive they were almost completely devoid of risk.  

One of his best known calls was the Northern Pipe Line, an oil transportation company managed by the Rockefellers.  The stock was trading at $65 a share, but after studying the balance sheet, Graham realized that the company had bond holdings worth $95 for every share.  The value investor tried to convince management to sell the portfolio off, but they refused.  Shortly thereafter, he waged a proxy war and secured a spot on the Board of Directors.  The company sold its bonds off and paid a dividend in the amount of $70 per share.

When he was 40 years old, Graham published "Security Analysis", one of the greatest works ever penned on the stock market.  At the time, it was risky; investing in equities had become a joke [the Dow Jones had fallen from 381.17 to 41.22 over the course of three to four short years following the crash of 1929]. It was around this time that Graham came up with the principle of "intrinsic" business value - a measure of a businesses' true worth that was completely and totally independent of the stock price. Using this 'intrinsic value', investors could decide what a company was worth paying for - and make investment decisions accordingly.  His subsequent book, "The Intelligent Investor" [which Warren celebrates as "the greatest book on investing ever written"] introduced the world to Mr. Market - the greatest investment analogy in history.

Through his simple yet profound investment principles, Graham became an idyllic figure to the twenty-one year old Buffett. 

http://beginnersinvest.about.com/library/titans/nwarrenbio.htm

Buffett allocates funds in ways that build per share intrinsic value.

At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses.  As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses.  What's left, they send to Charlie and me.  We then try to use those funds in ways that build per-share intrinsic value.  Our goal is to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.

Warren Buffett: Intrinsic Value and Capital Allocation

Intrinsic Value and Capital Allocation

     Understanding intrinsic value is as important for managers as it is for investors.  When managers are making capital allocation decisions - including decisions to repurchase shares - it's vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it.  This principle may seem obvious but we constantly see it violated.  And, when misallocations occur, shareholders are hurt.     

     For example, in contemplating business mergers and acquisitions, many managers tend to focus on whether the transaction is immediately dilutive or anti-dilutive to earnings per share (or, at financial institutions, to per-share book value).  An emphasis of this sort carries great dangers.  Going back to our college-education example, imagine that a 25-year-old first-year MBA student is considering merging his future economic interests with those of a 25-year-old day laborer.  The MBA student, a non-earner, would find that a "share-for-share" merger of his equity interest in himself with that of the day laborer would enhance his near-term earnings (in a big way!).  But what could be sillier for the student than a deal of this kind?

     In corporate transactions, it's equally silly for the would- be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure.  At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value.  Our approach, rather, has been to follow Wayne Gretzky's advice:  "Go to where the puck is going to be, not to where it is."  As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism.

     The sad fact is that most major acquisitions display an egregious imbalance: They are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer's management; and they are a honey pot for the investment bankers and other professionals on both sides.  They usually reduce the wealth of the acquirer's shareholders, often to a substantial extent.  That happens because the acquirer typically gives up more intrinsic value than it receives.  Do that enough, says John Medlin, the retired head of Wachovia Corp., and "you are running a chain letter in reverse."    Over time, the skill with which a company's managers allocate capital has an enormous impact on the enterprise's value.  Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally.  The company could distribute the money to shareholders by way of dividends or share repurchases.  Often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense.  That's like asking your interior decorator whether you need a $50,000 rug.

Warren Buffett: Book Value and Intrinsic Value

Book Value and Intrinsic Value

     We regularly report our per-share book value, an easily calculable number, though one of limited use.  Just as regularly, we tell you that what counts is intrinsic value, a number that is impossible to pinpoint but essential to estimate.

     For example, in 1964, we could state with certitude that Berkshire's per-share book value was $19.46.  However, that figure considerably overstated the stock's intrinsic value since all of the company's resources were tied up in a sub-profitable textile business.  Our textile assets had neither going-concern nor liquidation values equal to their carrying values.  In 1964, then, anyone inquiring into the soundness of Berkshire's balance sheet might well have deserved the answer once offered up by a Hollywood mogul of dubious reputation:  "Don't worry, the liabilities are solid."

     Today, Berkshire's situation has reversed: Many of the businesses we control are worth far more than their carrying value.  (Those we don't control, such as Coca-Cola or Gillette, are carried at current market values.)  We continue to give you book value figures, however, because they serve as a rough,  understated, tracking measure for Berkshire's intrinsic value. 

     We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.  Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move.  Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

     To see how historical input (book value) and future output (intrinsic value) can diverge, let's look at another form of investment, a college education.  Think of the education's cost as its "book value."  If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job.

     For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value.  First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education.  That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day.  The dollar result equals the intrinsic economic value of the education.

      Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn't get his money's worth.  In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed.  In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.

     Now let's get look at Scott Fetzer, an example from Berkshire's own experience.  This account will not only illustrate how the relationship of book value and intrinsic value can change but also will provide an accounting lesson.  Naturally, I've chosen here to talk about an acquisition that has turned out to  be a huge winner.

    The reasons for Ralph's success are not complicated.  Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.  In later life, I have been surprised to find that this statement holds true in business management as well.  What a  manager must do is handle the basics well and not get diverted.  That's precisely Ralph's formula.  He establishes the right goals and never forgets what he set out to do.  On the personal side, Ralph is a joy to work with.  He's forthright about problems and is self-confident without being self-important.   He is also experienced.  Though I don't know Ralph's age, I do know that, like many of our managers, he is over 65.  At Berkshire, we look to performance, not to the calendar.  Charlie and I now keep George Foreman's picture on our desks.  You can make book that our scorn for a mandatory retirement age will grow stronger every year.

How do you value this company OPQ?

I have been looking at this company.  Its business is doing very well.  It has grown its revenues, profit before tax and earnings consistently over many  years.  Its business is growing due to its excellent products and marketing.

Its PBT margin and net profit margins have grown over the years from single digits to double digits.  It latest PBT margin and net profit margins were 17.4% and 13% respectively.  Its ROE is consistently above 30% for many quarters and the last few years.  It DPO ratio averages 70%.

Its latest trailing-twelve months earnings was $110 million and its market capitalisation recently was $ 3200 million.  It is projected that it will probably deliver $130 million in this financial year with a high degree of predictability.

(A)  Calculating the value of this company today.
How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $110 million per year?
3.  Answer:  $110 million / 4% = $2750 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about $77 million.
5.  How much deposit would you need to put in the bank to earn $77 million at present prevailing interest rate of 4% per year?
6.  Answer:  $77 million / 4% = $1925 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 110 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 110 million / (4% - 2%) = $ 5500 million.
12.  With its dividend of $ 77 million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 77 million / (4% - 2%) = $ 3850 million.


To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 2750 million.
- the dividends stream is the equivalent to an asset of $1925 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 5500 million.
- the dividends stream is $ 3850 million.

This company's market capitalization was $ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $1925 million (this price is supported by its dividend yield) and $ 2750 million (supported by its earning yield).

At $ 3200 million, its reward:risk ratio is against the investor as the current price of this company is higher than your calculated intrinsic value of $ 2750 million.

(B)  Calculating the value of this company at the end of this financial year, using (projected earnings and dividends).

However, it is projected that this company will deliver $ 130 million in earnings and at DPO of 70%, $91 million in dividends.

Let's recalculate the values you will place on these earnings stream and dividend streams.

How would you value the earnings and dividends of this company?

Using the thinking similar to that of Buffett:

1.  The risk free interest rate offered by the banks is 4% per year.
2.  How much deposit would you need to put in the bank to earn $130 million per year?
3.  Answer:  $130 million / 4% = $ 3250 million.
4.  This company pays out 70%+ of its earnings as dividends, i.e. about $91 million.
5.  How much deposit would you need to put in the bank to earn $91 million at present prevailing interest rate of 4% per year?
6.  Answer:  $91 million / 4% = $ 2275 million.
7.  A fixed deposit gives you a fixed interest rate of the same amount every year, assuming that the interest rate paid remains unchanged.
8.  On the other hand, this company's earnings are expected to grow quite fast in the coming years.
9.  Assuming that this company can grow its earnings at 2% per year for the next few years, with a high degree of predictability, how would you value this company?
10.  Let's continue with the analogy above.
11.  With its earnings of $ 130 million, growing at 2% per year, you will need to have a fixed deposit of the equivalent of $ 130 million / (4% - 2%) = $ 6500 million.
12.  With its dividend of $ 91million, growing at 2% per year, you will similarly have to have a fixed deposit of the equivalent of $ 91 million / (4% - 2%) = $ 4550 million.

To summarise:

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate as the discount factor, the present values of
- the earnings stream is the equivalent to an asset of $ 3250 million.
- the dividends stream is the equivalent to an asset of $ 2275 million.

When growth is factored into the earnings and dividends stream, even at a low rate of growth of 2% and still using the 4% risk free interest rate as the discount factor, the present values of:
- the earnings stream is $ 6500 million.
- the dividends stream is $ 4550 million.

This company's market capitalization was $ 3200 million recently.  Assuming no growth in the earnings of this company, the value of this company is anywhere between $ 3250 million (this price is supported by its dividend yield) and $ 2275 million (supported by its earning yield), at the end of its financial year..

At $ 3200 million, it is priced close to the calculated intrinsic value for the company in the end of its financial year of $ 3250 million.  There is little margin of safety as demanded by Benjamin Graham in his teaching.  The upside reward = 50 million and the downside risk = 925 million, that is, a reward;risk ratio = 1 : 18.5.

But what if you also factored in the strong growth of this company?  What would be its intrinsic value?

Conclusion:

Since, this company is projected to grow its earnings with a high degree of predictability in the future, will you buy this company at its current price of $ 3200 million?

Those with a short term perspective in their "investing" will realise that the current price has priced in the growth expected for this financial year. 

However, for those with a longer term perspective in their investing, for example 5 years, they will realise that the earnings of this company will continue to grow consistently and predictably.  Considering the earnings growth potential, and including this factor into their calculation of intrinsic value, they may rightly be of the opinion that this company is indeed undervalued.  

Relative versus Absolute Valuation

Dear New Investor,

Take Andy Warhol’s “200 One Dollar Bills” silkscreen for example. This piece of art, which probably cost right around $200 to create sold for a staggering £26 million in late 2009. How can that price be justified?

To start, you could attribute much of the value to the Warhol name. Then you’d probably consider the meaning to the buyer, the piece’s importance relative to other works, and what someone else might pay for it down the road.

Using that same thought process, how would you justify the price tag of, say, £3, £4 or £5 for any particular share? There are many paths to the mountaintop, but all valuation techniques attempt to answer this question.

At Share Advisor, whether we’re looking at an income producing share or the next great growth story, we don’t want to overpay for a share. Not only does this reduce potential future gains – it increases our chances of losing money. That’s why any time we put money into a company’s shares, valuation will be a key part of the process.

Relative vs. Absolute

There are two major schools of thought when it comes to the valuation of shares:

1. Relative valuation: This is by far the most common type of valuation method in the market, for reasons I’ll discuss in a moment. With relative valuation methods, you’re comparing one company’s metrics (price-to-earnings, price-to-book, etc.) versus another company or the industry at large. For example, if there are two equally good companies, but one trades for ten-times earnings and the other for fifteen-times earnings, you would conclude that the company that trades for ten-times earnings is relatively undervalued.
2. Absolute valuation: The point of absolute valuation methods like the dividend discount (DDM) and discounted cash flow (DCF) models is to determine the “intrinsic” or fair value of a company, regardless of how its metrics stack up against competitors at a given time.

While the Share Advisor team may employ some relative valuation methods in our analysis, we’ll largely rely on absolute valuation to make our buy and sell decisions.

The Case For and Against Relative Valuation

According to Aswath Damodaran, a professor at New York University’s Stern School of Business, relative valuation is “pervasive”. He reckons that:

		Almost 85% of equity research reports are based on valuation multiples and comparables.
		More than 50% of all acquisition valuations are based on multiples.
		Rules of thumb based on multiples are not only common but are also often the basis for final valuation judgments.

If this doesn’t scare you, it should.

Why?

Because if most shares are trading at 30 times earnings, relative valuation could make a share trading at 25 times earnings appear undervalued and therefore worth buying.

But if it turns out that all shares are overpriced and should be trading at just 15 times earnings, you might lose money along with everyone else when the market declines. Your share wasn’t undervalued at all.

Despite its flaws, it’s easy to see why relative valuation is prevalent among City traders. Using relative numbers, analysts can always find undervalued shares (ever wonder why analysts can rate so many shares a buy?), and portfolio managers can always justify being fully invested at all times.

Because money managers make their bread by having assets under management, Warren Buffett aside, you won’t find many of them saying, “I can’t find anything to buy, so it’s time to cash out.”

Finally, when your own performance is judged relative to other analysts and portfolio managers, it’s much safer to ride with the herd and make relative valuations. After all, you only need to be marginally better than your peers to become a star. On the other hand, if you deviate from the herd and are proven wrong, you’re often wrong alone and your time as an analyst will likely be short-lived.

To borrow a lesson from childhood, remember that what’s right is not always popular, and what’s popular is not always right.

Sticking to Fundamentals

The inherent volatility spawned by this irrational behaviour creates opportunities for business-focused investors with longer time horizons.

At Share Advisor, we stick to the business fundamentals – think profits and cash flows – to estimate a share’s intrinsic value. By taking this approach though, we implicitly assume three things:

1.		That the market can be irrational in the short term.
2.		That we have something the market doesn’t have.
3.		That the market will eventually correct itself.

I think many people would agree on the first point that the market can be irrational. As for the second point, the individual investor’s greatest advantage over the market is our ability to be patient and remain focused on an investment’s underlying business, regardless of the market’s happy days or temper tantrums.

This type of patience is uncommon. The average holding period for a FTSE share is just7 months, according to a September 2010 speech given by Andy Haldane of The Bank of England. That’s down from eight years in the 1960s.

That’s not investing; that’s trading.

When we buy a share at Share Advisor, we plan to own it for at least three years, or as long as the valuation and business make it worth owning. In fact, the longer our time horizon, the better our chances should be of being proven correct – by giving the market more time to revert to what we regard as the company’s proper value (and meanwhile, a growing, fundamentally strong company should continue to add value).

So as long as we can stay patient, we should have a distinct advantage over other investors.

This leads us to our third point, which is the biggest assumption because it requires a catalyst that’s beyond our control. Whether it’s a positive earnings report, a change in management, or an unexpected event, an undervalued stock can’t reach its fair value without something knocking some sense back into the market.

Admittedly, the longer we need to wait for the market to recognize a company’s fair value, the more trying it becomes to hold onto the position, especially if the share continues to underperform. To resist our human tendencies to follow the herd, we deliberately review our businesses’ fundamentals to determine whether we should keep holding our shares.

Using Share Advisor Valuations

In all of our Share Advisor buy reports, we give you our estimate of the fair value for the company and a preferred price at which to buy the share (though if you can get in lower, that’s generally better). The numbers are our best estimates at the time – so they’re not set in stone. Sometimes following good results our forecast will improve later, and we’ll tell you when that happens, whilst other times it will decline.

There’s no such thing as a precise valuation. Every estimate of fair value is just that – an estimate which attempts to weigh the probabilities of various good and bad scenarios that could befall a company and its shares. Measuring probability accurately is pretty tricky and sticking too tightly to an estimate of value runs the risk of creating a false sense of precision. I would be wary of any analyst that provides you a value estimate down to the pence for a share – it is just unreasonable to expect that level of accuracy from any valuation method.

The uncertainty around our estimates of value is one of the reasons we require a meaningful margin of safety (usually around 20%) from our estimated fair value before recommending a share.

Our preferred buy price isn’t the be-all and end-all either. If a share is trading just above our preferred buy price, that shouldn’t stop you from buying it if you want to – remember, we’re giving you our best estimate of fair value and estimates are fuzzy, so applying overly strict buy limits creates another opportunity for false precision.

By taking a long-term, business-focused approach to valuing shares, we should have a distinct advantage in an irrational market. Over time, we expect it will help us build a diverse portfolio that generates superior income as well as winning returns.

Motley Fool

Two Approaches to Stock Valuation

There are two broad approaches to stock valuation. One is the ratio
based approach and the other is the intrinsic value approach.

If you have ever talked about a P/E ratio, you've valued a stock using
the ratio-based approach. Valuation ratios compare the company's
market value with some financial aspect of its performance--
earnings, sales, book value, cash flow, and so on. The ratio-based
approach is the most commonly used method for valuing stocks,
because ratios are easy to calculate and readily available.


The downside is that making sense of valuation ratios requires quite
a bit of context. A P/E ratio of 15 does not mean a whole lot unless
you also know the P/E of the market as a whole, the P/Es of the
company's main competitors, the company's historical P/Es, and
similar information. A ratio that looks sky-high for one company
might seem quite reasonable for another.

The other major approach to valuation tries to estimate what a
stock should intrinsically be worth. A stock's intrinsic value is based
on projecting the company's future cash flows along with other
factors. You can compare this intrinsic or fair value with a stock's 
market price to determine whether the stock looks underpriced, fairly
 valued, or overpriced.


http://news.morningstar.com/classroom2/course.asp?docId=145096&page=5&CN=COM

The important investment question is how you can estimate true value.

"In the final analysis the stock market is not a voting mechanism but a weighing mechanism."
Benjamin Graham, Security Analysis

Valuation metrics have not changed.

• Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors.  
• In the final analysis, true value will win out.  
• The important investment question is how you can estimate true value.

Markets can be highly efficient even if they make errors.

• Stock valuations depend upon estimations of the earning power of companies many years into the future. Such forecasts are invariably incorrect. 
• Moreover, investment risk is never clearly perceived, so the appropriate rate at which the future should be discounted is never certain. 

Thus, market prices must always be wrong to some extent.

• But at any particular time, it is not obvious to anyone whether they hold only "undervalued" stocks and avoid "overvalued" ones.  
• The fact that the best and the brightest on Wall Street cannot consistently distinguish correct valuations from incorrect ones shows how hard it is to beat the market. 

Buffett's Opinion on Calculation of Intrinsic Value

Try using Free cash flow.
Set a process for identifying future cash flows and based on that try to calculate intrinsic value of a company.

Read what is written by Warren Buffett in his letters to shareholders. 

While writing about Calculation of Intrinsic value in the Owners manual Buffet says...

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. 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.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover — and this would apply even to Charlie and me — will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.

Read owners manual on http://www.berkshirehathaway.com/

Intrinsic Stock Value

When it comes to investing, everyone wants to know what stocks are going to go up. Unless you have the ability to see into the future, you'll have to settle for doing things the old fashioned way: by research them. Even though it may not be possible to be right on all of your stock picks, you can tilt the odds in your favor by learning as much as you can about the stocks you're investing in. One useful tool that you can use to make an educated decision on whether or not to buy a stock is the intrinsic value, which gives you an idea of approximately what the stock is worth.

Valuing a stock is not always very easy to do. Ratios like the P/E ratio give you a quick idea but it doesn't go into depth very well. The intrinsic value makes up for some of what the P/E ratio lacks by accounting for its growth rate and the discount rate. The growth rate allows the intrinsic value (IV) to value the stock not only on their currentearnings per share but also on their future earnings per share. The term "discount rate" refers to the rate that you would have to earn to make an investment worth the risk. By accounting for this, it helps weed out some stocks that may be less lucrative investments.

Calculating the Intrinsic Value

There are actually a few different ways to calculate the IV but we'll just go over the most common method. To get started, you must first gather the company's EPS figures. You then take this number and divide it by the annual return of the investment you are comparing it with (discount rate). For example, if XYZ stock has $3.46 in earnings per share and you want to compare it with 6% treasury bonds, you simply divide 3.46 by .06 to get an intrinsic value of 57.66. This means that XYZ stock has an intrinsic value of 57.66. So this means that, relative to government bonds, the stock is "worth" about $58 per share.

That example only takes into consideration the stock's current earnings. If you are interested in finding out what the stock will theoretically be worth next year, you just substitute next years expected EPS with the current one. So if XYZ stock is expected to earn $3.90 per share next year, you divide 3.90 by .06 which gives you an intrinsic value of $65, relative to government bonds.

Calculating the intrinsic value seems pretty complicated and if you don't like doing all of the math, you can cheat by using Quicken.com's evaluator to have it figure the IV for you.

Using the Intrinsic Value

I know all of this sounds pretty confusing but, trust me, it really isn't. Calculating the intrinsic value is probably the most confusing part. Using it is actually pretty easy. Now that you know what the stock is "worth", you can compare its current stock price with its intrinsic value to decide if it is worth the risk. For example, if XYZ was trading at $45, you would consider it undervalued because its trading at a price that is less than its IV of $58. However, if it was trading at $75 per share, it would be considered overvalued.

The only big disadvantage that the intrinsic value has is that it doesn't allow you to calculate it for stocks that don't have positive earnings. So if you were hoping to figure out the value of that hot new internet stock, you might want to use another method. But, in general, the intrinsic value has very nice advantages over other methods and I've even found it more accurate. By using it, you give yourself one more way to check out a stock to decide if it really is worth the risk.

http://www.teenanalyst.com/stocks/intrinsic.html

Calculation of Intrinsic Value

I have created an excel sheet that could be usefull when calculating Intrinsic values of stocks.
All you have to do is open the excel sheet, and fill in the red numbers in the excel sheet, which you can find on the links next to each box.
Excel will then automatically calculate the intrinsic value of the stock you are analyzing.

If you want to change the ticker, open a hyperlink in a box next to a red number, and change the ticker in the web address.
For example, if you are looking at http://finance.yahoo.com/q/ks?s=PEP+Key+Statistics and you would like to see the data of Coca Cola co. instead of Pepsico, change the ticker from PEP (which is the ticker of Pepsico) to KO (which is the ticker of Coca Cola).
The link to visit then becomes: http://finance.yahoo.com/q/ks?s=KO+Key+Statistics for example.

Method number one is a very simplistic model, which calculates a price target for the next 5 years based on historical valuations, the last 4 quarters results and future growth.
Method number 2 is more advanced, and takes into account Free cash flow, net cash position and future growth.
This method discounts the future values at a discount rate of 9% per year, which is the return you can expect over the long run in the stock market (7% price appreciation per year + 2% dividend yield per year).

To open the excel sheet, please click here: Calculate_Intrinsic_Value

Please be aware that calculating an intrinsic value is not an exact science. It is based on subjective estimates.
The best thing you can do is to use methods used by the biggest value investors in the world, such as Warren buffet, Joel Greenblatt, Monish Pabrai and the likes…

http://profitimes.com/value-investing/calculation-of-intrinsic-value/

How to Calculate Intrinsic Value for Stock Investing

How to Calculate Intrinsic Value

Discounted Earnings, Instead of Just Cash Flow

Summarized Overview

You will find information about why you should calculate intrinsic value in stock market investing, and step by step guide on how to do it.

You will also find information about which key financial ratios to use and what you have to do after calculating intrinsic value.

Why You should Calculate Intrinsic Value

Simply because, you don't buy any stock at any price, do you? Do you know why? Because you want as much return as possible!

The price you are paying is the ultimate determinant for the rate of return that you'll be earning. The higher the price you pay for it, you'll be getting lower rate of return. This is why, you need to know how much a stock worth. Once you know its value, you can identify which stocks are traded at discounted price.

However, buying a stock simply because it is cheap is not the right approach either. This is another reason to calculate intrinsic value. To buy quality stocks at discounted price, value for money right?

How to Calculate Intrinsic Value

The way to go is, search for stocks whose prospects you believe in ( with good stock pick method ) and then use a valuation technique to ensure the purchase price is acceptable. Here, I use net present value (NPV) formula.

How to do it? Let say you are valuing stock ABC,

From 13 years historical data, you get the information as above. To proceed, you also need to firm up your expectation based on your risk profile. In this example:

• I set my investment horizon as long as ten years from 2007. So that in 2018 I can use the fund to finance my children's study
• I am confident stock ABC will continue growing 13 per cent per year for the next ten years (13 years records prove this stock able to grow 13 per cent EPS per year)
• I assume stock ABC will be having the same PER and dividend payout by end of 2017 (or early in 2018)

I am expecting 12 per cent return on investment (ROI) so that my initial investment able to cover my children's tuition costs in ten years time.

Let's start calculating intrinsic value of stock ABC.

Step One: Forecast Share Price

First of all, you need to forecast its share price ten years down the road. In this case, I project the price for the next ten years using 13 per cent per year growth.

Step Two: Forecast Total Future Value

Secondly, you need to calculate the total future value. This must include the potential dividend as well.

Look, some investors doesn't care much about dividend. To them, dividend is just too small to be considered. But as it has effect to the total future value, it should be taken into consideration.

By the end of the day, you can compare the stock's profitability to others; which may not pay any dividend at all.

Step Three: Calculate Intrinsic Value

After having all these data, then only you can calculate the intrinsic value for stock ABC.

Step Four: Compare with Current Stock Price

The intrinsic value above is because my goal is to get 12 per cent per annum from this stock. If so, current stock's price, which is $33.50, is acceptable indeed (stock price is below the intrinsic value).

How Do You Calculate Intrinsic Value? Discounted Cashflow Discounted Dividend Discounted Earnings Never Calculate What For?

But if your goal is about getting 25 per cent per annum return on investment, the intrinsic value will be $22. In this case, the current stock price will no longer acceptable for you.

For this same reason, you can say that current stock price is suit to those who are aiming for 15 per cent return per annum (in economics, this called as Internal Rate of Return or IRR)

What's Next?

As you can see, intrinsic value can be relatively different from one investor to another depending on the expected return. Expecting very high return will limit your investment options. On the other hand, having very low expected return may as well better keep the cash in fixed deposit.

As an investor, it is crucial to set a realistic target on the expected profits.

It is better if before you calculate intrinsic value of your selected stock, assess your own risk profile first. This will help you to determine your realistic preferred return based on your need, ability and investing habits.  Eager to buy stock? Hang on first! You need to have the fair value as another comparison. This is what mention by Warren Buffet's guru, the margin of safety 

http://www.stock-investment-made-easy.com/calculate-intrinsic-value.html

Calculating Intrinsic Value

Security Analysis 401: Calculating Intrinsic Value

By Sham Gad 
August 23, 2007 |

In the previous three articles in this "Security Analysis" series, I discussed the concept ofmargin of safety, explained why you should rely on intrinsic value to make investing decisions, and showed why you want to find great businesses with wide economic moats. Once you've taken those steps and found a business that looks attractive, you next need to determine theintrinsic value of that business, to find out whether a bargain of an investment opportunityexists.

Every business has an intrinsic value. According to John Burr Williams in his 1938 publicationThe Theory of Investment Value, that value is determined by the cash inflows and outflows -- discounted at an appropriate interest rate -- that can be expected to occur during the remaining life of the business.

This definition is painfully simple, but it works. Let's apply it to a couple of businesses so you can see for yourself.

Solid, stable cementCEMEX (NYSE: CX  ) is a Mexican producer and distributor of cement. Competing with the likes of LaFarge (NYSE: LR  ) , it is one of the largest cement players in the world. It produced free cash flow -- cash from operations less capital expenditures -- of about $2.6 billion in 2005 and around $2.75 billion in 2006. Meanwhile, between 2004 and 2005, it grew free cash flow by around 50%, but that same figure was virtually flat from 2005 to 2006. That may give you an inkling that it makes no sense to try predicting a different rate of cash flowgrowth each year. Instead, when attempting to calculate intrinsic value, you should stick to one or two consistent conservative growth rates, although smaller companies starting with a lower base figure can be assigned higher rates of growth. When calculating intrinsic value, I use a 10-year forecast, because I think that's an adequate time period to provide sufficient data, and I apply a 10% rate discount rate, which is equivalent to the S&P 500's historical return.

Cemex, however, is a huge business, and while it may experience some years in whichcash flows grow abnormally, it's more logical when determining its intrinsic value to use a meaningful conservative figure. Always work with a margin of safety.

In this case, it's reasonable to assume that Cemex can grow its free cash flow by 10% for four years. While this growth rate can continue for a longer period, I like to be extra cautious and predict that free cash flows stabilize at a 3% growth rate thereafter. Cemex is a very well-run company, and there will always be a need for cement in the world, so I think 3% free cash flow growth is very achievable.

Let's look at the calculations. Dollar figures are in billions.

Year	Free Cash Flow	Present Value of FCF
2007	$3.02	$2.75
2008	$3.30	$2.75
2009	$3.70	$2.75
2010	$4.02	$2.75
2011	$4.43	$2.75
2012	$4.56	$2.57
2013	$4.70	$2.41
2014	$4.83	$2.25
2015	$4.98	$2.11
2016	$5.13	$1.97

The sum of the present value (PV) of the free cash flows comes to about $25 billion.

Next, you need to determine a terminal value for the business. Conservatively, I assume that Cemex would be worth 10 times its 2016 free cash flow, or $51.3 billion, which has apresent value of $19.7 billion. So by adding all of the PV cash flows together, my estimate of intrinsic value for Cemex comes to about $45 billion. With about 790 million shares currently outstanding, Cemex has a per-share intrinsic value, based on my assumptions, of approximately $57 a share, versus the current stock price of $31.

Does this mean you should back up truck and load up on Cemex? No, even though I do think Cemex is a fantastic company selling at an attractive price. For one, the number ofshares outstanding 10 years from now will surely be a different number from what it stands at today. Assume, for example, that the share count rises to 1 billion shares and the intrinsic value comes down to $45 a share. Then you're talking about a whole different set of numbers.

Most importantly, though, you need to know the business inside and out in order to estimate cash flow growth with a high degree of confidence. The ability to assess the quality and competence of management thus becomes critical. Knowing how management spends company dollars tells you a lot about how much cash the company will produce years down the road. In short, do your due diligence ... and when you are done, do it again.

The hard part

Calculating intrinsic value is simple and straightforward. It's having accurate data that's the difficult part. That's why Benjamin Graham remarked: "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right." That's also why Warren Buffett, the best investor on the planet, spends a lot of time focusing on businesses with durable competitive advantages, such as the brand value that Coca-Cola(NYSE: KO  ) offers, or the monopoly-like industry that American Express (NYSE: AXP  ) operates in.

It's easy to predict future cash flows with a high degree of certainty for businesses like this -- ones that have wide economic moats insulating them from the threat of competition. That gets back to our last discussion. And it shows how all of our discussions tie together to make you a better investor.

http://www.fool.com/investing/value/2007/08/23/security-analysis-401-calculating-intrinsic-value.aspx