Latest / Money Grows on Trees / #364 - Warren Buffett's Method Of Calculating Intrinsic Value

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#364 - Warren Buffett's Method Of Calculating Intrinsic Value · Money Grows on Trees

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Warren Buffett has turned a single number into the most powerful filter
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in investing. Most people have never heard of it and it's called intrinsic
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value. And the idea is very simple. Every business has
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a real worth based on the cash that it will produce over
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a lifetime discounted to a value today. The price on
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the screen is what the market thinks it's worth today. The
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gap between those two is where the wealth is
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made. I'm Lloyd J. Ross, seven-figure investor and entrepreneur. And
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in this short episode, I'm going to break down Warren Buffett's exact method for
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calculating intrinsic value, why it's the most useful concept in
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stock picking, and how to use it yourself before you
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buy your next share. All right, before we jump into this, as you can see, it's
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Ferrari week here in the studio, and I can see my car behind
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me there. If you haven't done so yet, go back and check out the episode, the
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full episode I did, where I dove deep into why I
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bought the Ferrari, how I bought it, how you can buy one, the details of
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how the money works, taxation, all that stuff, and the story of
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how I coached myself to buy it. I love the episode. If you haven't checked it
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out, go check it out now. I'm sure you'll love it. There's lots of lessons to learn in that, and
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let's crack on. So I want to talk about this number intrinsic value. Let
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me break this down for you and help
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you understand it and then how you can implement it. It's quite interesting. Ben
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Graham, who was, if you follow Warren Buffett, you'll know that he had a
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mentor in Ben Graham. And Ben Graham was the co-author of
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the book, The Intelligent Investor. Graham and Dodd wrote that. And
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Security Analysis, incidentally, too. That's quite a big book. So if
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you buy the book Security Analysis, a fairly technical read, actually. It
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talks a lot about bonds as well as shares and some concepts of investing. The
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Intelligent Investor is a much easier book to read. Specifically, I
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believe, if you pick up that book, Chapter 8 is really important, learning
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about how the market moves around the intrinsic value I'm going to talk
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about today. So Ben Graham, Warren Buffett's mentor, who's
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effectively the inventor, I guess you could say, of value
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investing. And I believe what Warren and Charlie have said in the past,
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that all investing should be value investing. I don't know any investors who
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go and invest not to try and create value, but Warren Buffett
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effectively learned this intrinsic value thing from Ben Graham. And
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so, how it's very easily explained, as
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I mentioned at the start, is there's a fairly
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true value of what a business is worth based on
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the assets that it owns and specifically what those assets
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are going to produce for the company in the future in terms of cash flow.
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Now, in corporate finance, you
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learn time value of money and you learn how to discount future potential
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or estimated cash flows back from the future to a value that you'd
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pay today based on a prevailing interest rate. Now, without getting into the
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details of that mathematical formula, which it is, you can go and Google if you
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want. But what that's doing, when you're estimating cash
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flows in the future and you're discounting them back to a value today, that's
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the rough estimate of what the business is worth. Because a business is
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only worth the amount of cash flow it can produce. That's
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why you can't do valuation calculations on
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things like gold and bitcoins because they don't produce cash flow. So
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you can't ever determine the true intrinsic value of it. You just
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can't. So you're always stuck with anchoring it
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to previous prices, which is where trading gets in the way and then people
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lose money, which is why you never see crypto traders or FX
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traders or gold traders in the top 400 Forbes because
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that's not how the big wealth is made. It's too uncertain and unknown
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and it just destroys you over time, a bit like gambling. And that's why
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Warren Buffett doesn't hold any crypto. That's why he doesn't hold any gold. That's why, because he has to
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understand, if I'm buying this business asset, I've got some level of
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certainty around what it will produce in the future. So he can estimate roughly
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what he thinks. And he likes to look out five years plus. So
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he likes to think, okay, what's this business going to do in the next five years? Because outside
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five years, it's also a little bit tricky to estimate what the business will produce because
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things change so much. So that's why he also looks to buy businesses that
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don't change that much. So a lot of people get caught up buying the latest tech
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stock or whatever, thinking that change is good for a business, but the
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reality is if you can buy a company like he talks about, Wrigley's and Coca-Cola and
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these hundred-plus-year-old companies that aren't going to change, that's what you want to
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get your hands on, I think, because change is not
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always value accretive. So if we can anticipate or
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estimate the future cash flows over the next five
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years, and we can discount them back to a discount value, to
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a value today, we can have a rough guide of what we think a
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business is worth. So on a small scale, when we bought our
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laundromat business, it was producing like $250,000 turnover,
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and it's only a little one at $100,000 of net profit, a profit
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multiple of say three, you'd estimate to buy it, it'd probably be
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worth between $300,000 and $400,000, rough guide. So that the
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intrinsic value of the laundromat is between $300,000 and $400,000. Based
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on what its cash flows could produce, like a three to four year payback
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period is a reasonable expectation for a business of
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that risk profile based on its performance and
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the way that the business is built around machines and not people. So
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there's those elements to consider. But that's rough,
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the rough intrinsic value of that laundromat business is
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between 300,000 to 400,000. So the intrinsic value is not a single number. It's
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actually a range, because no one can absolutely determine what a business is
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worth. They just can't. Some businesses like mortgage
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books, they'll sell for seven. The more certainty around
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a business, the more it's worth. But if we look at a laundromat, three to four times annual
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profit, 300,000 to 400,000. Cool, that's what the intrinsic value
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is. But now if you can buy that for less than that, you're then
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buying, you're getting it for a bargain. So you're instantly
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creating equity. So when we bought it for $250,000 actually,
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we knew it was worth beyond $300,000. In fact, it was probably worth at the time
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$325,000. So we knew we were getting it for 75% cheaper than the
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intrinsic value, really what it's worth. So if you can figure
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out what something's really worth based on its future cash flows and comparables in the
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marketplace, et cetera, and you can buy it for less than that, you're creating alpha.
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You're creating, Instant value and
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so in Warren Buffett's early career He was finding companies for
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example that and I know he bought Disney the same way, too He
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was finding companies that if you look at the price to pay for the stock for
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the whole business the whole business was selling for less than
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Its net tangible assets its land its physical
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tangible equipment like crazy things he was finding
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back in the 50s and 60s and And so when you find things, basically
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he talks about you can buy dollar bills for 50 cents. Now
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you can't do that in the present marketplace. I'm sure there's some opportunities around, but we
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bought our laundromat for probably 75 cents on the
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dollar. So we were buying what was really intrinsically a dollar. We
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were buying it for 75 cents. And if you can buy things like that,
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then you do mitigate a lot of your downside risk. It
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doesn't mean there's no risk. It just means you're mitigating your risk. So it's important
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to understand how this intrinsic value calculation is done. Now,
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what's funny about this is Charlie Munger has famously said at
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the Berkshire meetings before that he's
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never seen Warren Buffett do a discounted cash flow
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model on an Excel spreadsheet, which is how you do it. For example, like
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if you Because an intrinsic value calculation is
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only as good as the estimated cash flows that the business can produce. So there's a level of
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guesstimation that happens. But for some people, they go, I can guess that. I
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can estimate that pretty closely. Not one can. But Warren likes to, from
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what I understand reading, listening to Todd Coombs, who used
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to work for him, and Ted Wessler, and so these guys, they would talk about
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these times where they'd sit with Warren, and they'd talk about what are the best companies on
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the planet, where we can estimate their actual cash flows for
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the next five years, that are still going to be around for 100 years without us having
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to sell it. They're looking for long-term capital allocation decisions.
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But if I was to pick up my chatty-patty and say, Based on the
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current cash flows of BHP and the estimated
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growth in earnings over the next five years, based on historical
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earnings and what the copper price and iron ore price will do, based on
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what you know in the marketplace, can you please estimate
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the intrinsic value of a share of BHP based
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on those things using the net present value formula,
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discounting back to a reasonable discount rate today? Let's
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see Now that might be too mouthful for you like what the hell did Lloyd
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just say that's another language I get it, but it's just you
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can even ask it. What's the intrinsic value calculation? What's
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the net present value calculation says? Yes. I'll treat this as
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a five-year DCF for BHP It's a bit slow the
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the net internet here. Hopefully it's gonna do it. Okay, so Okay.
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So it's going to take, so there's a way you can do this where you can take, if a company
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is paying a dividend, that's also a cashflow that tends to grow with
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earnings. So you can actually take a proxy of the cashflow as
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the dividend. So if you've got a company that's got a dividend yield, an actual dividend
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being paid, and it's consistently been paid for a long time, and you can see a pattern
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of it tends to grow over time. Like there's some amazing dividend aristocrats,
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like what was the recent one? I think it was McDonald's just went through its 50th year. Coca-Cola's,
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I think it's 65 years or something of dividend growth. Dividend growth, not
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just dividend growth. American Express, like 20, 70, there's a lot. And
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so the more consistency or certainty you have around what's dividend, you
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can use the dividend cash flow and estimate that
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for the next five to 10 years and discount that back. That's called a dividend discount model.
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And you're trying to estimate the intrinsic value of the asset or
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the business based on its dividend cash flow, which
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you can do. It's called a dividend discount model. It's calculating it
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now. So it's calculating BHP's free cash flow. Oh
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no. Dividend cash flow. Okay. So here
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we go. I get a base case intrinsic value of roughly $46 per
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BHP share. Okay. So roughly a range with
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a reasonable valuation range of $31 to $68. Quite a
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broad range, right? So it took the $9.8 billion
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of free cash flow. It's up 83% actually, and
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it's estimating what the growth in copper and iron ore will be, and the
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estimated free cash flow. So the estimated free cash flow of BHP
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from next year, $8.5 billion, to
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$12 billion. So it's going to be probably a 50% uplift in earnings over
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the next five years, which is pretty good. A lot of that is already priced in.
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BHP says it is an organic pipeline to deliver 40% more copper production.
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So the intrinsic value today of BHP, based on this estimate,
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is $45.70 per share. The price is currently $62, and
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so you're actually buying it for more currently than what
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it's worth. There you go. So that's interesting. which
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is roughly probably about right, maybe even be $50, but we don't know. The
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thing is that companies like this that are
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bullish on their earnings next five years, they seldom sell for less
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than their intrinsic value. They'll typically sell for more. Some
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of these will sell for a premium for the next 10, 20, 30 years. And
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I think of Costco. So look, does that make sense? So the actual valuation
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is probably more about 50 bucks. It's something to see too, but it's overvalued. But
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I think it's in its simplistic terms, you're
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seldom going to find companies of high quality that are going to sell below intrinsic
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value. Yeah, you could have picked up BHP for like in the
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late 30s recently before the big copper story if you had had
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the information. So that's why it's not easy. And that's why quite
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often you're going to have to buy companies at a premium if they're going to
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be good companies in the future because they sell and go on sale. If
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you look at what Warren Buffett has done on his Coca-Cola, American Express, Apple
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purchases, Bank of America purchases, not so much Google, he's
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actually bought them at very reasonable prices that
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he has estimated to be below the intrinsic value. He bought
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them at 10 times earnings. So he's really good at identifying these good quality
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companies that haven't quite, that are actually selling cheap. But
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you've got to wait years. Like he bought Coke when they brought vanilla Coke
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out and there's a bit of a short, there's a drop in the price. He bought American Express
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with the salad oil scandal when it fell out of its butt and
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he bought it for seven times earnings, which is crazy. He bought Apple at
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10 times earnings and he put 50 billion in famously into that. So he waits
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for these really good quality companies to go on sale and he bets big.
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And that takes tremendous patience. And quite often you miss
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a huge run up by doing that, but he mitigates his downside so well. I'd
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love to own Costco. It's a great business, a wonderful business, one
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of the best in the world, but it's like selling for 50 times
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earnings. This is too much. But if it fell to 25 times earnings, even though
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it might be selling above its intrinsic value, I might be considered to
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buy it because companies like that will predominantly always
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sell at a premium. And you can often say the same thing about Moody's, American Express,
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Mastercard I should say, Visa, et cetera. I currently feel that
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American Express is undervalued based on
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its potential intrinsic value because it's selling for 17 to 18 times earnings. And
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I believe if it can fall below, I bought it for $2.92, sold
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it for $3.50 thereabout, I would love to buy American Express in
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the $200s. Just quickly, if you're ready to take control of your finances but feel
12:54
stuck on where to start, I have a solution. My book, Money
12:57
Buys Happiness, simplifies investing and wealth building with
13:01
practical steps to help you achieve financial peace. Get
13:04
your copy via the link in the show notes and let's get your money working for
13:07
you. Now back to the episode. Google is much the same. It's down to
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$3.32. I'd be glad to buy Google in the $200s, and I'd probably throw a million. I
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could hold some of these companies and throw a lot of money at them quickly. Coca-Cola,
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I almost bought it at $66. That was probably selling below its intrinsic value. But
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you can understand now, I think, based on this episode, that there is an
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actual calculation either on the dividends it's going to produce or the free cash flow
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the business will produce and what it's worth to you today. And
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paying less than that is important, but it's just so hard because
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it takes so much patience and time. And you
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have to also estimate the intrinsic value properly. You have
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to kind of know what's cool about AI is now you can act. Look
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at that. I prompted that and got a pretty good estimate. Now
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it doesn't mean it's completely accurate, but it means, Hey, it's pretty close. You
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can tell, should I buy? So right now I wouldn't buy more BHP shares.
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I'd leave it. But if it fell down again, to be fair, if it fell down below 50, I
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would probably, it's just, it's. Even if it's sell like even
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if it's a great business is Selling
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for its intrinsic value or roughly around there. It can
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often still be in a marvelous bar Because it's seldom
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sells below. Okay, so I think you have to be conscious of
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that Chris Hahn talks about this if you follow his supervisor Chris
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on he's one of the fact he was the best hedge fund manager last year and And
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he says, you can estimate an intrinsic value today for a business. And
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if you try and buy below that, you may miss it because the next 30 years it may
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just compound to oblivion and you just miss it completely. So he said, quite
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often we underestimate the intrinsic value of a current business
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based on the quality of it over the next 30 years because it just, it evolves and
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the productivity gains are what we can't see. And like he said,
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it's just compounds. You look at Moody's and Amex and
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Visa and these incredible companies. Almost
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everyone has underestimated the power of their ability to compound. And I believe Warren
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Buffett recently felt that when he, or calculated that,
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I should say, when he looked at Google. Because if you look at Google's business, five
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businesses in one, even though it's a $4 trillion company, he's
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obviously thinking, God, I'd probably get under, it's probably gonna be
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cheap looking forward for 30 years. And that's what makes him an
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effective investor. He doesn't always have to get it for super cheap, but it has to
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have a propensity to increase his earnings. If you look at Google, Yes,
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there are some investment gains that's included in its earnings report that
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pop up there, but it had a flip and huge blight and it's 80% earnings
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growth. It's just mental what's happening with that company. So if
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the earnings growth is really high, higher than what you anticipate
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it's going to even be, perhaps some of those intrinsic value calculations are
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inaccurate. So it's not always easy, and I'm not purporting
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to say it's easy, but at least you know now that one,
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there's a mathematical formula for how to calculate the rough estimate
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valuation of a business based on its cash flows. You know now why
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I don't touch crypto and gold as other ones that don't produce cash flow because I can't do that calculation. So
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I don't know if I'm getting a good deal or not. And you
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also know now that sometimes you've got to pay up
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for good quality businesses because they seldom go on sale. and they
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can compound to a marvelous rate. And I think those three are good
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three lessons to take away from this episode. But of course, if you
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literally have no idea what to do when it comes to shares, a
16:18
couple of things I'd love you to do. If you want to amplify your knowledge in this space, I'd
16:21
love you to go back on our YouTube channel and our podcast
16:25
episodes and go back to the episode I did on shares masterclass,
16:29
not meant for the public. It's still available. Go back and check it out.
16:33
It's a masterclass. I never watch my own content. I tell you,
16:36
I don't. I don't want to watch my own content. But I watched this
16:39
back for some reason, and I was like, that's fucking pretty good. So
16:44
if you want to go watch it, then also if you want a tactical play-by-play
16:48
of how to turn your finances around when it comes to all parts of money, then
16:52
I want you to go grab the book, Money Buys Happiness. You can find that in the show
16:55
notes, moneybuyshappinessbook.com. Go check it out. It will help turn,
16:59
like when you go to that, you'll see the testimonies of people that turn their whole financial journey around
17:02
with that one book. So there's some two good resources. There's some
17:05
two good resources. That's terrible English. There are a couple of great resources for
17:09
you to begin your financial education journey. So
17:12
hope you enjoyed this episode. Let me know in the comments what you think about this.
17:16
I'm sure there'll be some comments on this. Particularly if you're a very seasoned investor, you may have something to
17:19
say about it. Pop it below or come and have a chat in there and
17:22
then hit the subscribe button. If you can, go smash that. That'd be awesome.
17:25
And then thank you for sharing this episode with a friend and hope you've enjoyed Ferrari Week