How does Warren Buffett determine what companies he should invest in? Why does he look for a margin of safety?
One of Warren Buffett’s investing strategies is to buy stock in companies that are undervalued. In order to identify such companies, he calculates a company’s intrinsic value. Then, he translates that value into a margin of safety.
Keep reading to learn Warren Buffett’s intrinsic value formula, as described in The Warren Buffett Way by investment professional Robert G. Hagstrom.
Warren Buffett’s Intrinsic Value Formula
Before we get into Warren Buffett’s intrinsic value formula, let’s clarify what intrinsic value is. Roughly put, the intrinsic value of a company’s stock is the fair value of that stock, assuming all relevant information was known. To illustrate, if excessive optimism had led investors to aggressively buy Tesla stock at the start of 2023, rapidly increasing its stock price, then it’s possible that Tesla’s intrinsic value was lower than its share price of $118.47.
Buffett’s teacher Benjamin Graham points out that, if you buy stock at a discount to its intrinsic value, you’ve gotten a good deal on the stock. Moreover, he argues that, because a company’s share price tracks its intrinsic value over the long term, value investing makes it likely that you’ll profit on your investment as the discounted share price increases to match its intrinsic value. For instance, if Tesla was undervalued at $118.47, at which point you chose to invest in it, then you’ll ultimately profit when the market adjusts its share price to match its intrinsic value.
While Graham taught Buffett the general principles of value investing, Buffett developed his own approach to calculating intrinsic value to find companies that are undervalued. We’ll examine how Buffett determines a stock’s intrinsic value by establishing a company’s intrinsic value and then translating this value into a margin of safety when he invests.
Metric #1: Intrinsic Value
A stock’s intrinsic value is roughly its fair value. According to Hagstrom, however, Buffett refines this definition by starting with the company’s intrinsic value, which is its expected net income over its lifetime, deducting an appropriate discount rate.
Though Hagstrom doesn’t specify how Buffett calculates a company’s expected net income over its lifetime, he clarifies that Buffett seeks companies that historically have had consistent earnings growth because it’s easier to estimate future earnings for such companies. Next, after estimating a company’s future earnings, he discounts that figure by the long-term government bond rate.
(Shortform note: Buffett discounts expected earnings by the long-term government bond rate to account for the time value of money—the idea that a fixed amount of money in the future is worth less than that same amount of money today because you could invest the money received today. For example, if you received $100 at the beginning of 2023, you could invest it in a ten-year treasury bond at 3.79% interest, leaving you with $145 by the beginning of 2033. This means that, in effect, $100 given to you at the beginning of 2023 is worth more than $100 given to you at the beginning of 2033.)
Metric #2: Safety Margin
As Hagstrom relates, Buffett determines a company’s intrinsic value to create a margin of safety when investing, as he seeks companies whose stock is significantly undervalued relative to their intrinsic value. Specifically, he seeks companies whose intrinsic value per share—that is, the company’s intrinsic value divided by its number of outstanding shares—is much higher than their share price on the stock market.
Buffett’s reasoning for seeking a safety margin is twofold. First, because companies’ stock prices over the long term will correspond with their intrinsic value, companies whose stock price is currently undervalued are likely to see their stock rise in the long term. Second, when his investments have a margin of safety, they’re less likely to see their stock prices drop even if their intrinsic value takes a hit since their intrinsic value per share is higher than their share price to begin with.
(Shortform note: In The Intelligent Investor, Graham further argues that you can increase your margin of safety by diversifying your portfolio—that is, by increasing the number and type of companies you’re invested in. After all, if you only invest in one company, then you’re more likely to lose money because all it takes is one company tanking for your investment to fail. By contrast, if you invest in multiple companies across different industries, then you’ll still be able to turn a profit even if some of the stocks suffer a price hit.)
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- How to invest like Warren Buffett and earn above-market returns
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