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How to Calculate the Intrinsic Value of a Stock (Full Example)

Jun 07, 2021
Warren Buffett says that the three most important words in investing are margin of safety and there is no doubt that margin of safety is an integral concept used widely by

value

investors both past and present. We are talking about people like Charlie Munger Warren Buffett Benjamin Graham Monish Prabrai Guy. Spear Peter Lynch Phil Town Heck, Seth Clarman's book is literally called margin of safety, so for us aspiring

value

investors it's probably a good idea for us to learn about the concepts of marginal safety and make sure we use them in our investment approach. The problem is that most investors, most aspiring investors, have never learned how to

calculate

the

intrinsic

value of a given company in the first place and therefore do not understand how to apply margin principles. security in your own investments, so I want to solve that.
how to calculate the intrinsic value of a stock full example
At the end of this video I hope that you have all the skills that you need to be able to

calculate

the

intrinsic

value of any company that you look at and thus calculate what is a fair price margin of security for that company, so let's start right. So, first of all, in order to talk about the margin of safety, which is so essential to Warren Buffett's investment approach and so fundamental to his continued success as an investor, we must first be able to understand how to find the intrinsic value of a company. value is simply the fair value of the business is what the business is really worth now a quote commonly used by Warren Buffett that draws from American economist John Burr Williams' investment theory of value is the intrinsic value of any

stock

bond or business nowadays. is determined by the discounted cash inflows and outflows at an appropriate interest rate that can be expected to occur over the remaining life of the asset, where in this case the asset is the business, so the intrinsic value of a business is simply the present value of all the future cash flows of that business are added up, so if you imagine that you own this business outright, you are the sole owner, okay, you own everything, so to calculate the value intrinsic to the business, it needs two. information you need to know how much cash that company will generate you in the future.
how to calculate the intrinsic value of a stock full example

More Interesting Facts About,

how to calculate the intrinsic value of a stock full example...

You need to know what those future cash flows are worth to you here today, so first of all, how much cash a company generates for its owners. It's called owner's earnings and the way you actually calculate what the owner's earnings are for a company in a particular year is to go to the cash flow statement, take the operating cash flow and then subtract the capital expenditure from maintenance, operating cash flow sometimes The so-called cash flow from operating activities is simply the amount of cash that the business operations of this particular company produced in that period of time and then the maintenance capital expenditure is simply the amount of money that is spent simply to maintain and maintain the business in its current competitive position, now the owners' profits is the most accurate number to use in these calculations;
how to calculate the intrinsic value of a stock full example
However, the annoying thing is that while companies do not have to report their maintenance capital expenditures, some do, some large companies do, which is very useful, but most do not. Not so many investors, instead of using maintenance capital expenditure, they simply use total capital expenditure, so it is the purchase of property, plant and equipment on the cash flow statement and that only includes yes, maintenance capital expenditures, but also includes all capital. expenses used to grow the business and for simplicity of calculations, we will also use free cash flow for these calculations. Technically, using free cash flow is more conservative;
how to calculate the intrinsic value of a stock full example
However, being more conservative, it is also a little less precise; However, another advantage of using free cash flow, as I was talking about before, is that it can be calculated from any cash flow statement, so it is a very easy number to find within the financial statements, it is simply operating cash flow less the purchase of property, plant and equipment, with all that said. How do we really find the intrinsic value of a business? For this

example

, let's imagine that we are going to try to buy the local corner store that has only sold snacks and drinks for the last 10 years.
This is what is free. Cash flow has been similar every year for this corner store business and if you notice, it just so happens that every year the free cash flow of this business grows by 10, how's that for maintaining the coherence? So what are we going for? What we need to do is take the most recent free cash flow number and take that growth rate which is proving to be a very consistent growth of 10 and we're going to increase that free cash flow again by 10 every year for 10 years in the Future, we'll assume that after that 10th year we'll be able to sell the business for 10 times its free cash flow, so if we put all those numbers on a spreadsheet, this is what it looks like.
Surely the intrinsic value of the business for us is simply that we add up all these cash flows, we just add them all up and then that is the value of the business for us, that is the cash flow that we are going to receive as owners not quite if we are looking to make this purchase right now here and today, the reason it's not intrinsic value is because the cash flows that we're going to receive, say, in the seventh year of ownership or in the eighth year or in the ninth year of property, those cash flows are not as valuable to us as the cash flows that we are going to receive, say next year or the year after, and the reason they are not as valuable to us is because it will take a long time before That we actually receive those cash flows, those cash flows will happen in the distant future and of course there is a time value of money if you ask me do I want ten dollars now or ten dollars in a year.
I'm always going to take the ten dollars now because what I can do is take that ten dollars, put it to work and in a year I can turn that ten dollars into eleven dollars, so I'm a dollar better off. So I'm always going to take the money before, so with that idea we have to take the future cash flows of this business and discount them to what they're actually worth to us today and we'll discount that by 15 annually. because that's what we want to achieve with our investment, so if we go ahead and discount all of these future cash flows by 15 annually, this is what the table looks like now, now we also discount that single cash flow that we're going to get. get by selling the business in 10 years for 10 times its free cash flow and after that we now have the present value of all the future cash flows of this investment, so the intrinsic value of the business for us today is all of these flows of cash just adds up, so in this case the corner store has an intrinsic value of approximately 306,000, so if we were to meet with the owners and make them an offer of three hundred and six thousand dollars for their business, It's likely that we're going to get 15 returns running that business assuming it grows as 10 free cash flow annually when you get 15 returns every year for 10 years, however, if the business owners turned around and said no, no , we don't want 500,000 for the business, obviously our return will be much lower if the business owners are just desperate to go ahead and get rid of this business, they say, look, take it for 200,000 seriously, I want it gone, so obviously We are going to achieve a much higher return, but generally for 15 returns each year 306,000 is the intrinsic value of that business.
Now this is what the

stock

market gives us every day the price of thousands and thousands of businesses. We can look at the market capitalization of each business and determine the price that that entire business is currently selling for, that's a big advantage for us because what it means is that we can look at the financial statements of these companies, calculate the intrinsic value of that business and then compare it to that one. current market capitalization of the company to see if it is trading at its intrinsic value, if it is trading at a premium to its intrinsic value or if it is trading below its intrinsic value, but the issue is all the calculations that we have done to try to calculate the intrinsic value. value, these are just guesses, this is an educated guess.
Yes, we can minimize the risk of our guesses being wrong by finding companies that we know have an economic moat or that we know have a consistent and very predictable history of financial data, but we have to recognize that there will always be things that could potentially happen to any business. old in the future that we simply cannot foresee and that we simply cannot control. I mean, what if there was, say, a fire at the corner store and it meant that the business simply had to go away? stay closed for a year while it was repaired, or, do you know what would happen if a juice bar opened right next to our business and that reduced our beverage sales by 50 percent?
Now these situations might be unlikely, but it shows that all of our estimates can. You can't trust it 100 percent, okay, it's like if the Travis Layer lines up for a shot 10 meters directly in front, it will probably happen, but you're not 100 percent sure and because our flux estimates If we are not 100 percent sure, then our estimates of intrinsic value are not 100 percent sure either, so to account for this we need a margin of safety to not buy our business at our calculated intrinsic value because then Even if we are slightly wrong in our calculations of intrinsic value, that will have a real impact on our returns, so what we need to do is give ourselves a safety cushion, a margin of error or a margin of safety.
Benjamin Graham writes this about the margin of safety the function of the margin of safety is essentially to make unnecessary and precise estimates of the future seth clarkman says that a margin of safety is necessary because valuation is an imprecise art the future is unpredictable and Investors are human and they make mistakes, so what we do is we take our intrinsic value and then we reduce it a little bit just to have a margin of safety and a buffer for being wrong in our estimates, so if we calculate that the intrinsic value of that store of the corner would be 306,000 we could only offer the owners, let's say 200,000 or 250,000, so we only buy a business once they offer it to us below its intrinsic value, but to what extent below the intrinsic value, This is where it's up to you, for

example

, the experienced one.
Investors who are very confident in the predictability of future cash flows from businesses might opt ​​for, say, a 20 or 30 percent margin of safety, but potentially, if you are a new investor or investing in a company, such maybe a little more. risky, a little less predictable, then you might choose to say a margin of safety of 50. Don't get me wrong, it's very difficult to get a margin of safety of 50, and if you look in today's market, you're unlikely to do it. We are going to find businesses with a 50 margin of safety, however, that is the mentality we have to adopt as investors, we sit patiently, wait our turn until the market presents us with the businesses we have been analyzing at a price that is well below the intrinsic value that gives us that margin of safety because if you invest in a business with a margin of safety of 50 you can be very, very wrong in your predictions of the future for this business and you will probably still end up with, let's say, a return of 15 at year, so it's a real goldmine if you can find it, that's how you eliminate a lot of the risk when you buy a business, you eliminate a lot of the downside risk by making sure you're only buying with a price spread of safety actions now, lastly, I wanted to go over and take a look at this illustration as I put this illustration on the screen that we've talked about in this video.
Now feel confident that you can interpret this graph and explain exactly what it means. So what this chart shows is, first of all, the price of the business, this is what the stock market offers us to the business and of course that fluctuates every day there is a new price, there is a new price that the market offers us for the shares of that company, then here we have the intrinsic value of the business, which is what we calculate from our discounted cash flow analysis where we add the sum of all the future cash flows to determine how much the business for us as sole proprietor.
So as we can see from this chart, the price of the business eventually comes down and touches the intrinsic value, but of course that's notour buying trigger, it's good I see that the price has now equaled the intrinsic value, but that doesn't necessarily mean that we buy yet because of course what we're talking about we need that buffer, that buffer for us, potentially being a little bit wrong in our predictions of the future. and our predictions of what the intrinsic value actually is, as you can see when the stock price or the market price of the business continues to fall, let's say this line is 30 percent below the intrinsic value and once it crosses below that line. so that's our sweet spot, that's our gold mine opportunity and that's when we decide that we want to be in this business.
We have done our due diligence. First we understand the company. We know that the company has a great competitive advantage. We have checked. The management team is leading the company with skill and integrity. Okay, the management of the company has very low debt and we finally have the last key ingredient now we can buy this company at a discount to its intrinsic value and we have the margin of safety and that protects our downside risk quite substantially and this is really the key ingredient to why all those notable investment names that I mentioned earlier have proven to be great investors decade after decade after decade, is because they simply won't let themselves be exhausted by the current market situation and, oh, they don't want to. miss this trendy action or anything like that, they hold up perfectly. rational and they wait for opportunities where they buy great businesses in this situation where they're in that stock price margin of safety where there's a lot of upside and very little downside, so overall I hope it's helped you.
I learned something from this video. If you did, I would really appreciate it if you left a like on the video. If you want more examples and complete analysis of discounted cash flow analysis, as well as some other valuation methods, definitely take a look. The profitable links are in the description, this will actually be the last day of our new year sales, so if you want to get started with your investments and want to participate, check out the introduction to stock analysis, that will be the course. For you, it has a huge discount right now if you want to purchase it and that discount will probably disappear tomorrow, so act quickly if you want.
This will be the last time we do a big profitable sale for a while, so if you want to get in, get in now, but other than that guys, thanks so much for watching. I really appreciate it. I hope you enjoyed the video. I hope you learned something from it and I'll see you next time.

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