How to Calculate Intrinsic Value

Subjective Value - Objective Price - Cash Flows - Discount Rate - Margin of Safety

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According to Warren Buffet: "Price is what you pay, and value is what you get." There might be a big gap between value, which is subjective, and price, which is objective. The challenge is thus to objectivize value a bit.

In business, the value of a bond or a stock is determined by the cash inflows and outflows, discounted at an appropriate rate until the asset's end of life. Intelligent CEO Robert Keane, from Cimpress, define the intrinsic value as follow: "as (a) the unlevered free cash flow per share that, in our best judgment, will occur between now and the long-term future, appropriately discounted to reflect our cost of capital, minus (b) net debt per share." 

Predicting cash flows requires a profound understanding of the business and its underlying market. It means being knowledgeable about the earning power of the company and its growth potential. It also demands a risk assessment of the firm and an opinion about its long-term competitive moats. Most errors at this stage are made due to an overestimation of cash flow growth. A business can't grow at a fast pace indefinitely. Ultimately, there will be a reversion to the mean, but no one knows when and how.

The second factor is the discount rate. Warren Buffet previously used the 30-year Treasury Bond yield. If the bond yield were to drop below seven percent, Buffet would adjust by adding three additional points. The long-term treasury bond had a yield of around 9% at the beginning of the nineties and felled to 2% today. Needless to say that the bond yield is so low that one might add more than three additional points. Buffet and Munger don't communicate clearly on their discount rate, but their hurdle rate might be around 10%+. Discounting is very important because it adjusts the time value of money. A dollar today is worth more than a dollar tomorrow.    

There are several ways to discount the cash flows of a business. The most famous is the Discounted Cash Flow analysis (DCF). The formula takes cash flow (CF) for a given year divided by the discount rate (r).

The recipe is simple; the difficulties lie in the assumption regarding the cash flow and the discount rate. The key is to keep the math simple and focus on the business hypothesis. According to Charlie Munger: "Some of the worst business decisions I've seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they've got to do something."

The calculation is thus an estimate because making an accurate prediction about the future is impossible. No one knows the total cash flows that will occur over the life of a business. Two people looking at a similar business will come up with different numbers. That's why a margin of safety is so crucial. It gives room for imprecision, errors, and miscalculations. When calculating an intrinsic value, one has to be conservative regarding the cash flows and the discount rate. 

Finally, coming up with the right intrinsic value doesn't mean the price will align immediately. Significant discrepancies between value and price can occur for years. Price above value is a burden for the Intelligent CEO, whereas price under the intrinsic value is a lifetime opportunity. When the price is under the intrinsic value, Intelligent CEOs buy companies or buy back their own shares. The vital thing to keep in mind is to stay the course because price and value align in the long run. Benjamin Graham summed it up correctly when he wrote that the market is like a voting machine in the short run--tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine--assessing the substance of a company.

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