Investing Lessons [Beginners]
Warren Buffett Often Talks About Intrinsic Value: What is it?
Chris Lee Susanto, Founder at Re-ThinkWealth.com
1 May 2018
Warren Buffett often talks about intrinsic value.
But what exactly is an intrinsic value?
Knowing what is intrinsic value is the FIRST step for any aspiring investors who want to be a practitioner of value investing.
UNDERSTANDING what is intrinsic value is, of course, the second step for aspiring value investors.
Because knowing and understanding is two different things.
Of course being a value investor takes much more than simply knowing and understanding intrinsic value – having the right character is another vital aspect. But let’s save the character discussion for another day.
Today’s topic is… what is intrinsic value?
To give you a general idea at the start, I will share with you what Warren Buffett says about intrinsic value:
“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.
The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.” – Warren Buffett
So from what Warren Buffett says above, intrinsic value calculation is vital for any investor who wants to invest in stock/business because that is the only logical way.
Here are four key takeaways that will shed light on what is intrinsic value, based on Warren’s quote above:
- Intrinsic value is logical – which means that it should be backed by facts and logic.
- Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life.
- Calculating intrinsic value is hard.
- Intrinsic value is more of an estimate rather than a precise figure – which has to be adjusted according to interest rates movement and future cash flows forecast change.
I have a confession to make: I always come out with an intrinsic value of all the stocks that I have bought before – and so far, seems like the strategy is working as my annual return as of quarter 1 of 2018 is still above the S&P 500 return.
There are many ways to calculate intrinsic value – which as Warren Buffett said is the discounted value of the cash that can be taken out of a business during its remaining life.
But what we need to know today is simply that intrinsic value is the calculation all of us needs to make before making any stock purchases and when intrinsic value > market value of the stock, we should buy it.
That also means that when intrinsic value < market value of the stock, we should sell it.
Maybe I will write an article sharing my view on calculating intrinsic value in the future but I am sure one article would not cut it.
Each company would have a specifically different way of calculating intrinsic value – and that is what makes investing so fun – because its so dynamic.
So do you understand what is intrinsic value now?
If you want to be a value investor (or any investor for that matter), we should look for an asset that is selling at a price well below their intrinsic value.
So we should definitely try to understand what is intrinsic value.
Calculating that value and the accuracy of calculating the value is what separates a good investor and a not so good one.
Only time will tell whether one is right in his or her intrinsic value calculation or not.
Key question: Can one be right in calculating an intrinsic value but still lose money?
The answer is yes if the market do not realize that value over time. As the saying goes, we are may be right and still lose money and be wrong and still make money.
But let’s aim to be right first, shall we?
Since intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life, intrinsic value essentially is about the cash that the business generates.
Let me tickle your brain just a little… what if the business as of now, have not generated cash? Which means that it has a negative net income. Instead of generating cash, it is burning cash.
Can we still find out its intrinsic value?
Let’s delve even deeper into Warren’s thoughts on what is intrinsic value.
Over time, it seems like Warren Buffett’s definition of intrinsic value is the same as a term he coined as “owner earnings”.
In his 1986 letter, Warren said this about owner earnings – which sounds like intrinsic value:
“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 ( c) 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.)” – Warren Buffett
So if we assume that intrinsic value = the discounted cash that can be taken out of a business during its remaining life, owner earnings sound like a more precise calculation as to how we can calculate those “cash” in the business.
So if that is the case, an intrinsic value may be = owner earnings which are = reported earnings plus depreciation, amortization and other non-cash charges less the average annual amount of capital expenditures plus any future potential increase in working capital.
But if you do not want to view intrinsic value as owner earnings, then it is alright too because of your perspective of the cash that can be taken out of the business during its life can also be other factors – for example, dividends?
So in conclusion, intrinsic value is essentially the discounted cash that can be taken out of a business during its remaining life – as stated clearly as possible by Warren Buffett.
Who would understand intrinsic value better than Warren Buffett? I am sure not many – or even none. But then again, what he revealed may only be 1/100 of what he knows about the topic of intrinsic value (even if that’s the case, it’s still pretty damn good right? As I for one, have benefited a lot from Warren’s teachings as I study a lot of his writings extensively.).
Anyway, if there is one thing I know for sure is this… being able to calculate intrinsic value accurately is key to our success, as an investor.
And it is a never-ending lifelong journey of continuous learning.
So the next time someone asks you what is intrinsic value, you should be able to answer them right?
Intrinsic value is essentially the discounted value of the cash that can be taken out of a business during its remaining life – which is calculated before buying a stock to see if a stock is cheap or expensive relative to its market value.
Disclaimer: The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.
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Thank you for your time reading.
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