Compute The Rate Of Return For The Following Cash Flow How to Calculate the Intrinsic Value of Stocks Like Warren Buffett

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How to Calculate the Intrinsic Value of Stocks Like Warren Buffett

One of the most sought-after calculations in all of investing is Warren Buffett’s intrinsic value formula. While it may seem elusive to most, for anyone who has studied Buffett’s business professor at Columbia, Benjamin Graham, the calculation becomes more obvious. Remember that the intrinsic value formula that Buffett uses is an embellishment of Graham’s ideas and fundamentals.

One of the most amazing things about Benjamin Graham is that he actually thought bonds were a safer and more likely investment than stocks. Buffett would not agree with this today because of the high rate of inflation (another topic entirely), but this is important to understand in order to understand Buffett’s method for valuing stocks (stocks).

When we look at Buffett’s definition of intrinsic value, we know that he quoted that intrinsic value is simply the discounted value of a company’s future cash flows. So what the hell does that mean?

Well, before we can understand that definition, we must first understand how a bond is valued. When a bond is issued, it is marketed at face value (or face value). In most cases, that face value is $1,000. Once that bond is on the market, the issuer pays a semiannual (in most cases) coupon to the bondholder. These coupon payments are based on the rate that was established when the bond was originally issued. For example, if the coupon rate was 5%, then the bondholder would receive two annual coupon payments of $25 – a total of $50 per year. These coupon payments will continue to be paid until the bond matures. Some bonds mature in one year and others in 30 years. Regardless of the term, when the bond matures, the face value is paid to the bondholder. If you would value this security, the value is entirely based on these key factors. For example, what is the coupon rate, how long will I receive those coupons, and how much face value will I receive when the bond matures.

Now you may be wondering why I described all this information about bonds when I write an article about calculating Warren Buffett’s intrinsic value? Well the answer is very simple. Buffet values ​​stocks the same way he values ​​bonds!

You see, if you were going to calculate the market value of a bond, you would simply plug the entries of the above terms into a bond market value calculator and run the numbers. When it comes to stocks, it is no different. Think about it. When Buffett says he’s discounting the future value of the cash flows, what he’s really doing is adding up the dividends he expects (just like the coupons on a bond), and estimating the future book value of the business (just like the par value of a bond). By evaluating those future cash flows according to the key terms mentioned in the previous sentence, he can discount that money back to today’s value using a respectable rate of return.

This is the part that often confuses people – discounting future cash flows. To understand this step, you need to understand the time value of money. We know that money paid in the future has a different value than money in our hands today. As a result, a discount must be applied (just like a bond). The discount rate is often a hotly debated topic for investors, but for Buffett, it’s pretty simple. For starters, he discounts his future cash flows with a ten-year federal note because that gives him a relative comparison to a risk-free investment. He does this to begin with so he knows how much risk he is taking with a potential pick. Once that figure is determined, Buffett then discounts the future cash flows at a rate that forces the intrinsic value to equal the current market price of the stock. This is the part of the process that may confuse many, but it is the most important part. By doing this, Buffett is able to immediately see the return he can expect from any stock selection.

Although much of the future cash flows that Buffett estimates are not concrete numbers, he often mitigates that risk by choosing good, stable companies.

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