This content explains how to calculate a stock's intrinsic value using a discounted cash flow (DCF) model, similar to the method employed by Warren Buffett, to identify undervalued investment opportunities, especially in a recessionary market.
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The markets have been
falling from its highs
from December 2021,
and we are looking at
a recessionary environment
where there are so many good companies
at extremely cheap prices.
Today we are going to discuss
how to find the fair value of the stock
in the same way that Warren Buffett does.
Well, intrinsic
value is what is the number
that if you
are all knowing about the future
and could predict all the cash
that a business would give you between
now and Judgment Day
discounted at the proper discount rate,
that number is what
the intrinsic value of a business it.
So what Warren Buffett does
is he uses a discounted cash flow model.
So what I'm going to do
is start with an example.
So this is a simple Excel
spreadsheet template that I have created.
Don't be worried about the numbers
as of now.
I'll explain to it
in very simple English
so you guys can understand
it as easy as possible.
You can download this template
from the description box
so you guys can play around with it
and put in any numbers,
put in any stock data
and get the intrinsic value calculator.
Okay.
So let's start
with these For discount rate
growth rate,
we're going to ignore all these things.
As of now,
just we're just going to do the ticker,
which is basically Apple.
We're going to focus on
Apple stock as of now,
the share price
and the outstanding shares
can be gotten from any data feed.
I'll use QuickFS and also gurufocus.
There's also Google Finance and Yahoo!
Finance and many other information.
So if you can go to Gurufocus
and go to ownership,
you will get the number
of shares outstanding,
which is what I have plugged in here.
And obviously the share price is what?
And so you can go into the cash
flow statement.
You've seen the cash flow
from operations.
So if I can go to the quick FS,
then go to cash flow statement, so
QuickFS is free
so you can get all these data for free.
So I'm taking the past five years
data of cash from
operations that's right here
and paste data here.
And then is CapEx,
which is short form
for capital expenditure,
which is basically expense
of the property plan and equipment.
I've taken that one
and I have pasted here,
which is an expense.
And then free cash flow
is basically the difference of this one
and this one since already it's negative.
Ali, I just have to put in some here.
So 77
-13 and gives you a 64
and that is basically our free cash flow.
So this is a free cash flow
slash discount cash flow model.
The growth rate of the free cash flow
is basically the final value divided
by the first value to the power.
The number of years, of this one,
we have taken five years
minus one,
and that gives you the growth rates.
So we've also got the earnings,
which is a net income,
which again, I'm copied
from the income statement.
You can just
go down in the net income statement,
you can get the values here.
So we're not going to use much
about the earnings or the net income.
But I'll come back to why
we have copy paste of this
so you guys can use it later.
So what's the difference
between a cash flow and earnings?
So basically
cash flow
is like the actual cash
that comes in goes through you.
So let's say your boss pays you £10,000
this month.
A On paper he might have paid £10,000.
So that would be reflecting the earnings
or on theory, I mean, practically,
he probably might not have paid it,
like he might have just given you £8,000
and told you, Hey, man,
I'm going to pay you back
next week or something like that.
The rest are £2,000, so
the cash flow will show
£8,000 is coming into your wallet
and £2,000 is yet to come.
So that is why people, including Warren
Buffett and value
investors like Bill
Ackman and Charlie Munger
and everybody focus on the cash flow
because that shows the actual amount
that has come and gone.
So cash flow from operations
is like if you're running a restaurant,
whatever money
you made from the restaurant,
from the sales of the restaurant,
that is the cash flow from operations,
cash flow from financing activities
will be
whatever came from like banking or,
you know, loans and debts
and all those things
that comes from the cash, from financing
and then cash from
investing is basically,
you know, the capital expenditure
or acquisitions and investments
and all those things.
So we will just be focusing on cash
from operations and CapEx
and the growth rate.
So now I'm going to put in the final
free cash flow here, 11443 equals.
So this one here.
Okay.
So we've got that values at year
one free cash flow.
So what is the present
value of it after one year?
So what happens
is that every year
the purchasing power of your $100
or whatever you have goes down.
So let's say you have $100
today, that's $100.
Ten years from now, it's not worth $100.
It might be worth
just one third of that value.
And that's
where the discount rate
comes into perspective.
So that is basically you take this one
and you divide it by that discount rate
to one plus 10%
to the power.
It's just one year.
So after year one,
the free cash flow is going to be that.
So 101.
So you can see
the number has reduced
from 111 to 101 311 for me too.
So I'm going to do a small
tip for you guys.
I'm just going to put in a dollar here.
So because that discount
rate is a constant,
so we've got the free cash flow here
and you've got the present value,
which is the discounted
value of the free cash flow.
So what happens in year two
is that every company
goes to a growth rate
and that's what we've calculated here.
We've got roughly 0.7,
only just basically 2%.
So putting growth rate of 12%
for the first
five years and growth
rate of 12% for the rest
five years as well.
So what happens is that this free cash
flow will grow next year.
So all I need to do is one plus
dollar, one plus this one here
and that's it.
I'm just going to give it a dollar sign.
Just put that a constant for
the first five years,
the growth rate is pretty much
I forgot to put the asterisk
here.
So next
year, the year free cash
flow will be 124,000.
I'm just going to do this
for the next five years,
so let's see if it has gone through.
Well, yeah.
139 156 175
So from year six
we're going to use another value.
So I'm just going to put this one here
and instead of be seven,
eight is going to be B eight,
drag all this thing down
and basically you have got
the free cash flow for the next year.
So obviously the present value
has to be reflecting as well.
So I'm going to drag this down as well
today
because you've got the present value.
So you can see that 300,000
which we are going to receive
ten years from now, is
basically just 119,000.
When you factor in the discount rate,
then what we need to do is
we can keep on doing this
the next ten years, 11
years, 15 years, 20 years.
So there's no point doing it
continuously for a substantial long time.
So what we do is we take the final value
and we multiply it
with the terminal value
that is number ten.
So this can be 15,
20 or five or eight up to you.
Universities have done a lot of research.
We just going to take
a rough measure of ten.
As of now,
it depends on your risk metric,
which we'll discuss in a bit.
We also need the present value
of that one as well.
So I'm going to drag
that one into the value.
So we've got this one value here
and all we need to do
is we just need to sum all these things
and we will get
the intrinsic value of the company.
So that's the intrinsic
value of the company.
So interesting
share price will be this
divided by outstanding shares.
So there
you go with the
intrinsic share price
that we have calculated is $144.
So what's the current price?
Current price is
basically the share price.
Now it's no difference.
So what's the 50% margin of safety?
That is the intrinsic share price
divided by two.
Okay.
So we've actually done
with our valuation,
you can see how simple the valuation is.
It's just putting in numbers in there
and just calculating the values.
So now comes the other thing
about conservative methodology
and more of a progressive or growth
kind of mentality kind of thing.
So if you can see this terminal value,
if I increase this number,
then the intrinsic value
calculation goes higher.
So if I keep it lower, then
the intrinsic value goes lower.
So you need to have like a smooth
kind of a measure
So I like to keep it at ten,
but again, it's up to you.
So if it's a company, it's
kind of like a risky
company is better off.
You become more conservative.
If it's not so risky company,
then you can go more higher numbers
as well.
It's the same thing goes for growth rate.
You can see the growth rate is 12%.
So that's our rough estimate calculation.
So I can change these values as well.
So we've calculated 2% growth
rate from the past five years.
So you can do it for the past ten years
or you can also get
some kind of subjective
kind of an assessment,
because in the past 12 years
we've been past five years,
we've been through quite a lot.
We've been through the coronavirus,
and that has affected the economy
and all those things.
The economy has been
in a difficult situation, so
we can assume that this 12%
might be a bit
underestimating the growth.
If I put in like 20%,
you can see
the intrinsic
share price suddenly goes to $185,
you know,
so you can play around with these growth
rate numbers,
but that is up to you really.
I would like to put it at 12%
right now,
but you can change it
to whatever you want.
So roughly,
our intrinsic share price is $144.
So according to Warren Buffett,
he likes investing in good companies.
Note the word good companies
at fair value.
So at the present moment,
with our valuation,
Apple is kind of in a fair value.
So buying this company
could be a good idea.
So on the other hand,
if you are investing in a company
which is young, like a growth company,
then I wouldn't recommend
investing at a fair value.
I would say
you might as well invest
in a 50% margin of safety.
So you have that
room for
error, that margin for error, so that
all these calculations can be wrong
and still
there is room for you guys to improve.
For example, Mohnish Pobrai
a huge,
huge advocate
for like a massive margin of safety.
So lots of myths out there
who really, really prefer
the margin safety
but in order to find margin of safety,
you need to know how to calculate
intrinsic value.
And that's what this video is all about,
to calculate the intrinsic value.
Now, coming back to the earnings.
So why have I put in the earnings
as well?
So sometimes, especially young companies,
their cash flow from operations
might be negative
because they are spending lots of money.
And so, for example,
I have a restaurant
and I'm
expanding the restaurant
to whatever money I'm
getting from the cash from operations.
I would be spending it
on more property and plants,
and I'll be expanding the restaurant
in one city to another city
so my free cash flow can be negative.
So in that case,
calculate the free cash flow model
will be a difficult thing to do
because we have all got
negative values in here.
So in that case, using
the net income will be far more ideal.
So for instance,
if you go to Netflix
and Netflix had a negative cash
flow a few years back,
So if I can go Netflix,
you can look at cash
flow from operations,
you can see there's
a bit of a negative value here.
So during that time it's better off
buying.
I mean, assessing your statements
by using the earnings
and putting the earnings
final number here.
You also don't need
to put the final values
in the free cash flow or the net income.
You can actually take an average of this.
Again,
that'll be like a conservative
way of doing it.
Or you can subtract,
you know, 20, 30% of the final value.
These are all subjective.
You can change around,
you can play around
with all these things,
but this is just the
theoretical form
of calculating the discounted
cash flow model.
It's all about adjusting your numbers
based on your risk profile.
He's now just alone.
Doing this is not enough.
You need to calculate.
You need to find out
the return on invested capital.
You need to assess a debt to equity.
You need to understand
the retained earnings growth rate.
You need to know whether the company
has got a depreciation asset
like, for example,
any of the manufacturing companies.
They tend to have higher CapEx.
So every year
they will have to spend
a huge, considerable amount of money
on expanding their factories
and maintaining their factories.
But some companies, they don't need to.
For example,
the reason why Warren Buffett likes
Moody's is simply
because they barely have any CapEx.
So you need to assess
not just the intrinsic value,
but everything from the debt,
from the ownership, from the increase
in the growth
rate of the sales, the revenue,
all these things
factoring in when choosing a company.
But this is just a simple template
for you guys
to calculate the intrinsic value.
So I have made a pretty decent amount
in the value based
investing the past few months
in this month alone, I made 24% return.
That's for this year
and that's been one month.
So I was able to buy
a lot of cheap stock,
especially made
some great returns in Netflix and in
I think Adobe as well.
So these two are
the big ones that I perform well.
So it
you can see a blurred out
some of the things that total value
we can see this is a real account
the number is here.
I also got a quantity based fund as well.
So either way,
if you do value based investing
or quant based investing,
it involves lots of work.
It's just not
you know, it's not that easy.
If quant based trading involves
lots of coding
and lots of mathematical analysis,
value based investing involves a lot
a lot of readings.
You have to read
a considerable amount of books
and financial statements.
And our report
try to find out small things
like contingent liabilities
and things like that,
because those kind of
factors play a huge factor
in choosing a company.
You need to understand
the management is management
have any fraudulent behavior
and all those things will factor
in while doing a value based investing.
So having a great portfolio,
both value based
investing and quant
based investing would be a great idea
that a lot of data available out there,
lots of information available out there,
and I hope
this video will give you the foundations
on how to calculate the intrinsic value.
So what I'm going to do in
the future is I'll
I'll do a balance sheet and also
income statement
and cash flow statement analysis
so you guys can understand how
how to read these statements
much effectively.
So because enjoy this video.
Have a great, great day.
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