Investing

Intrinsic Value of Stock: Here’s What It Means Based on Warren Buffett

Chris Lee Susanto, Founder at Re-ThinkWealth.com

6 July 2019

intrinsic value of stock

Image source: Flickr

Here’s the thing:

1. Different people may have a different definition of intrinsic value.

2. Even if two people have the same definition of a stock’s intrinsic value, they would most likely not get the same precise value of a company during valuation.

Lets tackle [1] first, then I will go on to [2] later.

What is Warren Buffett’s definition of intrinsic value?

Warren Buffett’s definition of intrinsic value is “the discounted value of the cash that can be taken out of a business during its remaining life”.

Now take a moment to pause and think about the above definition.

Isn’t it logical?

I think that it is easy enough to understand.

Basically, the intrinsic value of any stock is the estimate of future cash flows that a business can produce out of its remaining lifetime.

Now that is where [2] comes about. Remember above I said that even if two people have the same definition of a stock’s intrinsic value, they would most likely not get the same precise value of a company during the valuation?

This is where investing in stocks get interesting and fun.

If we break down the definition properly, there are 3 assumptions or inputs or estimates that an investor needs to make based on this definition of intrinsic value:

1. The future cash flows of the business

2. The number of remaining years the business can last

3. The rate as to which we discount the cash flows to the present value

So first, it means that to be able to get a business’s intrinsic value, we need to be able to predict with quite a high certainty of the business’s future cash flows.

This requires the investor’s understanding of the target business.

The estimated number of years and the rate of return to present value the cash flows need to also have a range.

That is where we can do a sensitivity analysis.

But the key is this: the next time you want to analyze any business to come out with its intrinsic value, you must first ask yourself: Can you get a reliable estimate of the future cash flows of the target business? Can you estimate its future well enough to understand the estimated length of life it can have?

If the answer is no, it is likely that this business is not within your circle of competence and it is best to skip it.

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Disclaimer:

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