“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” – Warren Buffett
Owners Earnings
“If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)” — Warren Buffett
Intrinsic Value Formula
Owners earnings = Net income + Non-cash charges – Maintenance capital expenditures (CapEx)
Free cash flow (FCF) = Operating cash flow – Total capital expenditure
“And once you’ve estimated future cash inflows and outflows, what interest rate do you use to discount that number back to arrive at a present value? My own feeling is that the long-term government rate is probably the most appropriate figure for most assets. And when Charlie and I felt subjectively that interest rates were on the low side – we’d probably be less inclined to be willing to sign up for that long-term government rate. We might add a point or two just generally. But the logic would drive you to use the long-term government rate. If you do that, there is no difference in economic reality between a stock and a bond. The difference is that the bond may tell you what the future cash flows are going to be in the future – whereas with a stock, you have to estimate it. That’s a harder job, but it’s potentially a much more rewarding job.” – Warren Buffett
Intrinsic value = [FCF1 / (1+r)1] + [FCF2 / (1+r)2] + …. + [FCFn / (1+r)n] + [FCFn * (1+g) / (r – g)]
where:
FCF = free cash flow (or owners earnings)
r = discount rate (required rate of return)
g = estimated annual terminal growth rate
n = time period
Calculating Business Value is an Art and a Science
“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.” – Warren Buffett[1]
