Value Investors Tribe

Warren Buffett has been asked multiple times on how to find intrinsic value of the business in the Berkshire Hathaway Annual meetings, in the interviews, in the lectures he delivered and on similar other occasions. He has emphasized that intrinsic value is a combination of qualitative and quantitative factors and probably more of a qualitative factors associated with the business.

In this blog, we’ll explore the answer he gave to the similar question in his 2001 talk he gave at the University of Georgia. He was asked how to calculate the intrinsic value of the business and Warren Buffett replied “Intrinsic value is the number that if you were all knowing about the future, and could predict all the cash the business would give you between now and judgment day, discounted at the proper discount rate, that number is what the intrinsic value of the business is.”

This sounds simple however there are multiple moving pieces to the puzzle. We basically require following things to calculate intrinsic value of the business: 1) predict how much cash the business will generate 2) what’s the timeframe of investment (judgment day) and 3) what’s the appropriate discount rate. It is important to note that even though we need only three things to calculate intrinsic value, all there are variable. It varies from business to business, analyst to analyst, industry to industry and from anything and everything you can think of. This is the primary reason why it is difficult to calculate intrinsic value of the businesses.

A good practice to calculate intrinsic value accurately is to not calculate it deterministically! Having a conservative estimate of cash flow growth rates, discount rates and timeframe can lead to a range of intrinsic value. This would be more accurate than coming up with a fixed number. For instance, if you think the stock X has intrinsic value somewhere between $100-$120 and it is trading at $75, it is most likely undervalued business given your assumptions for intrinsic value calculations are rational and logical.

One of the things which is crucial to this concept is that the calculations can be garbage in – garbage out. Any business can be categorized as undervalued or overvalued based on the either of the three components essential for calculations. Maybe this is the reason Warren Buffett and Charlie Munger have mentioned multiple times that just working out the math is not enough to make a good investment. The understanding of qualitative factors such as moat of the company, performance compared to peers in the industry, managerial abilities and similar others are more important. However, the quantitative part helps to put a number to the business value which can help in determination of buy or sell decisions.

Key Takeaways:

1. The intrinsic value of a business can be calculated by predicting the cash flow a business is expected to generate in future and discounting it back with the appropriate discount rate.
2. The three parameters required to calculate intrinsic value of a business are: 1) predict how much cash the business will generate 2) what’s the timeframe of investment (judgment day) and 3) what’s the appropriate discount rate
3. Qualitative factors are more important than the quantitative factors to calculate intrinsic value of a business and avoid garbage in – garbage out type of computational model.