Intrinsic value is the future value of an asset. Let’s see how Warren Buffett calculates Intrinsic value and use his formula on Indian stocks
You possibly know I follow Warren Buffett closely. So let me today explain how he determines the intrinsic value of the stock.
Then we will use his idea to create a formula to calculate the intrinsic value of the stock. Moreover, then we will apply the method to a few of my favorite shares in the Indian market to understand with a real example.
So let’s now begin.
What is the Intrinsic Value of a Stock?
Intrinsic value is the investor’s perception of the future value of an asset. Everything has an intrinsic value.
A few examples of intrinsic value are company, stock, bond, gold, or real estate.
The intrinsic value bonds are stable and don’t change too much with time.
A government bond with an investment of 1Lakh and after a few years to become 1.2Lakh has a future perceived value of 1.2Lakh. So its intrinsic value for the investor after the period is 1.2Lakh.
Similarly, a ₹500 note has an intrinsic value of ₹500 in India. However, a traveler in a foreign country, the intrinsic value of ₹500 varies depending on the forex rate changes for the Indian Rupees and that country’s currency.
Similarly, for gold or real estate, it is easy to find the intrinsic value.
Warren Buffett’s Concept of Intrinsic Value?
When it comes to stock, the intrinsic value is not so apparent like other asset classes like gold, bond, or even for that matter real estate.
So when the intrinsic value of the stock is not so obvious, we have to make sure we try to estimate it correctly before investing.
The best person to define intrinsic value is none other than Warren Buffett. So here is what he has to say about how he finds the intrinsic value of a stock.
You can watch this video to see how Warren Buffett answers to a question about what is intrinsic value.
To sum up what he has said:
The intrinsic value of a stock (or any investment) is the ability of the business to generate cash flow in the future discounted at a rate equivalent to a long-term risk-free government bond.
How I Find an Intrinsic Value of a Stock
We have an idea of what an intrinsic value—the critical aspect of applying it to stock while investing.
So now, we have to find the cash flow from the business for the tenure we want to remain invested.
The reason I am not using EPS because it includes depreciation as an expense. However, depreciation is the cash that remains with the company, but for taxation, it reduces the profit.
Similarly, EPS, EBITDA also includes depreciation and amortization. The closest ratio to watch should be either EBIT or operating profits.
Operating profits is the best match because it is the amount of cash the company is generating from operations. Then based on the debt level (which we anyways like to keep to very low levels) pays interest.
On profits, it pays tax accounting for the depreciation and other such expenses.
Calculation of Intrinsic Value
Let us use operating profit from business and an estimate of growth rate to find out how many years the company will take to generate total operating profits equivalent of the current market cap compounded at the current Indian government’s long-term bond rate, which is equal to 6%.
Here is the Google sheet for the same.
Make a copy of the Google sheet and apply the calculation for the stocks you want to hold.
Let us take Divi’s Lab as our first example. It is expected to be in the high growth phase for the next few years.
Still, at the current market cap of 60k Crores, it will need 15 years off a consistent 20%+ growth rate to generate total profit from operations.
Let’s assume you have 60k Crores. So you want to buy Divi’s Lab.
The profit the business can generate at a CAGR of 20%+ for the next 15 years to make an amount equal to what the government bonds will fetch you in 15 years.
Now because I have invested in the business at even less than 20k Cr market cap, the whole equation changes considerably.
No evaluation is complete without my all-time favorite stock of Pidilite, which is overvalued for sure. Now let us see how based on the above method as well.
At its average growth rate of 13.5%, it will require more than 15 years to surpass the total operating profits equivalent to the current market cap.
Forget about the compounding of the market cap at the government bond rates of 6%.
Let me also share an example of a stock that isn’t into a high growth phase at the moment. The stock is Bajaj Consumers and sees what happens in the above method.
The company is generating good profits but lacks high growth.
So, it only manages a meager growth of 4 to 7% growth in the next 10 to 12 years. Still, the company can generate the total operating profits more than the current market cap that one is willing to pay.
However, the above sheet and calculation are done before the results announced by the company on 16Jul2020. After that, the company has run-up 20%+. So the current market cap is a lot higher than the one you see in my Google Sheet.
The last example I like to share is a company that is a very neglected sector and has an impact on Covid-19. The stock is JK Paper.
Schools and colleges are closed. Offices aren’t working at full capacity. So it is expected the demand for paper will reduce drastically.
However, paper packaging material demand will increase as more and more people will order online.
On top of that, the use of paper is considered unfriendly for the environment.
So I assume a 25% de-growth in earnings in FY21 and then flat growth even on top of the low base after de-growth year.
Still, the company generates a profit, which is more than the current market cap in the third year itself.
Modifying the Formula as Convenient
According to Warren Buffet, if the total cash generated by a business is higher than the long-term risk-free government bond return amount at a future date, one should invest in the company.
In the Google sheet, I have used market cap and operating profit.
Anything that you consider as the close approximation of the cash generated in the business is the right choice. However, the free cash flow may not be ideal because if the company is investing the money, the FCF will reduce.
The idea is if you have the amount of money equal to 1 share of a company. Should you buy the long-term risk-free government bond or invest in the company and hold for the same amount of time.
Consider the impact of COVID-19, for the next year or so for growth. I have kept the growth for each year as a variable in the Google sheet. Input value that you consider a reasonable estimate of the growth of the company in each of the coming years.
The four stocks discussed are only for educational purposes to understand the process Mr. Warren Buffett has explained in the video for the intrinsic value and are no way any kind of recommendation to invest in them.