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Dave Ahern
Dave Ahern
Articles (12)  | Author's Website |

Intrinsic Value: Warren Buffett's Thoughts

Arguably the greatest investor of our generation, Warren Buffett has illustrated his thoughts on intrinsic value throughout his letters

December 17, 2017 | About:

“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.”

-- 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.”

-- 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.”

-- Basehit Investing

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.”

Vintage Value Investing

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.

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Comments

Thomas Macpherson
Thomas Macpherson premium member - 10 months ago

Outstanding stuff Dave. Really enjoy reading your aricles. Best - Tom

dunyuliu
Dunyuliu - 10 months ago    Report SPAM

I learned a lot! Thank you so much!

Dave Ahern
Dave Ahern - 10 months ago    Report SPAM

Thanks guys, I appreciate the comments. It was a lot of fun to put together and read all the great Buffettims!

JOSEEE2
JOSEEE2 - 9 months ago    Report SPAM

Great information

rrurban
Rrurban premium member - 9 months ago

Very good explanation of maintenance capex and the exact method I use.

As a beginning point you want to find maintenance owner earnings (for a no growth business). Once you have that, you want to determine reinvestment rates on the growth capex as well as length of the runway. Doing this will allow you to fine tune your future FCF estimates. Since valuation requires forecasting FCF you will need to be somewhat certain of your forecast for the next 5-10 years, so competitive advantages are key here. Forecast FCF, find the average FCF, then divide by an appropriate discount rate determined by the quality of the business, predictability of cash flows and amount of leverage being used, discount rates being typically 10 yr rates + 5-10% risk premia. You will now have the valuation of free cash flow. However, all value starts with assets, tangible and intangible so you need to add those into the valuation, going line by line off the balance sheet and footnotes in the 10k trying to estimate REAL values as close as possible. I do not like to double count intangibles as they are mostly accounted for in FCF generation. You will get good results using this valuation method if you can remain confident in your valuation, and most importantly, remain extremely patient and only bet when odds are hugely in your favor. Many will be skeptical of adding in asset values into the valuation, even stating this is double-counting. But what we're really interested in here is the real life value if you were to buy 100% of the company. So think of it this way; if you bought the whole company and FCF suddenly dries up your remaining value (safety net) will be in the assets of the business. If the assets have value in the absence of profits then they certainly still have value in the presence of profits. The value was always there. Thanks for the article!

A-3
A-3 - 9 months ago    Report SPAM

It was a great read, thank you for the article. Sometimes I make quick & dirty evaluation of owner's cashflow/earnings this way: owner's earnings = cashflow from operations (from CF statement) - maintenance CAPEX.

relkunk2
Relkunk2 premium member - 9 months ago

Dave, I’m a novice but I have been doing a lot of studying of companies and the more I study the more I want to learn. But just to let you know I have no background in financial statements of a company but believe a true understanding of a company derives from the understanding financial statements, so if you could, please help me out to further my knowledge.

Regarding Step 4, figuring the maintenance capital expenditures to which you came up with 9814. Since the revenue change was positive for the years Dec 2011 to Dec 2012, Dec 2012 to Dec 2013, Dec 2013 to Dec 2014, Dec 2014 to Dec 2015 and Dec 2015 to Dec 2016 I performed the calculation for NET PPE. By using PPE of Dec 2012 divided by revenue of Dec 2012 and came up with .658 then multiplying that by revenue change and came up with 12350.64. I did this for years from Dec 2012 to and including Dec 2016; the result provided me with Growth Capital Expenditure going back 5 years. Using your third calculation, I made the Capital Expenditure positive then subtracted Growth Capital Expenditure from it. E.G. for Dec 2012; the Capital Expenditure was -9975, therefore changed it to 9975 which then subtracted from it 12350.64 resulting in -2575.63. I got negative numbers for Dec 2012 and 2013 and positive number for Dec 2014 to Dec 2016. So for years Dec 2012 and Dec 2013 the Maintenance Capital Expenditure= 9975 and 11087, respectively. The Maintenance Capital Expenditure for 2014 to 2016 = 6339.16, 4903.26, and 4303.62, respectively. Now averaging those 5 years I get 7281.61. This of course does not match your calculations of 9814. Where did I go wrong since my number is so much different than yours?

Moving on to the fourth calculation, you indicated to get the average of the 5 years maintenance capitalization but the numbers you showed were quarterly numbers beginning Dec 2017. You summed them up and got -11396. To which I really got lost, so I hope you provide me with where I’m getting this all wrong.

Step 5, for the Change in Working Capital, Berkshire provides that number as a line item, please correct me if I’m wrong. You just indicated a different way for other companies, so thank you.

I’d like to thank you in advance if you decide to help me out in this venture to get a possible snapshot of one of the ways to get the intrinsic value of a company.

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