One of the most sought after calculations in all of investing is Warren Buffett’s inherent value formula. Although it may seem elusive to most, for anyone that’s studied Buffett’s Columbia Business Professor, Benjamin Graham, the calculation becomes more obvious. Remember the inherent value formula that Buffett uses is an embellishment of Graham’s ideas and fundamentals.
One of the most amazing things about Benjamin Graham is that he truly felt bonds where safer and more probable of an investments than stocks. Buffett would strongly disagree with that today due to high inflation rates (a whole different topic), but this is important to understand in order to understanding Buffett’s method for valuing equities (stocks).
When we look at Buffett’s definition of inherent value, we know he’s quoted as saying that the inherent value is simply the discounted value of the future cash flows of a company. So what the heck does that average?
Well, before we can understand that definition, we must first understand how a bond is valued. When a bond is issued, it is placed on the market at a par value (or confront value). In most situations this par value is $1,000. Once that bond is on the market, the issuer then pays a semi annual (in most situations) coupon to the bond holder. These coupon payments are based on a rate that was established when the bond was initially issued. For example, if the coupon rate was 5%, then a bond holder would receive two annual coupon payments of $25 – totaling $50 a year. These coupon payments will continue to be paid until the bond matures. Some bonds mature in a year while other mature in 30 years. in spite of of the term, once the bond matures, the par value is repaid to the holder of the bond. If you were to value this security, the value is completely based on those meaningful factors. For example, what is the coupon rate, how long will I receive those coupons, and how much of a par value will I receive when the bond matures.
Now you might be wondering why I described all that information about bonds when I’m writing an article about Warren Buffett’s inherent Value Calculation? Well the answer is quite simple. Buffet values stocks the same way he values bonds!
You see, if you were going to calculate the market value of a bond, you’d simply plug the inputs of the terms listed above into a bond’s market value calculator and crunch the numbers. When dealing with a stock, it’s no different. Think about it. When Buffett says he discounts the future value of the cash flows, what he’s truly doing is summing the dividends he expects to receive (just like the coupons from a bond), and he estimates the future book value of the business (just like the par value of a bond). By estimating these future cash flows from the meaningful terms mentioned in the past sentence, he’s able to discount that money back to the present day value using a respectable rate of return.
Now this is the part that often confuses people – discounting future cash flows. In order to understand this step, you must understand the time value of money. We know that money paid in the future has a different value then money in our hands today. As a consequence, a discount must be applied (just like a bond). The discount rate is often a hotly debated issue for investors, but for Buffett it’s quite simple. To start, he discounts his future cash flows by a ten year federal observe because it provides him a relative comparison to a zero risk investment. He does this to start so he knows how much risk he’s assuming with the possible pick. After that figure is established, Buffett then discounts the future cash flows at a rate that forces the inherent value to equal the current market price of the stock. This is the part of the time of action that might confuse many, but it’s the most important part. By doing this, Buffett is able to closest see the return he can expect from any given stock pick.
Although a lot of the future cash flows that Buffett estimates aren’t concrete numbers, he often mitigates this risk by picking nice, stable companies.