Imagine for a second that I showed you a machine which could print currency notes. Now before you pick up the phone to call the police, let me assure you that it’s just a thought experiment.

Let’s assume that my machine could print a Rs 500 note once every year. This machine pulls the necessary particles from the air and rearrange their molecular structure to make the Rs 500 note.

If you had to buy this machine from me, how much would you pay for it?

Now, setting aside for a moment the question whether such a machine can be developed that makes money out of thin air, and whether that would go well with the legal and monetary system of a country, the question of how much this device would be worth is one of paramount importance to stock investors.

Let me first walk you through the question of how to value the currency machine as that would set the stage for us to discuss how to value stocks.

We know that my machine will spit out one Rs 500 note year for ten years, or a total of Rs 5,000 (Rs 500 x 10) during this entire period.

Obviously this caps the highest possible value for the device at Rs 5,000 (you won’t pay for something more than what you can get from it, right?)

Now, for a stream of cash payments that will add up to Rs 5,000 over the next 10 years, what do you think you should pay?

How about Rs. 4500? That would be Rs 500 less than the amount of money you will receive, allowing you to earn Rs 500 profit.

Well, certainly at Rs 4,500 you would get a Rs 500 profit on your money, that profit would only come in the tenth year.

You see, if you invest Rs 4,500 to get Rs 5,000 over the next ten years, you will get an 11.1% return (Rs 500 of profit divided by Rs 4,500) over that time period. Now, 11.1% return over ten years might look okay at first glance, but if we determine what this will be on an annual basis, we discover that it amounts to only about 1.0% a year.

I would rather park my money in savings bank account than buy this machine, because the former would give me a 4-5% annual return as compared to just 1% from the latter!

This brings us to a very important concept in financial – opportunity costs.

One of the key things we have to consider when valuing our currency printing machine is not just the absolute return, but the other places we could invest that same money and what kinds of returns we could expect from those places.

Given that savings bank accounts are insured by the government (up to Rs 1 lac) and that the average interest rate on such accounts now hovers close to say 5% – which is the opportunity cost for purchasing the machine – if someone tried to sell you the machine for Rs 4,500 you would have to turn them down and put the money in a savings account instead.

So how much should we pay for that machine? The first thing we have to do is quantify what we could earn on that same investment in other vehicles. Let’s assume here that there is a warranty on the machine, guaranteeing that it will spit out the Rs 500 note every year or you get your money back.

What other investments could you make that are guaranteed? Savings accounts, certificates of deposits, and bonds immediately come to mind. Given that you could get around 8% annual return on your money in a CD or bond over ten years, you would have to beat 8% or the machine would be worthless to you.

How much money invested in an 8% bond today would become Rs 5,000 in ten years? You can calculate that by discounting Rs 5,000 to be received after 10 years to its present value using this formula: Rs 5,000 / (1.08)^10 = Rs 2,316.

In other words, Rs 2,316 in today’s rupees will be Rs 5,000 in ten years at 8%. Because you know what your risk-free rate of return is, you can figure out what price to pay in today’s rupees for earnings that you will receive ten years from now (assuming you get the entire Rs 5,000 after ten years). So, unless you can get that machine for less than Rs 2,316, it is not even worth considering.

Anyways, in order to value Vikram’s machine, which will spit out Rs 500 every year for the next 10 years, we have to take the stream of income it would generate and calculate the “net present value” or NPV of that income stream, assuming what rate of return we could earn on that money elsewhere.

See this excel to understand how to calculate the NPV of that stream of income.

￼￼So, you should not pay more than Rs 3,355 for the machine that would give you Rs 500 every year for the next 10 years. This is assuming that an opportunity cost or discount rate of 8% that a bond would earn you.

This Rs 3,355 is the “intrinsic value” of this machine.

Now, had you demanded 15% annual return from the machine (the historical return of the BSE-Sensex), the machine would only be worth Rs 2,509 (the more return you want, the lower you must pay).

￼

Demanding higher rates of return makes the currency printing machine worth less and less in terms of today’s rupees relative to the future value of those rupees.

Now the question is – How does this all relate to investing?

Replace the Rs 500 of cash flow from the currency printing machine with the cash flow that a business generates, and you can find its “intrinsic value” just the way you found the intrinsic value of the machine.

The only – and a big – problem here is that while your cash income from the machine is known with certainty at Rs 500 per year for the next 10 years, the cash flows of a business are anything but certain.

Anyways, here is how Warren Buffett described his thoughts on intrinsic value in his 1994 letter to shareholders…

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.

Here is what Buffett wrote in his 2005 letter…

…calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.

In Berkshire’s Owner’s Manual Buffett writes …

Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses.

Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.

Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value.

This brings me to another important facet of intrinsic value, and one that is so different from how most investors look at it –intrinsic value is just an ‘estimate’ and not a ‘precise’ figure like a ‘target price’ that most analysts and investors are worried about.

What is more, while people often get anchored to a stock’s intrinsic value or its target price, Buffett says that this (estimated) number must change with times.

If you can remember this, you will not fall into the trap of holding a ‘bad business’ whose stock has fallen to, say Rs 50, just because your original calculation of its intrinsic value was Rs 100.

Now, however fuzzy this concept of intrinsic value is, you must still know how to roughly estimate it so as to decide whether a stock is worth buying at a given price or not.

We will be dicussing the DCF valuation and the Relative valuation methods in next lessons.

However, don’t forget that the problem with cranking out valuation methods is that they create the impression of false precision. So the idea behind learning the valuation is to be roughly right and not to be precisely wrong.

Remember, if you don’t get the part right about whether it’s a good business and where it will be in a few years, the investment most likely won’t work out as planned – whatever its valuation tells you.

**P.S.** If you wish to study the art and science of picking great stocks, and the process and principles used by some of the world’s best investors, I invite you to **look at my premium, online course in Value Investing – Mastermind.** Click here to know more.