Value Investing Using Intrinsic Stock Value

What does Warren Buffett do which makes him and his investment approach different from most of the investors? He reads. It may sound simple, but is one of the most important factors which have contributed to his success as an investor. According to CNBC, Buffett starts his morning by reading The Wall Street Journal, USA Today, and Forbes. These (and of course many other) readings allow him to do what people call as “value investing” in the investment world.

If you are a long-term investor, then value investing should be something that you always consider before making a stock purchase decision. In simple terms, value investing means buying stocks of quality companies when they are trading at discount compared to their intrinsic value. As a simple example, if the current price of Stock X is $100, while the intrinsic value is $120, then the stock is trading at a discount and should be considered for purchase. At the same time if the opposite holds true (intrinsic value less than current market price), then it means the stock is trading at a premium, so should not be bought at this price. There are 2 variables in this equation — current market price and intrinsic value. Finding current market price is straight forward and you can just do a simple web search.

The tricky question is — how do you find the intrinsic value of a stock? There are multiple methods used in the industry, such as:

• Discounted Cash Flow Method: This looks at a company’s all future cash flows and computes the present value of each cash flow based on a discount rate. If cash flows in year 1 = C1, year 2 = C2 and so on, then Intrinsic value = C1 / (1+r)¹ + C2 / (1+r)² + ….. Cn / (1+r)^n. Here r is the rate of return if you invest the money in some other place. This method could be tough to apply for beginner investors, as it requires an understanding of future cash flows of the company, which is hard to predict. You can start with the current and historical financial statements of the company and see the cash flows to build some estimates for the future.
• Asset-Liability-based valuation: This is a very simple method where intrinsic value is calculated using the difference of the company’s asset and liability. While simple, there are multiple drawbacks of this approach, as it is quite static and does not consider any future growth prospects of the company. This will also lead to much lower intrinsic values for the company (hence more conservative). This could be a useful approach for cautious investors with low-risk appetite (as this approach would suggest buying shares at lower price points). At the same time, being simple, this approach can be easily applied by early investors.
• P/E ratios: This is another simple (yet one of my favorite) approaches to calculate intrinsic value. Most of the numbers required in this approach are easily available over web and company financial statements. Consider company X with Earning per Share (EPS) of $10. The average price to earnings ratio of the company (say over the last 5 years) = 20. The company’s Earning per share (EPS) is expected to grow at 15% in the future (you can look at multiple analyst reports to assess this growth rate). This gives the value of stock X = $10 * 20 * (1.15)⁵ = $402. However, please note that this is the expected price after 5 years and we need to discount it to present value. Assume that the discount rate is 10% (average long-term rate of return by investing in a large stock market index). This gives the current intrinsic value = 402 / (1.1)⁵ = $250. This means you should buy the stock if the price is below this value.

Usually, different approaches will give different intrinsic values. As an investor, the ideal approach is to compute the intrinsic value using different approaches and identify the price range in which you are comfortable making the share purchase (e.g. you can buy below the lowest of all methods or anywhere between highest and lowest). If the current market price is higher than the highest value across all the valuation options, then it is better to wait for a correction in price and purchase once the share comes in your buy range.

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