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LESSON SUMMARY
This lesson shows the last of the four rules Warren Buffett always applies when considering a stock pick. It’s the most complicated, and the rule that you should look at only if the three previous rules are all met. Before buying a stock, you should always compare the current stock price with your estimation of the intrinsic value. You only want to buy stocks that you can find at a decent discount. This lesson also includes the following points.
1) How can we calculate the intrinsic value of a stock: The intuition behind stock investing is very simple. You put up an upfront payment to get a share of the company, in the hope that it will increase in value. The value of that single stock is in directly proportional to the discounted cash that you can expect to be taken out of the business in its remaining life. Remember a stock doesn’t have an expiration date!
2) Why is the federal note used as discount rate: The reason why we even discount cash in the first place is because cash changes value dependent on time. Everyone would rather have $100 today than in a year because you can either spend it and get more goods than in a year, or invest it and grow it to more than $100. Warren Buffett has said that he uses the federal note as a discount rate, because he knows that this is a risk free return. This should be seen as opposed to stock where the returns are always uncertain. In other words: If the risk free return – the interest on the federal note – is high, the value of the stocks gets lower, and vice versa.
LESSON TRANSCRIPT
This last rule is the most complicated – determining whether a stock is undervalued or not.
In the three previous lessons, we compared Sirius and Disney. Sirius failed the first rule – a company must be managed by vigilant leaders. Sirius had a lot of debt. Again, all 4 rules must be met in order for Buffett to invest, so automatically, Sirius is not qualified. On the other hand, Disney’s debt was manageable for the past 10 years, so it is considerable. With the second rule, Sirius is not anticipated to having long-term prospects 30 years from now, while it’s the other way around for Disney. Buffett proves that Sirius is not stable. Their debt, book value, and debt to equity were all over the place. Disney was stable and predictable. That is absolutely essential as we move into this lesson where we’re trying to calculate the intrinsic value. Without a stable company, we can’t make a good estimate of how much growth the company will have in the next 10 years. For the third rule, Sirius isn’t even worth the attempt to calculate, because they are unstable. Disney is.
Let’s learn how the intrinsic value calculator works. If you get lost in this portion, that’s fine; I have a couple of practical exercises where you can work on.
CALCULATING A STOCK’S INTRINSIC VALUE
How do we determine the intrinsic value of a company?
If you read Berkshire Hathway’s manual, Buffett said, “The 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. As our definition suggests, intrinsic value is an estimate rather than a price figure. And it is definitely an estimate that must be changed as interest rates move or forecast or future cash flows are revised. Two people looking at the same set of facts almost inevitably come up with slightly different intrinsic value figures.”
Keep in mind that the calculator itself isn’t different, but you might take it to a more conservative approach than what I will show you. When you do that, you’re going to get a different interest value.
If you want to use a different interest rate in the 10-year federal note, you’re going to get a different intrinsic value. As we start using the calculator, you’ll understand why Buffett said the quote above. He might look at a company a little bit differently the way you viewed it.
What does it mean by “Cash that can be taken out of the business during its remaining life”? When Buffett was assessing, he was referring to this: “If I could take out all the profit the company’s going to make over X number of years I’d own it, how much would that add up to?” He did it for 10 years into the future to compare that amount that he would collect to what he would make off of a zero-risk investment, which should be the 10-year federal note.
This might be misleading, but further you’ll understand why it has to only be 10 years in the future. When looking in a business, the EPS or profit per share is the magic number.
EARNINGS PER SHARE
Assume that we have $1.50 of EPS, your earnings for one year for a company named Company X. From the first course, the shareholder has an option to take the route of keeping the money in the bank account, invest that money back into the business, or pay it to the debt or whatever the case is.
However, what happens to the money is it either turns into more equity or less equity. It will reflect the book value because it is nothing more than equity per share. If you take option 1, that $1.50 of earnings comes to the company and the shareholder decides whether to turn into it more or less equity depending on how they choose to invest or pay the debts.
The second option that the BOD and CEO have is to give you a dividend. That $1.50 would sit there in the bank account and the managers will decide to pay the shareholders.
What you see with companies is not that they take 1 option or the other; they take both. They’ll put a portion of that $1.50 into the equity and then put another portion into the dividend. They might pay $.50 in the dividend and $1 into the equity of the business. That total is turning into either more equity or a dividend. Equity means book value because we’re talking on a per-share basis.
Look at Company X over the last 10 years to understand the calculation works. Refer to the model on the video. The book value in 2002 was $10. The EPS was $1.5. It was the same for 10 years straight. The book value increased by $.70 from 2002 to 2003. They paid $.30 per dividend. The EPS turned into $.70 added to the book value, $.30 paid to the dividend, and $.50 just disappeared. This is what you see a lot of times. Not all of those earnings per share actually materialize into money that’s showing up in your pocket. Even though you’re not actually seeing that book value payment added to the business, the market price of your company generally follows a trend with that book value. If it went up, the market price will trend in the same direction.
In 2004, the book value grew a little bit more and the dividend remained the same. The company became more efficient and the EPS of $1.50 went more into your pocket.
As we go year by year and you keep going down, the book value continues to grow. In 2012, the book value went up to $20 and they’re still paying their $.30 dividend. The EPS remained the same.
If we summed all of the EPS that would have occurred for the 10-year period, we would have $15. The combined results of the book value and the dividend of our 2 different options ended up at $13. Over a 10-year period, we lost $2 just through the system that his company was operating even though the net profit was made.
When we plot this over on the right-hand side, it’s really a nice linear-looking graph. Put a line right down on that graph, a plot that, and look at the slope to have a general idea of how 10 years from now that book value will grow. As long as the earnings are constant, Company X’s book values will be around $35. When you look at that slope and how it’s trending, the dividend will remain at $.30 a year.
That $13 was the cash gained over the past 10 years. Your job is to estimate how much cash will be taken out into the company in 10 years. Use the slope to predict its future value if the dividends are contrary growing. Stability is everything!
Always remember the book value growth and dividend come from the EPS. Always look at the projected earnings to ensure tour estimated cash in the future are realistic. You might have a great-looking slope and then you go and look at the earnings projected for next year and they are not making progress, I suggest you run away from that.
Assume that we looked at Company X’s future estimates in 2013 as $1.50 and 2014 as $1.55. This would trend with the $1.50 they had in the past. We could go ahead and say that book value will grow at that same slope that we saw in the past 19 years and they will continue the dividend payment. We can estimate what kind of cash we can get out of this business.
Another quote from Buffett says, “In other words, the percentage change in the book value in any given years is likely to be reasonably close to that year’s change in intrinsic value.” Use that with confidence and make sure you’re doing something stable.
What was the average growth of company X during the past 10 years? It’s time to use the buffettsbooks.com calculator just below the video.
BUFFETT’S BOOKS INTRINSIC VALUE CALCULATOR
The calculator is broken down into two different sections. We will use the top section first. Come up with a very rough estimate of how much that book value was growing annually throughout the 10-year period up to now where we’re at.
First, input the book value. In 2012, it is $20$, so put $20 there. Make sure you don’t out in a dollar sign; just put in the numbers. The old book value is $10 in 2002.
The number of years between the book values is 10. If you had 10 numbers up there, you’d only use 9 years right here, because the first year is just the baseline.
Hit calculate to show you an average book value change of 7.17% a year. The book value was growing at 7.17%. That is important because as we look into the next 10 years, we know that the book value now is 20. That gives us a good idea of what we might want to use when we estimate how the book value is going to grow over the next years for the bottom calculator.
Now we move down to the bottom calculator and use the numbers from the top calculator. The cash being removed from the business is the dividend.
In this calculator, I have a set up so that the dividend you only have to enter is for 1 year and what the calculator will do is sum up the dividend payment as if you’re getting it every single year for the next years. For one year, let’s say you’d make $.30, so put in .30 there. The current book value in 2002 is $20; put 20. The average percent change of book value over a year (This is what we calculated above) is 7.17. Put in 7.17, because that’s our expected book value growth.
This is where Buffett says that any two people will come up with different figures because estimates are not exact. I like to take the most conservative approach possible. If it’s a $.30-dividend today, I’m going to use a 30 cents dividend for the next 10 years as far as the book value growth.
If it’s high like over 15%, the calculator doesn’t even work at that point, because that’s a growth company and not a stable company. 7.7% is a pretty average growth rate.
This is where the guesswork of the intrinsic value calculation really comes in. it’s a matter of reference and risk; you have to tailor it to your specific needs. Based on how a flat line is, I’m going to use 7.17. If you’re always comparing it to a 10-year federal note, the number will always be 10.
The 10-year federal note is something you have to look up because it changes all the time. Right now, it’s 1.7. It’s the percent that you’d get if you would buy a 10-year federal note. In the next section when we calculate the intrinsic value for Disney, I’ll pull up the number to show you where I would go out to find that. Right now well just use 1.7%. Hit calculate and it’ll give you numbers in dollars – an intrinsic value of $36.50. That’s great, but you probably want to see this work on a real company.
Let’s move on to Disney with a market price of $44.33. Figuring out the intrinsic value for Disney is the same step as Company X. We have these numbers up, so I’ll show you how to fin all these numbers off on MSN money.
At the MSN page, scroll down and enter the Disney ticker D-I-S. It pulls up the Walt Disney Company. The first thing to look at is the trend for the earnings per share over the last 10 years. Go ahead and hit that 10-year summary. The earnings per share over the last 10 years are right here – $2.52 in 2011, $2.3, and it keeps on going down. You can see all those numbers on the left side of the video. 2012 is blank because we’re using that year as a baseline value for the book value.
The next to look at is the change in the book value. How do out find that? Go back to MSN money and click key ratios. When we get to the 10-year summary, get the book value per share. 11.61 at the top, 11.82 is the next and it keeps going down, the current book value at the end of 2011 was $21.21.
If you want an even more current book value than that, you could on in the balance sheet and pull of the equity and divide it by the total numbers of shares outstanding. For demonstration purposes, were just going to do it simpler. As for the dividend payment, they won’t have the 10-year history on MSN money and a lot of other stock listing websites. Go to the Disney website and search for their dividend history. That’s likely for you when you research companies.
If you can’t pull out the dividend Disney is paying now, the easiest way to do is something you can find on MSN money. Go to the top-level page. Type D-I-S and hit enter. Scroll down and look at the dividend rate which is $.60 at this point. Make sure you’re not using the dividend yield because that’s taking the rate and dividing it by the current market price.
The EPS summed up is $15.38. This is Disney’s earnings over the last 9 years from 2003-2011. What actually materialized for the shareholders was $12.68. We added up all those dividend payments and we summed how much the book value grew from 2002 to 2011. It was $9.80 and $3.80 for the dividend. That totals $12.68.
When we look at the Disney chart, the book value has grown very steady. This is really predictable and exactly what we are looking for. We can’t calculate the value of a company that has the book value, dividend, and debt all over the place. For Disney, we can generally assess. The slope can tell that Disney will still be around the $35 range in their book value by the year 2022.
Here we are back at the Buffets Books intrinsic value calculator. Just like before, start at the top with the current book value to figure out how much Disney’s book value has grown over the last 10 years. We’ll use $21.21. The old book value, which we’re going to get clear back to 2002, is $11.61.
The number of years between those book value terms is 9 years. Although there are 10 numbers, you’re only going to use 9 years because the first is just the baseline. Hit calculate. It gives an answer of 6.924%. Disney’s book value has been growing at an average of 6.924% per year.
Now we will use that average book value growth down here on the second intrinsic value calculator. When we look at the cash taken out of the business, this is our dividend. Currently, Disney paying is a $.60-dividend. In the past years, it has been a lot lower.
For me, most companies, whenever they set a dividend, they set it a fairly conservative value, because lowering the dividend has an enormous impact on the stock price. When they rose to $.60, it is a more conservative move because they know they can still pay that even if they go through hard times.
You might want to use a lower value or you might think, “it’s $.60 now, but the average might be higher in 10 years.” This is where they differ in intrinsic value.
I put in .60 there in dollars. That’s for the whole year’s dividend collection. The current book value for Disney is $21.21. Put that in. don’t use any dollar sign or percents, just put in raw numbers. The average percent change in book value per year over the next 10 years is 6.924%. That’s what we figured out on the top calculator based on the previous 10 years. I’m going to use the same number for the next 10 years. If it’s a bit high, you may use something higher and vice versa.
We used 10 years because we will compare it to a 10-year federal note. Although you put 9 years on the top calculator, it has nothing to do with the bottom calculator. The top is just how many years are between your book value figure. Down here is a completely different number that has nothing to do with the top. You’re almost always going to put 10 years here especially if you’re comparing it to a 10-year federal note.
Go to the US Department of Treasury and search 10-year federal note. Click on the chart and come down to the date we are looking for – May 18, 2012. Find the 10-year mark for this. It’s 1.71% for the 10-year federal note. When you go up, it’s 2.8%. The one was comparing is 1.21.
If we’re doing the calculation on the first of May, we would have been using 1.98. That goes up to Buffett’s quote when he said that the future cash flows change or if interests rate move, the intrinsic value will change. This is exactly what he meant.
Put in 1.71 and hit calculate. It says that the intrinsic value of Disney is $40.43. If you are watching this video from YouTube, this intrinsic value calculator is found at www.buffettsbooks.com under the course 2 unit 3 lessons 5 tabs. If you want to go directly to the calculator, this is the web access to follow: https://www.buffettsbooks.com/intelligent-investor/intrinsic-value-calculator.html.
The market price Disney is creating is $44.33. When you use the intrinsic value calculator, the value of Disney is $40.46 when compared to the 10-year federal note. What does that mean? If you could buy Disney right now for $40.46, we estimate you get a 1.7% annual return on your money for the next 10 years. However, it’s trading for even higher than that; it’s trading for $44.33. That means you’re going to get a worse return than the 1.7% annual return.
Is Disney undervalued? No. it’s actually overvalued. Walt Disney Company passed the first three rules, but when we came to the fourth rule, we cannot buy this because it’s overvalued.
When we come back to the intrinsic value calculator and we were using the 10-year federal note at 1.71%, we’re using that because it’s a risk investment. If I was given choice between buying Disney for $40.46 or investing in a 10-year federal note, which one am I going to choose? If I pick the 10-year federal note, it has zero risks! Disney has more risk that it might not produce the return that we estimated. It could be higher or lower.
What kind of return will we get from $44.33? To do that, just come under the 10-year federal note tab. Put the number in and lower that. Make it 1% and see what value we come up with. When we put it in like 1% return, the intrinsic value moves up to $3.18, which we’re still into at the price that it’s trading for. Let’s go down to .8%. If you’d buy Walt Disney at $44.33, you expect to get a .8% return on your money over the next 10 years. That’s not very good! This company is trading for an enormous premium way higher than I would ever buy it at!
Play around with the calculator; get used to it. Learn it.
When you have a higher federal note value, it will drastically change the intrinsic value. If you have questions, I encourage you to go ahead and click on the tab above on this website for the forum. If none of this made any sense, sign up for the form and start asking these questions. I’d be happier to answer them for you.
LESSON VOCABULARY
Market Value
The current price of the stock that is traded on the exchange. You can find this price on a simple Google search on the name of the company.
Intrinsic Value
The value of the stock according to your estimates. It is most likely that other another investor have another estimate for the same company that you are looking at. You want the biggest difference between the intrinsic value (high as possible) and the market price (low as possible).
Discounted Cash Flow
Cask taken out of a business in the future is not worth the same as it is today. If you had the money today you could invest them. Money in the future is partly eaten up by inflation, but more importantly more uncertain if it is there at all.
EPS
The earnings of a company dividend out to each individual share. If the company has $500 in earnings and has 100 shares outstanding the EPS is $5.
S&P 500
500 of the biggest listed companies in the US. There are detailed selection processes, but the way to think about S&P500 for the investor is ‘as the market’.
