How to Calculate Intrinsic Value: 3 Methods Warren Buffett Uses

Intrinsic value, the true underlying value of a company, is a cornerstone of value
investing. Warren Buffett, one of the most successful investors of all time,
emphasizes its importance. This article explores three methods that Buffett uses to
calculate intrinsic value, providing you with tools to assess the true worth of a
stock.

Understanding Intrinsic Value

Intrinsic value represents what a company is truly worth, independent of its current
market price. If the market price is below the intrinsic value, the stock is
considered undervalued, presenting a potential buying opportunity.

3 Methods Warren Buffett Uses

1. Discounted Cash Flow (DCF) Analysis

DCF analysis is a valuation method used to estimate the intrinsic value of an
investment based on its future free cash flows.

• How it works:
  • Project the company’s future free cash flows for a specific period (e.g.,
    5-10 years).
  • Estimate a terminal value, representing the company’s value beyond the
    projection period.
  • Discount both the projected free cash flows and the terminal value back to
    their present value using an appropriate discount rate (often the weighted
    average cost of capital – WACC).
  • Sum the present values to arrive at the intrinsic value.
• Buffett’s Perspective: Buffett emphasizes using conservative
  estimates for future cash flows and a discount rate that reflects the certainty
  of those cash flows.
• Limitations: DCF analysis is sensitive to assumptions, particularly
  future growth rates and the discount rate.

2. Owner Earnings

Owner earnings, a term coined by Buffett, represent the cash a company can distribute
to shareholders over its remaining life without impairing its competitive advantage.

• How it works:
  • Start with reported earnings.
  • Add back non-cash charges like depreciation and amortization.
  • Subtract capital expenditures necessary to maintain the company’s
    competitive position.
  • Adjust for changes in working capital.
• Buffett’s Perspective: Buffett believes owner earnings provide a
  more accurate picture of a company’s profitability than reported earnings, which
  can be distorted by accounting practices.
• Limitations: Calculating owner earnings requires judgment and
  can be subjective.

3. Replacement Value

Replacement value estimates the cost of replacing all of a company’s assets.

• How it works:
  • Determine the cost of replacing the company’s tangible assets (e.g.,
    property, plant, and equipment).
  • Consider intangible assets like brand value and competitive advantages.
• Buffett’s Perspective: Buffett often uses replacement value as a
  floor for intrinsic value, particularly for companies with strong competitive
  advantages.
• Limitations: Replacement value can be difficult to estimate
  accurately, especially for companies with significant intangible assets.

Important Considerations

• No Single “Right” Value: Intrinsic value is an estimate, not an
  exact number. Different methods and assumptions will yield different results.
• Margin of Safety: Buffett emphasizes buying stocks at a significant
  discount to their intrinsic value to provide a “margin of safety” against errors
  in estimation.
• Qualitative Factors: In addition to quantitative analysis, Buffett
  considers qualitative factors like management quality, competitive advantages, and
  long-term prospects.

Conclusion

Calculating intrinsic value is a crucial skill for value investors. By understanding
and applying methods like DCF analysis, owner earnings, and replacement value, you
can assess the true worth of a company and make more informed investment decisions.
Remember that intrinsic value is an estimate, and a margin of safety is essential.

Related Keywords

Intrinsic value, Warren Buffett, DCF analysis, discounted cash flow, owner earnings,
replacement value, stock valuation, value investing, calculate intrinsic value,
intrinsic value methods.

Frequently Asked Questions (FAQ)