# Lesson #7: Calculating Intrinsic Value-Part I

Moving ahead from the previous lesson on the basics and purpose of intrinsic value, let’s now move a bit further into this very important subject for value investors.

Let’s learn something about the different ways you can calculate the intrinsic value of a stock.

But first, here’s the easiest and the most important definition of intrinsic value that you’ll come across anywhere. This is what Warren Buffett wrote to his company’s shareholders in 1994:

“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.”

In simpler terms, intrinsic value of an asset is the discounted value of the expected cash flows that that asset can earn over its life.

‘Cash’ I know, but what’s the ‘discounted value’?
In his definition of intrinsic value, Buffett mentions that the intrinsic value is nothing but the ‘discounted value of cash’ that can be taken out of a business.

Let’s understand these two key terms –

1. Cash
2. Discounted value

Most investors believe that understanding the term ‘cash’ is akin to understanding the English alphabets.

But your see, cash isn’t as simple as C-A-S-H.

Cash is not what a company earns when it sells its products or services. And it is neither the profits a company makes during the year after paying its operating expenses (like raw material costs, employee salaries, sales & marketing costs, administrative costs), interest, depreciation and taxes.

Cash is beyond these – sales and profits.

Cash is what remains with a business at the end of a year and after paying for the cost of anything and everything a business buys and pays for during the year.

So it is a much-refined form of profits. But it is what remains with a company after also paying off the dividends, cost of new plant & machinery and buildings (or capital cost), and working capital changes (and adding back depreciation which is a non-cash charge).

This cash is also known as ‘free cash flow’, and it is the ultimate measure of a company’s profitability.

By looking at free cash flow, you can see whether a company is actually making any money and you can get a sense of what it’s spending its money on.

Let’s now turn our attention to the second critical element of Buffett’s definition – the ‘discounted value’.

Discounted value is used to define the present value of future cash flows. So it is also known as the ‘present value’.

Let us understand this concept using a simple example.

If I offer you Rs 100,000 and you could receive it now or in 10 years, when would you take it? Most likely you would say, “Now.”

This is because you already know that money received now is more valuable to you than money received in the future, simply because you can invest this money (Rs 100,000) to earn interest on it for the next 10 years.

Now assume that the interest rate that a bank is willing to offer you for Rs 100,000 that you deposit it there now is 10%. So your cash flow for the next 10 years will look like this:

PV when cash flows are constant (as in bank deposits) * Assuming interest rate of 10%, which will also be the discount rate

What this table shows is that if you deposit Rs 100,000 in a bank at 10% interest rate, you will earn Rs 10,000 as interest (cash flow) for the next 10 years, plus your capital (Rs 100,000) at the end of the tenth year.

Now, when you calculate the present value of each of these cash flows (as shown in column C), and total it, the sum comes to Rs 100,000, which is the present value of all these cash flows (that total to Rs 200,000 over this 10 year period).

So, as you can see from the example, while you receive a total of Rs 200,000 over these 10 years, when you calculate the present value, the number comes to Rs 100,000 or exactly what you had deposited in the bank.

Now, the question is, if the present value of Rs 100,000 deposited for 10 years at 10% per year is Rs 100,000, why would someone deposit or invest money at all?

Nice question, I must say.

But please know that this is a very simplified explanation of present value. In reality, what it means is that when I offer you Rs 100,000 and you want it now, you have the flexibility to invest in a business where you expect cash flows to grow by 10% per annum, instead of depositing in a bank where the cash flows remain at 10,000 each year for the next 10 years.

PV when cash flows are growing (as in a business) * Assuming annual growth in csh flow of 10%, and discount rate of 10%

As you can see from the table above, Rs 100,000 invested in a business earned you a cash flow of Rs 10,000 in the first year, which is exactly same as the bank deposit earned you in the first year. But from second year onwards, this cash flow grew by 10% every year.

So at the end of 10 years, your total cash inflow totalled Rs 259,374, and the present value of this cash flow stood at Rs 129,463.

So, while you invest Rs 100,000 today, the present value of your total cash flows stands higher by Rs 29,463, which makes it a profitable investment.

This calculation of Rs 129,463 minus Rs 100,000 is called as ‘net present value’ or NPV and is at the heart if all business decisions.

A company takes up a project or enters a new business only when the NPV is a positive number, as in the second example above. If the NPV is zero, like in the first example where you deposited Rs 100,000 and the present value of all cash flows for 10 years was Rs 100,000, it is a neutral case.

As an investor, you must invest in stocks of businesses where you expect to earn a positive NPV over your investment horizon.

And you can calculate the NPV using the free cash flows a business is estimated to earn over the next 10 years.

Know that the Rs 129,463 that we calculated as the present value of future cash flows, is the ‘intrinsic value’ of this business. And since this is higher than the original investment of Rs 100,000, it makes for a good investment opportunity if the business were to be listed on the stock exchanges.

Here is the formula for calculation of discounted cash flow (DCF) or present value (PV) of future cash flows:

PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k – g)] / (1+k)n-1

Where:
PV = present value
CFi = cash flow in year i
k = discount rate
g = growth rate assumption in perpetuity beyond terminal year
TCF = the terminal year cash flow
n = the number of periods in the valuation model including the terminal year

If you were to go through the DCF calculation excel, there are three key variables you need to calculate the DCF value of a company:

1. Estimates of growth in future free cash flows (FCF): Growth in FCF over say the next 10 years, using last 3 years average FCF as the starting point. (Click here to see the calculation of FCF from a company’s cash flow statement)
2. Terminal growth rate: Rate of growth in FCF after the 10th year and till infinity.
3. Discount rate: Rate at which the future cash flows must be discounted to bring them to present value. Now there are three key issues that arise with these variables:

1. What growth rate to assume for future FCF estimates?
2. What discount rate to assume?
3. What terminal growth rate to assume?

1. How do I predict future FCF?
As an analyst, I always found it difficult to predict growth rate in volumes, sales and profits. But I still tried to do that – after all, I was paid to predict the future!

However, as I’ve realised over the years, trying to find a perfect answer to the question “What growth rate to assume?” is like trying to find a “perfect couple”. None exist! 🙂

Given this limitation of trying to predict the future, I’ve changed my way of analysis to value stocks based on the present data rather than what will happen in the future.

That’s why I now don’t try be accurate with my FCF growth estimates. I just try to be reasonable and use common sense.

For most stocks, I generally perform a 10-year 2-stage DCF analysis. What this means is that I assume a particular growth rate for the first five years of my FCF calculations (as you can see in my DCF excel), and then another number for the next five years.

I rarely go above 10-12% annual growth rate for the first five years, and 6-8% for the next five.

The best practice is to keep growth rates as low as possible.

If the company looks undervalued with just 5% annual growth in FCF over the next 10 years, you have more upside than downside.

The higher you set the growth rate, the higher you set up the downside potential.

To repeat, while assuming FCF growth rate for the future, just be reasonable and use common sense.

A caveat – don’t take cues from the past as the past performance is rarely repeated in the future.

2. How much discount rate do I assume?
In simple words, discount rate is the rate at which you must discount the future cash flows (as estimated using above growth assumptions) to the present value.

Why present value? Because we are trying to compare the company’s intrinsic value with its stock price “now”….in the present.

Just to help with an example, what price would you pay for an investment today if company ABC’s future cash flow is worth Rs 1,000 after 1 year?

• If the discount rate is 5%, you must pay Rs 952 now (1000/1.05).
• If the discount rate is 10%, you must pay Rs 909 now (1000/1.1).
• If the discount rate is 15%, you must pay Rs 870 now (1000/1.15).

In other words, the higher the discount rate you assume, the lower you must pay for the stock as of now.

Finance textbooks and experts would tell you to use Capital Asset Pricing Model (CAPM) to calculate discount rate. I used CAPM myself to arrive at discount rates in the past.

However, if you are worried what CAPM is, don’t be because you can avoid knowing about it and still live happily ever after….like I am living. 🙂

Look at discount rate as the “annual rate of return” you want to earn from the stock.

In other words, if you are looking to invest in a business that has comparatively higher (business) risk than other businesses (like in case of most mid and small cap stocks), you may want to earn a 15% annual return from it.

For valuing such businesses, take 15% as the discount rate.

In case of relatively safer businesses (think Infosys, HUL, Colgate), earning around 10-12% annual return over the long term is a good expectation (because these businesses will also provide some stability to your portfolio during bad times).

For valuing such businesses, take 10-12% as the discount rate.

Better still, assume a constant discount rate for all companies. I am gradually turning to this model – of taking a constant 15% discount rate for all kind of businesses (safe or risky).

Simple – adjust the risk in FCF growth estimates. That is where the real risk lies, right?

3. How much terminal growth rate do I assume?
As I mentioned above, I do a 10-year FCF calculation for arriving at a stock’s DCF valuation.

But the companies I’m valuing won’t cease to exist after 10 year. Some will survive for 10 more years, some for 20 years, and very few for 50 years.

That is where the concept of “terminal value” (or the value after 10th year and till eternity) comes into picture.

The terminal value I generally assume lies between 0% and 2%. Assuming higher terminal value (>3-4%) is like assuming the company to grow bigger than the world economy in the infinity, which isn’t possible.

So the idea is to keep it as low as possible. Best to keep it at 0%.

P.S.: Got here via a link from a friend, or a forwarded email? This is the seventh lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor.