21. Warren Buffett Intrinsic Value Calculation - Rule 4

welcome to the course to unit 3 lesson 5

warren

buffett

's fourth

rule

for determining the

intrinsic

value

of a stock in this lesson we have two lesson objectives, the first is how we calculate the

intrinsic

value

of a stock and the second is how we use the Buffett

rule

. books Communications Intrinsic Value Calculator, so let's get started. Well, here we are at Warren Buffett's last rule and this is the most complicated rule and that is to determine whether a stock is undervalued or not. In the previous three lessons we were looking at Warren Buffett's Three Previous Rules and we were comparing Sirius XM radio and Disney to understand those rules and those principles, so when we looked at Cirrus, the first rule we looked at was whether the company was managed by vigilant leaders and So we were looking at debt and Sirius had a lot of debt and it didn't meet that rule and as you know from the previous lessons, all four rules must be met for Warren Buffett to invest in one of these. companies, then since that rule was not immediately met, we would have finished analyzing Cirrus and would know that we would not go further in evaluating its value, but we will continue to review the rules in order to write.

To make a comparison now with respect to Disney in the first rule, we looked at their debt and it was manageable over the last ten years; the forecast looked like it was going to be more of the same now regarding the second rule for long-term prospects, then the third rule for XM radio the numbers were not stable, that book value was all over the place, the debt to equity was all over the place, so with Disney we saw a very stable company and something that was very predictable, which is absolutely essential as we go through this lesson where we are trying to Calculate intrinsic value without having a stable company we cannot make a very good estimate of what the profits will be and how much growth the company will have in the next 10 years, so for XM radio I wouldn't even do the intrinsic value.

calculation

for that because the company was not stable, but for Disney we can do that, so let's go ahead and take a look at the rule number to calculate the intrinsic value of the Walt Disney Company and we know that the market price in mid-May. 2012 costs 44 dollars and 33 cents, so we have identified that Disney is a great company, but is it worth the 44 dollars and 33 cents per share?

That's what we're going to find out in this lesson before we find Disney's intrinsic value, I'm first going to start by teaching you how the intrinsic value calculator works if you get lost during this course and that's okay. I have a couple of practical exercises for you to work on and try, so stick with them. I and I believe that everything will work out in the end, so how do we determine the intrinsic value of a company? If you go to Berkshire Hathaway and you read the owner's manual that he has for Berkshire Hathaway, he gives you some clues about how he determines the intrinsic value of a company, so these are some direct quotes from Warren Buffett and he says that intrinsic value is you can simply define: it is the discounted value of the cash that can be withdrawn from a company during its remaining life, okay then?

He goes on to say that, as our definition suggests, intrinsic value is an estimate rather than a precise figure and, furthermore, it is an estimate that must be changed if interest rates move or forecasts of future cash flows to individuals are revised. that analyze the same set of facts. It's almost inevitable that we'll get at least slightly different intrinsic value figures, so keep that in mind as we go through this, the tool in the calculator itself is no different, but the way it evaluates the cash flows in the future you could take a more conservative approach than what I'm showing you and that's fine and when you do you'll get a different intrinsic value using the same calculator, let's say you want to use a different interest rate than the ten year federal note then You're going to get a different intrinsic value, so when we start using the calculator you'll understand why Warren Buffett has this quote because he might view a company a little bit differently than the way you view it with a more conservative perspective. eye or a more liberal eye depending on what future cash flows look like, so what does that mean?

When you say the cash that can be withdrawn from the business over its remaining life, what do you mean by that? When you evaluate the cash that can be taken out of the business, what you are really referring to is if I could take all the profits that the company was going to make for X years during which I would own it, how much would that add up to? and then what you do is you do it for ten years in the future and the reason you do it ten years in the future is because then you can compare the amount that you would collect from the business with that profit over the next ten years. years to what you would earn with a zero risk investment, which would be the ten-year federal note, and so it's only ten years in the future, so this quote might be a little misleading, but as we go a little further more In this lesson you will understand why we are only going to go ten years into the future, so when you look at a business, if you remember the first course with unit one where we talked about EPS or earnings. per share, this is really the magic number, EPS is earnings per share, so let's say we have a dollar fifty of EPS, which is their earnings for a year for a company and we'll just call it company X so that One dollar and fifty cents goes into the profits now, if you remember from that first course, the owner, which is you as a shareholder, has the option to take the first route, which is to keep that money in the corporate bank account and you're going to invest that money back in business or pay your debts or whatever the case may be, but what eventually happens to that money that you would be investing?

We are paying your debts that become more capital or less capital and that will be reflected in the book value because the book value is nothing more than capital per share. Well, if you take option one, let's say that dollar and fifty cents of profits come into the company and you as the owner decide that and you would do it. You wouldn't be the person to decide that actually the Board of Directors and the CEO who runs the company would decide this for you as their representative to run the company, but they would decide whether that adult, that dollar and fifty cents, would become more equity or less capital depending on how they choose to invest it or pay their debts.

Okay, now the second option that the board of directors and the CEO have to take that dollar and fifty cents of profits is that they can simply give you a dividend that they can pay you, okay, so if a company decided to pay out all of its profits in one dividend, one dollar and fifty cents would remain in that bank account and then the managers would decide to pay it to all shareholders. So if you own a stock and you make a dollar and fifty cents in profit, that would be included directly in the dividends, so what you really see with companies is not that they take one option or the other, but they actually take both.

What many companies do is put a part of that $50 in capital and then put another part of the $50 in dividends so they can pay 50 cents in the dividend and $1 in the company's capital, but that total of EPS is being converted into more capital or dividends. When I say equity, I actually mean book value because we're talking on a per share basis, so I use those terms interchangeably, but remember that book value is nothing more. than capital per share, so let's go ahead and look at this for this generic company that we'll call company X and then once we understand how this

calculation

works, we'll go ahead and do it for Disney.

Okay, here we are. and we can see the model there on the left. What we're going to do is look at this company a dollar and 50 cents and we're going to assume that that EPS was the same for ten years in a row and it never changed, it was a dollar 50. each year, so when we see that we look at how the book value changed from 2002 to 2003, the book value increased by 70 cents, okay, and then we look at the dividend and they paid a 30 cent dividend, so if we look at how much money that EPS became 20 cents was added to the book value and 30 cents were paid in the dividend and 50 cents just disappeared, and this is what you will see many times when you go back and look at a company.

Isn't it that all those earnings per share actually materialize into money that shows up in your pocket because, even though you're not actually looking at paying the book value, that capital that's added to the business, you are the market price of your company? generally follows a trend with that book value, so if that book value increased by 70 cents, you will see that its market price will generally trend in the same direction, so as we go from 2003 to 2004, you can see how The book value grew a little more than the previous year and the dividend remains the same, so the company became a little more efficient and that dollar and fifty cents of EP actually went more into your pocket, so As we move forward a year and continue to go down, we can see that the book value continues to grow and in 2012 the book value cleared up to twenty dollars and they are still paying their thirty cent dividend, and the EPS is still the same. , if we added up all the EPS that would have occurred during that ten-year period, we would have had $15.

Okay, then, if all the earnings that company received on one share would end up being fifteen dollars, but when we look at the combination of the book value into the dividend, which we know is the result of our two different choices. It only ended up adding up to thirteen dollars. Okay, you can see that the book value increased by ten and then we just added all of our. dividend payments and that comes to thirteen dollars when we add them up, so over a ten year period we essentially lost two dollars just through the system that this company was operating well, even though that profit was made through the cracks in the system, we lost two dollars in real money that should have gone into your pocket, so when Warren Buffett talks about the cash that can be withdrawn from the business over its remaining life when we look ahead to the next ten years, we can generally assume that this company is going to continue with this efficiency, so the $15 that the EPS represents will not be obtained.

You'd probably only see about $13 if these numbers continued to trend this way for the next ten years, so that would be the cash that $13 takes you out of business, that's what they take you out of business and that's that magic number, so when we plot this on the right side you can see that I plotted the book value from 2002 to 2012. You can see it's a very nice line graph and what we're trying to do when we're trying to calculate the intrinsic value is estimate how this will grow book value in the next ten years, so yes We could put a line right under that graph and just plot it and look at its slope.

We have a general idea, that is, ten years from now we will see how that book value would continue to grow as long as those profits are maintained. constant and you're still making those profits of a dollar fifty or more, we can generally say that this company here, company We can assume And this is the assumption to make every time you try to estimate how much cash you can get out of this business over the rest of its life, which we are doing for an additional ten years. Let's assume that dividend will remain constant at 30 cents a year, $13 was the cash earned over the last ten years, but your job is to estimate how much cash will be taken out of the company over the next ten years, so the value in books is growing. linearly use the slope to predict its future value if dividends stay constant or grow use that slope to predict future payouts and as you can see here stability is everything if you don't have something that is stable how are you going to be? able to predict something like this and the answer is no, but always remember that book value growth and dividends come from EPS, so when we try to figure out what it will do in the next ten years, we always have to look at how they say analysts that EPS will be seen next year in the following year.

There are usually only two years in the future, so always, always look at projected earnings to ensure your estimated cash flows. the future is realistic, so we may have a very steep slopeattractive and everything is linear, then we look at the earnings that the analysts are projecting for next year and they are really low and not even close to where they were. I've been in the last ten years, that's something. You're going to want to run away, you have to make sure that there are profits in the future or that they are very similar to what they have been in the past because that is what will drive the growth of your book value and also that dividend. payment, so let's say we look at the future estimates of company Go ahead and say yes. that book value will probably continue to grow at the same slope that we've seen over the last ten years and they will probably continue to make this dividend payment, so that's how we can go in and ask eight of them what kind of cash we would get from this business over the next ten years , so here's another quote from Warren Buffett and this is straight out of the Berkshire Hathaway owner's manual.

In other words, the percentage change in book value in a given year is likely to be reasonably close to the year's change in intrinsic value and that's exactly what I just taught you, so use it with confidence and make sure that you're using something that's stable and not all over the place because that's going to really throw off your estimates and that's where you assume all your risk is in that lack of stability, so what was the average book value growth of company the last ten years? So let's go ahead and use Buffett's ebooks.com calculator and get going.

Go ahead and use this chart right here and we'll do this for company X and we'll go ahead and estimate how much that book value has grown over the last ten years. Well, right now I have Buffett's books. The calculator that's right below this video has opened, so if you scroll down you can see that the calculator is divided into two different sections and what we're going to use first is the top section and what this top section does is Let's go. to get a very rough estimate of how much that book value is growing annually over that 10 year period so far that we're in, so what we're going to do is put in the current book value first and so when we look there in 2012, the current book value for company just putting in the numbers and when we look at the old book value, that's ten dollars, that's okay because that's where it started in 2002, it was $10 and then the number of years between the book values ​​is 10, that's okay now, if you look up , there are 11 numbers. but there's only 10 years of growth between them, okay, so if you had 10 numbers up there, you'd only use nine years here, so when we hit calculate, it shows you that the average change in book value was seven point one seven percent per year. that book value when we went from 10 to 20 in a 10 year period that was growing at seven point one seven percent now that number is really important because when we look at the next ten years we know that the book value is correct now it is 20, so that gives us a good idea of ​​what we might want to use when estimating how book value will grow over the next 10 years for the bottom calculator.

Okay, now we can move on to this lower calculator and We're going to use that number in this calculator for that the cash that's taken out of the business, so when we say the actual cash that's taken out of the business, we're talking about that dividend. Okay, now in this calculator I have it set up so that the dividend you only have to enter it for one year and then what the calculator will do is add up that dividend payment as if you received it every year for the next ten years, so just enter the dividend payment for one year, so for one year we're going to say you would get a dividend of 30 cents, so you put point three zero in there and then the current book value, the current book value in 2002 is $20, so Let's put 20 in there, the average percentage change in value per year, so this is what we calculated above.

We got seven point one seven, so we're going to go ahead and put seven point one seven because that's what we expect the book value to continue. grow so this is where Warren Buffett says you know two people were going to come up with different numbers because this number here or if you went back to dividends and said well I think 30 cents is maybe a little bit. It's a little high estimate or a low estimate, maybe you can earn a dividend of 35 cents on average over the next ten years. I like to take the most conservative approach possible, so if it's a 30 cent dividend today, I'll use a 30 cent Dividend for the next 10 years because that's a pretty conservative estimate that mine paid out now as far as book value growth, If this number was really high, if it was higher than 15%, I would probably say that the calculator doesn't even work for that. point because it's a growing company and not a stable company, but here I think 7% is a pretty average growth rate, so we're going to go ahead and use 7.7, so this is where the guesswork really comes in. calculation of intrinsic value.

It's a matter of preference, it's a matter of risk, it's something you'll have to tailor to your specific needs, but for this, depending on how flat that line is, I'm going to go ahead and use the 7.17. the years, so this is going to be the next 10 years, so if you're always comparing this to attend your federal note, this number here will always be 10 now, the 10 year federal note, so this is something that you're going to do . having to look up because it changes all the time for now is one point seven is the percentage that you would get if you went out and bought a 10 year federal note in the next section when we calculate the intrinsic value of Disney, I'll actually pull that number out to show you where would I go to find it, but for now we'll just go ahead and use 1.7 percent.

Now you'll notice that I'm just putting in the numbers that I am. I didn't put any percentage or dollar sign or anything like that for the one point seven percent. I didn't put point zero one seven. I put one point seven percent. Well, all those numbers are there and then I hit calculate and then it's. I'll give you the dollar value and if it's a real company, this calculator says the intrinsic value of that company is $36.50, so that's it, that's great, but you probably want to see this actually work. with a real company. We're going to go ahead and move on to Disney and we're just going to go ahead and move our slide here, so let's actually do this with the Walt Disney Company, like I said before, Disney's market price is 44 dollars and 33 cents, like this let's go ahead and figure out what that intrinsic value is for Disney, so here are the numbers for Disney, just like we had them for company en I'm going to show you how to find all these numbers in MSN money, so let's go ahead and do it right now.

Well, here we are on MSN, your top level page, and we're just going to move on. go ahead and scroll down and we're going to go ahead and enter the Disney ticker that is and press enter and it will bring up the Walt Disney Company, so the first thing we'll look at is the trend. for earnings per share over the last ten years, so we go ahead and get to this ten-year summary and when you click on it, our chart appears and we can see that earnings per share over the last ten years is here. so we got two dollars and fifty-two cents in 2011, two dollars and three cents and it's still going down and you can see I have all of those numbers entered into this chart here on the left.

Now I left 2002 blank because we are using that year as the base value for the book value, so the next thing we will look at is the change in book value, so how do you find it? You come back here to MSN Money and you go to click on the key ratios now I want you to remember that if you join us in this lesson right now, we've already done a lot of research on Disney by looking at their dead, looking at their current ratio and things like that to determine that this is a company that we can go ahead and evaluate, so some of those steps have already been skipped, what it will do for hot buffets, rule number one is rule number two and three, and so on, so if joins us right now you're skipping to the end so I recommend going back and looking at those lessons too before we get to this one so when we get to the ten year summary, let's click on the ten year summary and we get the book. value per share is okay and you can see that 1161 is this number at the top 1182 is the next number and it keeps going down in the current book value at the end of 2011 it was twenty one dollars and twenty one cents now if you would like to go in and get a book value even more current than you could go into the balance sheet and take out the capital and divide it by the total number of shares outstanding to get an even more current book value than what is listed here, but for demonstration purposes we are going to continue Go ahead and do it this way now as far as paying dividends here, unfortunately they don't have the ten year track record of MSN's cash dividend and also many other publicly traded stocks. websites, so to do that I went to Disney's website and opened up their dividend history and what they paid out and that's how I got these numbers and that's very likely for you, whatever company you're going to look into.

You'll probably have to go to that company's website to check their dividend history so you can see those numbers if you want to get the dividend that Disney is paying right now. Currently, the easiest way to do this is something you can find. in MSN Money you would go to the top level page, so we type D is and press Enter and it takes you to this top level page and you scroll down and look at the dividend rate and you can see that the dividend rate is correct. here and that's 60 cents, make sure you don't use the dividend yield because that's taking this rate and dividing it by the current market price, that's not what you want for the calculator, for the calculator you want to use the dividend rate and that's 60 cents if you're going to use that for the current dividend and that's what I'm using.

Well, when we look at the EPS, if you remember, we had some of that and it came to 15 dollars and 38 cents is what. The profits that Disney made in the last nine years are good, so from 2003 to 2011 their EP totaled 15 point 38 cents. Now, what that actually materialized for the shareholder was $12.68. We added up all those dividend payments and added up how much the book value grew. from 2002 to 2011 it was nine dollars and 60 cents and three dollars and eight cents for dividends and that adds up to a total of $12.68. When we look at this graph here for Disney, look how the book value was growing very steadily, this is really predictable for a company. and this is what we are really looking for, we are looking for a company whose value we can calculate.

You can't calculate the value of a company that has book value everywhere, dividends everywhere, debt everywhere. the place that just doesn't do well, so for Disney, I think we can generally evaluate if we were going to leave a line here and if we were going to look at that slope, you could say that Disney is probably going to be around the $35. $30 range in their book value for the year 2022, okay, here we are back to the intrinsic value calculator from Buffett's books and just like before, we'll go ahead and start from the top and start with the current book value and what we're going to do is calculate how much Disney's book value has grown over the last ten years, so for the current book value at Disney, we're going to use twenty-one dollars and 21 cents the previous book value that we're going to clear up to 2002 and we're going to put eleven dollars and 61 cents now, the number of years between those two book value terms if we count them is nine years Okay, even though there are ten numbers up there, you're only going to use nine years because the first one is just a baseline that doesn't count a full year. for growth, which is just where it started.

Okay, so let's put nine in there and then we hit calculate and we realize that Disney's book value has increased between six point nine and four percent per year, that's the annual average, okay, so let's go Let's go ahead and use that average book value growth here in the second calculator. So when we look at the cash taken out of the business, this is our dividend, this is our one-year dividend, so Disney is currently paying a dividend of sixty cents. If you look at the last ten years, the dividend payment has been much less than 60 cents.

They recently raised it to 60 cents, so to me most companies, increasinglythat set a dividend, they set it at a fairly conservative value because every time a company cuts our dividend, it usually has a huge impact on the stock price, so whenever Disney raised their dividend up to 60 cents, they probably did. as a pretty conservative move, knowing that even if they hit hard times, they'll be able to continue paying that 60 cent dividend, so I'm personally uncomfortable using 60 cents here. For the calculator you might want to use a lower value or you could even say it's 60 cents now, but in ten years the average could be 70 or 80 cents, so this is where the guesswork comes in and this is where people They get different values ​​for their intrinsic value, but for me I'm going to use 60 cents, so I put point six zero in there and that's in dollars, okay, and that's for the whole year.

They are the dividends that you will receive throughout the year, not for a quarter. Okay, so we got 60 cents for the dividend. The current book value for Disney is twenty-one dollars and 21 cents, so let's put that in and again do. I'm sure you don't use dollar signs or percentages here, you just put in the raw numbers, the average percentage change in book value per year over the next ten years, so I'm going to use six point nine to four percent, okay, and that is. what we calculated on the top calculator and that was based on the previous ten years, so I'll use the same number for the next ten years, if you think it's too high, then you use a slightly lower figure, which is higher. for you and if you think that's a little low, then use a higher number, so the years we're going to go ahead and use ten years because we're going to compare this to a ten year federal note, okay, even though you use nine years on the upper calculator that has nothing to do with the lower calculator.

Okay, the top one is how many years there were between your two book value figures. Down here, this is a completely different number that has nothing to do with your top number. Don't let that confuse you, you're almost always going to put 10 years in here, especially you're always going to put 10 years in here if you compare it to a 10 year federal debt, which we're fine with, so I promised. which would show you how I found the present value for the 10-year federal note, so I'm going to go ahead and do that now on the left side of the screen and keep the intrinsic value calculator at the top.

Well, if you go to the US Treasury Department, you can see that that's where I am now and all you have to do is type a 10-year federal note into Google and it will be the first search. result, then you will click on this graph and you will go down here to the date, so we are looking at May 18, 2012 and you will come to the graph until you see the 10 years. check and you can see that it is 1.71 percent for the 10-year federal bond when you go up to a 30-year bond it is 2.8, but the one that we are going to compare and the one that we are always going to use for our value calculation intrinsic is this rate here, so if we had done this calculation at the beginning of May we would have been using 1.98 and that goes back to Warren Buffett's quote every time he said that you know how future cash flows change or if interest rates move, intrinsic value is going to change and this is exactly what he means by that quote, so we would have had a completely different value for Disney on May 1st than we are going to have now, so Let's go Let's go ahead and enter a 1.71 and we're going to hit calculate and it says Disney's intrinsic value based on those numbers is 40 dollars and 43 cents, okay, so if you're looking at this.

YouTube video this intrinsic value calculator is located on WWF his books are in the course unit 3 lesson 5 AB if you want to go directly to the calculator this is the web address you should follow is HTTP www.facebook.com/news The The price of .about.syria currently trading on the market is 44 dollars and 33 cents. When we use the intrinsic value calculator, we discover that Disney is worth 40 dollars and 46 cents compared to the ten-year federal bill, so what? That means what does that 40 dollars or 46 cents mean? That means if you could buy your knee right now for $40 and 46 cents, we estimate you'd get a 1.7 percent annual return on your money for the next 10 years, if you could buy. for $40 and 46 cents, it's trading for even higher than that, it's trading at $44 and 33 cents, which means you'll get a return worse than 1.7 percent over the next 10 years if you buy it. at that current market price, to answer the question here, is Disney undervalued? the answer is no, it's not undervalued, it's actually overvalued, so even though the Disney Company had checked the first three rules, when we got to the fourth rule, the company was undervalued, that's a no.

So, we wouldn't buy this company because it's overvalued, so let me show you something else that's pretty interesting when we go back to the intrinsic value calculator and we were using the ten-year federal bond at 1.71% and I'm using that because it It considers zero risk in that investment, so if you gave me the option between buying Disney for 40 dollars and 46 cents or investing in a federal or 10-year note, which one would I choose well, obviously I think I would. Choose the 10-year federal note because it has zero risk, while the Disney Company has more risk of not producing the returns that we estimate could be higher, they could be lower, so when faced with that option and the price is exactly the same thing you just calculated well the bond is obviously the best option so now let's calculate what kind of return we would get for that forty four dollars and 33 cents that it is currently trading for so in order to do that we are just going to Let's go in here under this Ten Year Federal Notes tab where we enter that number and let's go ahead and lower that, let's put it as 1%, we'll put it as 1.0 and see what value we get.

Okay, so when we put it as a 1% yield, the intrinsic value went up to 43 dollars and 18 cents, which we're still not at the price it's trading for, so let's go down to 0.8 percent, okay and that's where we are. We're getting pretty close to what it's trading at, so if you bought Walt Disney and forty-four dollars and 33 cents, you could expect to get a 0.8% return on your money over the next 10 years, which is not very good and I can see that this company is trading for a huge premium right now, much higher than I would ever buy, so this gives you a very good idea of ​​how it is doing, so what I want you to do is do is I come here and I want you to play with this calculator.

I want you to get used to seeing how these numbers move when you have a higher federal note value, you'll see that that will dramatically change that intrinsic value. value and it will make it very easy for you to determine hey I need to buy bonds or hey I need to buy stocks because they have a really good value right now this calculator will help you a lot and I really hope you get a lot out of it and if you have any questions I I recommend that you go ahead and click the tab above on this website to access the forum if none of this makes sense or if you have questions. about how the calculator works, sign up for that forum and start asking those questions.

I'll be more than happy to come in and answer them for you and hopefully give you some feedback that will help you start calculating intrinsic value. of these companies, so that's it, those are their four rules, we covered all four of them, the last one here a stock must be undervalued, we proved that with the Disney Company and what I think was unique is that we went through the first three rules. and we had the Disney Company review those three rules, but when we finally got to the fourth rule, which is the really important one, which is whether the stock is undervalued, unfortunately for Disney, in this case they were overvalued and they weren't.

Let's not review that fourth rule, so if we were exercising Warren Buffett's rules we wouldn't be buying shares of the Walt Disney Company because he didn't pass that final rule. So this concludes the course for unit 3, lesson 5. Warren Buffett's fourth rule determines the intrinsic value of a stock we learned how we calculate the intrinsic value of a stock and then we also learned how to use the intrinsic value calculator from the books by Buffett. I hope this lesson really helped you and if you have any questions. Be sure to sign up for the Buffett Book Forum and ask your questions there, see you in the next lesson.