There are several ways to determine the value of an investment. Markets, for example, let you know what investors are willing to pay right now for a company’s stocks or bonds. Value investors, however, prefer a different measure of value called intrinsic value.
Intrinsic value can provide you with a deeper and more informed understanding of the value of an investment. When you use intrinsic value, you are following a key tenant of Berkshire Hathaway CEO Warren Buffett’s philosophy: “Never invest in a company that you cannot understand. “
What is intrinsic value?
Intrinsic value measures the value of an investment based on its cash flow. Where market value tells you the price other people are willing to pay for an asset, intrinsic value shows you the asset’s value based on an analysis of its actual financial performance. The primary metric in this case for analyzing financial performance is Discounted Cash Flow (DCF).
With DCF, the value of an asset is the present value of its expected future cash flows, discounted using a rate that reflects the risk associated with the investment. To determine the DCF, you must estimate future cash flows and select an appropriate discount rate.
When analyzing discounted cash flows, higher valuations result from larger expected cash flows and lower discount rates (and vice versa). In many cases, an analyst will use a range of different expected cash flows and discount rates, reflecting the uncertainties associated with estimating future performance.
Benjamin Graham and David Dodd of Columbia Business School were the first to use intrinsic value and DCF to value investment in the 1920s. Perhaps their most famous practitioner is Warren Buffett, who has popularized value investing since the 1950s.
How to calculate intrinsic value
Discounted cash flows can be used to determine the intrinsic value of any long-term asset or investment, such as a business, bond, or real estate. Let’s take a look at how to calculate the intrinsic value of a publicly traded company using the DCF model. To do this, you need three inputs:
- The estimated future cash flows of the business.
- The discount rate to determine the present value of estimated future cash flows.
- A method of valuing the business at the end of our cash flow estimate, often referred to as a terminal value.
Here is the formula for calculating intrinsic value with these three inputs:
- DCF: Discounted cash flow, or the present intrinsic value of the business.
- CF: Cash flow in years one, two, and so on.
- TV: Terminal value.
- r: The discount rate.
Estimated future cash flows
There are many ways to estimate the future cash flow of a business. Typically you start with the cash flows for the last 12 months and then assume a certain rate of growth to project those cash flows into the future.
It is important to take into account the assumed growth rate. Even small changes in the rate will have a significant effect on the valuation. While past growth rates should be taken into account, you should be careful not to assume that a fast growing business will continue to grow at above average rates for an extended period of time.
DCF models typically estimate cash flows for a limited period of 10 to 20 years. At the end of this period, the model then uses a terminal value often based on a multiple of the cash flows of the last year.
Although this is not the only way to estimate a terminal value, it is easy to calculate. You can estimate the multiple using industry data or the average multiple of the company being valued. A range of multiples can also be used to generate a range of intrinsic values.
The intrinsic value is very sensitive to the chosen discount rate. The lower the discount rate, the higher the value. Buffet uses the risk-free rate, or the yield on the 10- or 30-year treasury bill.
With historically low rates today, however, you need to be careful. As of mid-September 2020, the 30-year Treasury yield is 1.38%. Historically, however, the return has averaged closer to 5% and has reached up to 15%.
Beyond the risk-free rate, many will adjust the high discount rate to reflect the risk of the business. Here, it’s as much art as science. For this reason, many analysts use a range of discount rates, similar to using a range of growth rates.
Example of intrinsic value
To better understand intrinsic value, let’s take a look at a hypothetical example. As described above, the goal is to determine the present value of all of a company’s future cash flows. The starting point is to determine the current cash flow of a business. We will use Buffett’s concept of “owner’s income”.
Owner’s profits represent the profits available to investors after taking into account the capital requirements to maintain a company’s existing operations. As described in “The Warren Buffett Way”, owner’s income is calculated by taking net income, adding depreciation and subtracting capital expenses.
Net profit, sometimes referred to as net profit, is found in a company’s income statement, while depreciation and capital expenditures are found in the cash flow statement.
In our hypothesis, we will assume that the profits of the owners of ABC, Inc. were $ 100 per share at the end of the last fiscal year.
The current price / earnings ratio of the S&P 500 is around 28. We’ll use this multiple to assume that ABC is trading at $ 2,800 per share ($ 100 x 28). Now the question is whether the company is overvalued or undervalued.
Rate of growth
Next, we need to make an assumption about the future growth of the business. A good place to start is to calculate the change in the owner’s income over the past five years. For our purposes, we’ll assume that the company has increased its owners’ profits at a rate of 10% per year.
However, the question remains as to whether we believe the company will continue to grow at this rate and for how long it will continue to do so. We will assume that the growth rate continues at 10% for the next 10 years. We will also calculate intrinsic value assuming a 7% lower growth rate. This will highlight the importance of the growth assumption.
With these assumptions, we can project homeowner profits over the next 10 years. The formula for owner’s profit at the end of the first year assuming a growth rate of 7% is the owner’s current profit ($ 100 per share) multiplied by 1 plus the growth rate, or 1.07. In year 2, the owner’s earrings of $ 100 per share are multiplied by 1.07 ^ 2 and so on to reflect compound growth.
Here are the results:
As you can see, a difference of even 3% in the growth rate assumption has a significant effect on the resulting growth in owner’s income.
The table above represents the undiscounted proprietary earrings based on our assumptions. The next step is to calculate the present value of these gains.
To do this, we need to decide on an appropriate discount rate. First, we’ll use 1.5%, which is roughly equivalent to the current 30-year Treasury rate. As with the growth rate assumption, it is important to keep in mind that small changes in the discount rate can have a significant effect on intrinsic value.
The formula for discounting earnings at the end of the first year ($ 107 at a growth rate of 7%) at a discount rate of 1.5% would be $ 107 / 1.015 ^ 1. Using this formula for each year and growth assumption gives the following current values:
- 7% growth rate: $ 1,352.15
- 10% growth rate: $ 1,598.16
Now let’s compare these numbers using a 6% discount rate, reflecting a more normal yield on a long-term treasury bill:
- 7% growth rate: $ 1,053.38
- 10% growth rate: $ 1,232.91
It is generally best to take a conservative approach to assumptions. When interest rates are abnormally low, as noted above, it is wise to increase the discount rate above Treasury rates to reflect a more normalized interest rate environment. Warren Buffett takes this approach. For this reason, we will use the 6% discount rate in the future.
For the terminal value, we will use a simple approach of multiplying the owner’s profit at the end of year 10 by a multiple of 15. Again, as with other assumptions, calculating the terminal value at l Using different methodologies can have a profound effect on the outcome. For this reason, it is advisable to calculate the terminal value using several different methods. In this case, however, we will only use this one approach.
After multiplying the owner’s income for the last year by 15, we get the following values discounted to the present using our 6% discount rate ((196.72 or 259.37 x 15) / 1.06 ^ 10).
- 7% growth rate: $ 1,647.67
- 10% growth rate: $ 2,172.50
Put it all together
We can now add the present value of the expected cash flows over the next 10 years to the terminal value to arrive at the intrinsic value of the business.
- 7% growth rate: $ 2,701.05
- 10% growth rate: $ 3,405.41
Based on the current share price of $ 2,800, we can conclude that the company is overvalued at a growth rate of 7% but undervalued at a growth rate of 10%.
The limits of intrinsic value
Not all assets have cash flow, so not all assets have intrinsic value. A good example are commodities, such as gold and money. Because precious metals do not generate an income stream, they have no intrinsic value, at least as measured using the DCF. By a similar analysis, cryptocurrencies have no intrinsic value.
Some companies may be too difficult to estimate intrinsic value with a reasonable degree of confidence. Examples could include startups with no sales or no profits as well as highly volatile companies in highly competitive markets with uncertain futures. It is not that these companies lack intrinsic value, but rather that intrinsic value cannot be estimated with any degree of confidence.
Intrinsic value seeks to assess the value of an asset based on future cash flows, not current market value. As such, a company’s intrinsic value can vary, sometimes significantly, from a company’s stock price. While this is not the only way to value a business, it is considered one of the fundamental approaches to securities analysis, especially among value investors.