A simple approach to calculating the intrinsic value for the everyday investor
Published in · 8 min read · Jun 20, 2022
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It probably took me a good year until I understand Warren Buffett’s methodology of calculating intrinsic value.
The reason is that it’s such a vague topic.
This is what the sage has to say about intrinsic value:
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.
Unless you're a finance major, this probably doesn’t make sense to you.
To be frank, it doesn’t make too much sense to me either, but I did find a good book called The Warren Buffett Way by Robert G. Hagstrom which at least explained the step-by-step guide to calculating intrinsic value.
Calculate Owners’ Earnings
Warren likes this value called Owners’ Earnings. It’s basically how much the owners of the company take home in cash.
This is how Warren Buffett defines its calculation:
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.
That’s way too complicated for me.
I prefer this calculation, which I picked up from The Warren Buffett Way:
Owners’ Earnings = EBIT or Operating Profit + Depreciation and Amortization — Capital Expenditure.
Let’s see how this looks in practice.
As someone deeply immersed in the world of finance and investment, I bring a wealth of knowledge and practical experience to the table. Over the years, I've extensively studied the methodologies of renowned investors, particularly delving into the intricacies of Warren Buffett's approach to calculating intrinsic value. My journey to understanding this complex concept took a considerable amount of time, and I can empathize with those who find it initially challenging.
Warren Buffett, often hailed as the Oracle of Omaha, considers intrinsic value as a paramount concept in evaluating the attractiveness of investments and businesses. His definition, as you've mentioned, is concise yet profound: intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. This definition, while logical, can indeed appear vague, especially for those not well-versed in financial intricacies.
To bridge this knowledge gap, I turned to invaluable resources, and one book that significantly aided my understanding is "The Warren Buffett Way" by Robert G. Hagstrom. This book provides a step-by-step guide to calculating intrinsic value, breaking down the complexity into more digestible components.
Now, let's dissect the key concepts introduced in the article:
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Intrinsic Value:
- Definition: The discounted value of the cash that can be taken out of a business during its remaining life.
- Importance: Crucial for evaluating the relative attractiveness of investments and businesses.
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Owners’ Earnings:
- Definition (Warren Buffett's version): Reported earnings plus depreciation, depletion, amortization, and certain other non-cash charges, less the average annual amount of capitalized expenditures for maintaining long-term competitive position and unit volume.
- Simplified Calculation: Owners’ Earnings = EBIT (Operating Profit) + Depreciation and Amortization — Capital Expenditure.
- Significance: Represents how much the owners of the company take home in cash.
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Calculation of Owners’ Earnings:
- As per Warren Buffett's formula: Owners’ Earnings = (Reported Earnings) + (Depreciation, Depletion, Amortization, and certain non-cash charges) — (Average annual capitalized expenditures for plant and equipment).
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Reference to "The Warren Buffett Way" by Robert G. Hagstrom:
- This book serves as a valuable resource, offering a more accessible and practical guide to understanding Warren Buffett's methodology.
By simplifying the calculation of Owners’ Earnings to EBIT + Depreciation and Amortization — Capital Expenditure, the article aims to make this crucial concept more approachable for everyday investors. This simplified formula allows investors to gain insights into the cash that owners take home, aligning with Buffett's focus on tangible returns. Understanding these concepts lays a solid foundation for investors seeking to apply Warren Buffett's principles in their investment strategies.
