Intrinsic value gives a measure of how far the price is on either side, and though Buffett has never fully elaborated on how he arrives at the intrinsic value, he has explained how to look at it
Let's say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7 per cent return, so you'd pay $1,000/acre. If it's for sale at $800, you buy, but if it's at $1,200, you don't.
Annual meeting notes, 2007
In 1974 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million.
Now, if you come back, and the value you assign the company is $400 million, and the company is selling for $400 million in the market, you still have a story but it doesn't do you any good financially. But if you come back and say it's $400 million and it's selling for $80 million, that screams at you. Either you are saying that the people that are running it are so incompetent that they're going to blow the $400 million, or you're saying that they're crooked. Or, you've got a screaming buy when you can buy dollar bills for 20 cents. And, of course, that $400 million, within eight or ten years, with essentially the same assets, [is now worth] $3 or $4 billion.
But now you say 'I don't know how to evaluate the Washington Post'. It isn't that hard to evaluate the Washington Post. You can look and see what newspapers and television stations sell for. If your fix is $400 and it's selling for $390, so what? You can't [invest safely with such a small margin of safety]. If your range is $300 to $500 and it's selling for $80 you don't need to be more accurate than that.
I was a chartist. I loved all that stuff. I had charts coming out my ears. Then, all of a sudden a fellow explains to me that you don't need all that, just buy something for less than it's worth.
Lecture to MBA students, 1991
You have to get to the intrinsic value!
The simplest explanation of intrinsic value is offered by Buffett himself. It is the "discounted value of the cash that can be taken out of a business during its remaining life." That definition by itself opens up the Pandora's box. Estimating how much cash the business can generate during its remaining lifetime can be baffling alone. If you manage to do that despite its problems (discussed in depth below), then there is the grey area of using discounting-what rate to use?
The first decision that you will need to make is of opportunity cost. Picking stocks brings in the concept of opportunity cost. Every investment decision you make will be at the cost of one you didn't. This is not lost on Buffett. "The first question we ask ourselves is: Would we rather own this business than more Coca-Cola, than more Gillette? We will want companies where the certainty gets close to that, or we would figure we'd be better off buying more Coke. If every management, before they bought a business, said 'is this better than buying in our own stock or even buying Coca-Cola stock', there would be a lot less deals done. We try to measure against what we regard as close to perfection as we can get."
Using DCF analysis to arrive at the intrinsic value is not without its problems. Forecasting future cash flows is one of the biggest criticisms of using DCF analysis. At what rates will the company grow in the future is difficult to assess. A historical high growth rate is no guarantee of the same trend to continue in the future. Yet, analysts still pencil in growth numbers into stock value assessments five years from now. It is their way of telling you that they do know how the business will pan out in the future.
Here is an easy explanation given by Buffett, "Let's say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7 per cent return, so you'd pay $1,000/acre. If it's for sale at $800, you buy, but if it's at $1,200, you don't."
Here's another way to look at intrinsic value. "If you were thinking about paying $900,000 or $1.3 million for a McDonald's stand, you'd think about things like whether people will keep eating hamburgers and whether McDonald's could change the franchise agreement. You have to know what you're doing and whether you're within your circle of competence."
This story was originally published in June 2015.