Lecture Notes: Intrinsic Value Calculation by Warren Buffett

Introduction

• Objective: Understand how Warren Buffett calculates the intrinsic value of a stock, with an example included.
• Valuation Goal: Determine how much to pay for a business (viewed as a money-printing machine) to get a good ROI.
  • Compare intrinsic value to current market capitalization (market cap).
  • Market cap = Total stock market value = Shares * Share Price.
  • Overvalued if market cap > intrinsic value; Undervalued if market cap < intrinsic value.*

Understanding Intrinsic Value

• Intrinsic Value: Predict all future cash flows of a business, discounted at the proper rate.
  • Use to determine if investment makes sense.
• Bonds vs. Stocks:
  • Bonds have clear cash flows printed on them.
  • Stocks require analysts to estimate future cash flows.
• Investment Analysis:
  • Determine how much cash a business can deliver and when.
  • Look at entire business value, whether buying whole or part.

Discounted Cash Flow Analysis

• Process:
  • Calculate the present value of all future cash flows.
  • Determine if cash flows justify the current stock price.
• Steps:
  1. Determine Free Cash Flow (FCF):
     • FCF = Cash Flow from Operations - Capital Expenditure (CapEx).
     • Ideally, isolate CapEx for maintenance, not growth.
  2. Estimate Growth Rate:
     • Growth rate affects intrinsic value significantly.
     • Consider past growth, industry benchmarks, and future growth drivers.
  3. Project Future FCF:
     • Extend FCF by estimated growth rate over 10 years.
  4. Calculate Terminal Value:
     • Based on future FCF multiple.
     • Multiply 10th-year FCF by average past FCF multiple.
  5. Discount Future Cash Flows:
     • Use desired return rate (e.g., 15%) to discount future cash flows.
     • Account for opportunity costs of delayed cash.

Calculating Intrinsic Value

• Summation:
  • Add discounted future 10 years' cash flows and discounted terminal value.
  • Result = Intrinsic value today.
• Market Comparison:
  • If market cap < intrinsic value, potential for desired returns.
• Margin of Safety:
  • Add a buffer (e.g., 20-50%) to intrinsic value to account for uncertainties.
  • Helps protect against prediction errors and enhance returns if accurate.

Conclusion

• Practical Application: Try this method on favorite companies.
• Market Observation: Many stocks may currently trade above intrinsic value.
• Further Learning:
  • Linked resources for comprehensive walkthroughs and community support.

• Outro: Thank you for engaging with the content. Further support links provided for deeper dives into stock analysis.