How to figure out intrinsic value of a business

[Stockowner]

Does anyone know how Buffett figures out the intrinsic value of a business?

Buffett once said that he reads about the company, imagine what its intrinsic value is, and if the quoted price is way below what he first thought, he will buy it.

I'd still figure he has a slightly more mathematical way of doing it, I mean, projecting earnings, cash flow or something like that, into the future?

And how did Graham figure out its intrinsic value?

Now, I've only bought businesses that I understand are priced way below its intrinsic value, but I don't really know the intrinsic value in itself. Up until now I have bought businesses I know are cheap, has a good business model, a certain moat, and so on. But without knowing the intrinsic value, its kind of like shooting at targets with bad eyesight.

It works fine because the targets are right in front of me (ie I buy them very cheap and good businesses), but it wouldn't work so great if the targets were located a bit farther away.

I know it is very very essensial to figure out its intrinsic value, and I would like to know how. So how do the great ones do it?

[PrivateInvestor]

The book Value Investing From Graham to Buffett and Beyond by Joel Greenblatt (Value Investing: From Graham to ... - Google Book Search) goes into various ways to calculate intrinsic value.

Graham looked only at the assets. When net assets were much less than total liabilities, he found a bargain (i.e., a "cigar butt stock" -- one good puff left). Graham's approach worked well during The Great Depression of the 1930s when the overall economy was slow and many businesses were worth more dead than alive.

Buffett added the earnings power concept to the equation. A business with a great moat and great management could weather any economic storm and was also a bargain when the price was cheap enough. Buffett's approach works well when the overall economy is growing (much like it has since the 1950s) so that most businesses are worth more alive than dead.

There is more than one way to do value investing. The only common thread is to "pay 50 cents for a dollar bill," but every great value investor has a slightly different way of calculating that dollar bill (i.e., instrinsic value).

[joshuat]

The New Buffettology, written by, wait for it, Mary Buffett, and David Clark, a close associate of Buffett, goes into this in detail. Follow this up by reading Buffett's letters to shareholders - all available on the Bershire Hathaway site.

In other words, go to the source. :)

[hitone395]

There is a nice website Joe Ponzio's F Wall Street that goes into detail on how to value a business based on the DCF model. I have looked at the site and read most of the posts.

[joshuat]

But that (DCF) is not what Buffett does. The OP asked what Buffett does.

[hitone395]

Sorry, I thought Buffett used a DCF model.

[hitone395]

This is what Buffett wrote in the 1994 letter:

"We define intrinsic value as the discounted value of the
cash that can be taken out of a business during its remaining
life. Anyone calculating intrinsic value necessarily comes up
with a highly subjective figure that will change both as
estimates of future cash flows are revised and as interest rates
move. Despite its fuzziness, however, intrinsic value is all-
important and is the only logical way to evaluate the relative
attractiveness of investments and businesses."

[hitone395]

So what does Buffet do then? Opposite of what he writes?

[npg]

It appears that the Buffetology book has been publicly criticised by Warren Buffett for being too formulaeic...

Either way, there are a lot of different ways to perform and discounted cash flow calculation, just like there are tons of different ways to evaluate a business. That's why a margin of safety is so important because the value is actually a fuzzy figure and hard to pin down flat out. This is precisely what Buffett wrote in the 1994 letter. If you want to drill more into this, then you need to read "The Theory of Investment Value", by John Burr Williams, a book that Buffett read alongside other milestones such as the "Intelligent Investor" and "Common Stocks, Uncommon Profits".

The success of such calculations depend strongly on your ability to understand the business. Every investor adjusts figures in different ways. Even Buffet is often 20 - 30% off his initial estimates. You better learn how to live with that.

Hope this helps...

[joshuat]

He certainly values businesses on estimates on future earnings, which would seem to imply he does a DCF. Yet Munger has been quoted as saying that he has never seen Warren do a DCF. I believe him.

If the trailing 12 month's earnings are consistant, then you can just look at p/e to figure out if the business is cheap or not. For example, say your earnings are $2 and you have a great business growing at 15%. A price of $20 is a fire sale. A price of $80 is something to walk away from. Do these calculations a few times and you no longer have to reach for a calculator or spreadsheet to perform a calculation. Buffett looks for values that scream out at him. If you have to perform a DCF, as in actually plug values into a spreadsheet and calculate values 10 years out, it ain't screaming.

Go to the library some day and open up a Value Line publication. Go page by page and do a DCF with a calculator or spreadsheet - a few afternoon's practice and you won't need the calculator anymore - you'll know the value of the business just by looking at the earnings and price.