“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. 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.”
--Â Warren Buffett (Trades, Portfolio) from page 4 of his owner’s manual
Determining the intrinsic value of a stock is one of the most vital aspects of value investing. Finding intrinsic value is something we all struggle with, especially with trying to determine the right way.
Warren Buffett (Trades, Portfolio) is considered the finest investor or our generation or any generation. He has many thoughts on intrinsic value and how he uses it to find the value of any company that he is interested in buying.
My goal is to take a look at his thoughts on intrinsic value and how we can learn from the master.
Some other thoughts on intrinsic value from Ben Graham:
“The newer approach to security analysis attempts to value a common stock independently of its market price. If the value found is substantially above or below the current price, the analyst concludes that the issue should be bought or disposed of. This independent value has a variety of names, the most familiar of which is “intrinsic value.”
--Â Security Analysis (1951 edition)
Additionally, he said this:
“A general definition of intrinsic value would be that value which is justified by the facts—e.g., assets, earnings, dividends, definite prospects. In the usual case, the most important single factor determining value is now held to be the indicated average future earning power. Intrinsic value would then be found by first estimating this earning power, and then multiplying that estimate by an appropriate ‘capitalization factor.’”
Finding intrinsic value is in large part determining numbers, but it is also part intuitive, which can be difficult to determine.
My goal with this post is to look at how Buffett defines intrinsic value and what he looks for. Additionally we will take a look at how he might calculate it via a formula.
Intrinsic Value as an Art Form
Calculating intrinsic value is an extremely difficult thing to do, in large part because you are using estimates to find this value. There is no formula you can use that will with absolute certainty give you an exact number that will provide you a margin of safety in your investment.
“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure… two people looking at the same set of facts… will almost inevitably come up with at least slightly different intrinsic value figures.”
What Buffett is saying here is so critical to understanding the definition of intrinsic value and how it impacts our decision making.
When he says, it is an “estimate rather than a precise figure.” That captures one of the central ideas of trying to determine intrinsic value.
We have to remember that there is no final answer to determining intrinsic value, it is a fluid thing, and it is only an estimate. It takes practice to get better at anything, including determining intrinsic value.
“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all- important and is the only logical way to evaluate the relative attractiveness of investments and businesses.”
As Buffett points out determining the intrinsic value is all important because it allows us to find the price relative to the market price and then determine if there is enough of a margin of safety for us to invest in that company.
Buffett’s Intrinsic Value Formula
What is always the biggest challenge in determining intrinsic value. What formula does Buffett use?
Answer.
No one knows with any certainty.
He has never divulged his exact formula that he uses, whether it be a discounted cash flow or any other cash flow formulas that are out there.
Why would he be so vague about this formula when he is so forthcoming about so many of his other thoughts?
I think it is because he wants us to determine this for ourselves, and because it is an estimate as opposed to an exact number he wants us to learn how to do it for ourselves.
The more cynical people out there think it is because he wants to hoard this secret for himself, as his secret sauce that allows him to have this advantage over the rest of the market.
He does, however, hint at what formula he might use to determine intrinsic value.
In the 1986 Berkshire Annual Shareholder Letter Buffett outlined his thoughts on owners earnings.
"If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in (c). However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)"
Why owner earnings?
Buffett feels that earnings are the most important single factor in determining the value of a company.
What we are trying to determine is how much a business earns in a single year and how much that is worth to me.
Buffett’s owner earnings formula is essentially a discounted cash flow modified.
So how does this all work? Let’s take a look by diving into a company close to Buffett’s heart, Berkshire Hathaway.
To learn more about the ins and outs of owner earnings, click here.
Berkshire Hathaway Owner Earnings
Let’s take a quick refresh of the formula.
Owner Earnings = Net Income + Depreciation, Amortization +/- Other Non-cash charges – Full Capex +/- Changes in Working Capital
First, we will have to calculate the TTM or trailing twelve months for all these numbers as we are a few earnings periods removed from the latest 10-k.
Step 1. Find the “net income” from the income statement. The TTM for the latest filing September 2017 was $18,675. I came up with this number from:
· Dec 16 = 6286.300
· Mar 17 = 4060.00
· Jun 17 = 4262.00
· Sep 17 = 4067.00
Step 2. Depreciation, Depletion & Amortization, this comes from the cash flow statement. Berkshire will pay this back because it is not a cash item and the company does not need to pay for it.
Berkshire’s Depreciation, Depletion & Amortization for the TTM ending September 2017 is $9131 Million.
Again these came from:
· Dec 16 = 2296
· Mar 17 = 2243
· Jun 17 = 2296
· Sep 17 = 2296
Step 3. Other non-cash charges usually include stock-based compensation and change in deferred tax. To be on the conservative side, I am not going to include any stock-based compensation. And the easy one is the change in deferred tax, as Berkshire doesn’t have any for the TTM. So that figure is $0
Step 4. Average maintenance capital expenditure over a business/industry cycle. It is best to use an average, and in this case, we will use the five year average of $9,814 million.
Ideally, it is best to take an average of maintenance capital expenditures. The best scenario would be ten years, but since a lot of firms don’t have ten years of history, we use a five-year average instead.
To explain this process, I am going to use some help from one of my favorite financial websites, GuruFocus.com.
The following will show you how to reach this calculation:
First, calculate the revenue change regarding the previous year. If the revenue decreased from the previous year, then the Maintenance Capital Expenditure = Capital Expenditure (positive).
Second, if the revenue increased from the previous year, then calculate the percentage of Net PPE as of corresponding Revenue.
Growth Capital Expenditure = Percentage of Property, Plant, and Equipment as of corresponding Revenue * Revenue Increase
Third, calculate Capital Expenditure (positive) - Growth Capital Expenditure.
If [Capital Expenditure (positive) - Growth Capital Expenditure] was negative, then the Maintenance Capital Expenditure = Capital Expenditure (positive).
If [Capital Expenditure (positive) - Growth Capital Expenditure] was positive, then the Maintenance Capital Expenditure = Capital Expenditure (positive) - Growth Capital Expenditure.
Fourth, get the average of the five years maintenance capital expenditure.
Thus the numbers will be:
· Dec 16 = -3525
· Mar 17 = -2355
· Jun 17 = -2794
· Sep 17 = -3262
The numbers above would give us a total of -11,936 million for previous TTM; then we would calculate the average over the last five years.
Therefore we would average the past five years and get $9,814.11 million.
Step 5. Next up is the change in working capital, which comes from the cash flow statement. We calculate this number by adding the items under the change in operating assets and liabilities, also from the cash flow statement.
Sometimes this number is referred to as a different name, depending on the company. That is one of the fun things about these deep dives into the companies financials.
There is no standardization of some of the terms, which can make things challenging and difficult.
The numbers for the last four quarters:
· Dec 16 = 811
· Mar 17 = 12,118
· Jun 17 = 1678
· Sep 17 = 4321
All that equals $18,928 million for the TTM.
Step 6. Berkshire’s shares outstanding (diluted) for months ended in Sept 2017 was 2466.983 million
Now that we have all the numbers for our formula, let’s go ahead and calculate it for Berkshire Hathaway.
Again the formula:
Owner Earnings = Net Income + Depreciation, Amortization +/- Other Non-cash charges – Full Capex +/- Changes in Working Capital
· Net Income = 18675
· Depreciation, Depletion, and Amortization = 9131
· Change in deferred tax = 0
· Five year average of maintenance CapEx = 9814.11
· Change in working capital = 18928
· Shares outstanding (diluted average) = 2466.983
Plugging the numbers in:
Owner Earnings = ( 18675 + 9131 + 0 – 9814.11 + 18928 ) / 2466.98
Owner Earnings per share = 14.97
Now to calculate price to owner earnings, we divide the current price by the owner earnings per share TTM
Price to owner earnings = 196.70 / 14.97
Price to owner earnings = 13.14
Compare that to the current P/E ratio of 25.98, which is obviously much higher.
Why Does This Matter?
As you can see from our calculation from owner earnings, there are some additional steps to include items that Buffett obviously felt was very important.
It also gives a truer number as to the financial health of the company.
You simply calculate earnings per share by dividing the top line net income from the income statement by the shares outstanding. Not very complicated and certainly doesn’t do much to delve into the financial health of the company.
Using the earnings per share divided by the current market price can lead to an overvaluation of a company. Just basing your evaluation on a P/E ratio can lead to an error in judgment, as can anyone formula or metric.
Final Thoughts
Buffett’s whole mantra with owner earnings is how much cash can an owner take out without affecting the operations of the business.
Wall Street’s mantra is how much money can I make, as you have seen the calculations regarding earnings per share and P/E ratio is incredibly simple.
But they don’t tell any picture about the operations of any business or how much money is being made. And after all isn’t that the whole point of owning a company is to make some cash.
Wall Street spends so much time talking about earnings and whether they are going up or down, and all that focus on the top line doesn’t tell you much about the inner workings of the company.
As we have talked about intrinsic value is an art form, there is more to it than just net income. There are depreciation, changes in working capital and so on.
No one formula will help you determine the intrinsic value of a company. The key is to find a few that work for you and use them as a guide to help you find intrinsic value and a margin of safety.
Remember what Buffett said, “intrinsic value is an estimate, not a precise figure.”
To learn more, read more
The author is long Berkshire Hathaway and has no other positions in any stocks mentioned.
