{"id":106261,"date":"2023-06-25T20:55:00","date_gmt":"2023-06-26T00:55:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=106261"},"modified":"2023-06-27T15:12:53","modified_gmt":"2023-06-27T19:12:53","slug":"warren-buffett-intrinsic-value-formula","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/warren-buffett-intrinsic-value-formula\/","title":{"rendered":"Warren Buffett’s Intrinsic Value Formula: How He Finds Good Deals"},"content":{"rendered":"\n

How does Warren Buffett determine what companies he should invest in? Why does he look for a margin of safety?<\/p>\n\n\n\n

One of Warren Buffett’s investing strategies<\/a> 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.<\/p>\n\n\n\n

Keep reading to learn Warren Buffett’s intrinsic value formula, as described in The Warren Buffett Way<\/em> by investment professional Robert G. Hagstrom.<\/p>\n\n\n\n\n\n\n\n

Warren Buffett’s Intrinsic Value Formula<\/h2>\n\n\n\n

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\u2019s stock is the fair value <\/em>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\u2019s possible that Tesla\u2019s intrinsic value was lower than its share price of $118.47.<\/p>\n\n\n\n

Buffett’s teacher Benjamin Graham points out that, if you buy stock at a discount to its intrinsic value, you\u2019ve gotten a good deal on the stock. Moreover, he argues that, because a company\u2019s share price tracks its intrinsic value over the long term, value investing makes it likely that you\u2019ll profit on your investment as the discounted share price increases to match its intrinsic value<\/strong>. For instance, if Tesla was undervalued <\/em>at $118.47, at which point you chose to invest in it, then you\u2019ll ultimately profit when the market adjusts its share price to match its intrinsic value.<\/p>\n\n\n\n

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<\/strong>. We\u2019ll examine how Buffett determines a stock\u2019s intrinsic value by establishing a company<\/em>\u2019s intrinsic value and then translating this value into a margin of safety <\/em>when he invests.<\/p>\n\n\n\n

Metric #1: Intrinsic Value<\/h3>\n\n\n\n

A stock\u2019s intrinsic value is roughly its fair value. According to Hagstrom, however, Buffett refines this definition by starting with the company\u2019s intrinsic value, which is its expected net income over its lifetime, deducting an appropriate discount rate<\/strong>.<\/p>\n\n\n\n

Though Hagstrom doesn\u2019t specify how Buffett calculates a company\u2019s expected net income over its lifetime, he clarifies that Buffett seeks companies that historically have had consistent earnings growth because it\u2019s easier to estimate future earnings for such companies. Next, after estimating a company\u2019s future earnings, he discounts that figure by the long-term government bond rate.<\/p>\n\n\n\n

(Shortform note: Buffett discounts expected earnings by the long-term government bond rate to account for the time value of money<\/a><\/em>\u2014the idea that a fixed amount of money in the future is worth less than that same amount of money today<\/a> 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<\/a>, 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 <\/em>than $100 given to you at the beginning of 2033.)<\/p>\n\n\n\n

Metric #2: Safety Margin<\/h3>\n\n\n\n

As Hagstrom relates, Buffett determines a company\u2019s intrinsic value to create a margin of safety when investing<\/strong>, as he seeks companies whose stock is significantly undervalued relative to their intrinsic value. Specifically, he seeks companies whose intrinsic value per share<\/em>\u2014that is, the company\u2019s intrinsic value divided by its number of outstanding shares\u2014is much higher than their share price on the stock market.<\/p>\n\n\n\n

Buffett\u2019s reasoning for seeking a safety margin is twofold. First, because companies\u2019 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\u2019re 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.<\/p>\n\n\n\n

(Shortform note: In The Intelligent Investor<\/em><\/a>, Graham further argues that you can increase your margin of safety by diversifying your portfolio<\/a>\u2014that is, by increasing the number and type of companies you\u2019re invested in. After all, if you only invest in one company, then you\u2019re 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\u2019ll still be able to turn a profit even if some of the stocks suffer a price hit.)<\/p>\n","protected":false},"excerpt":{"rendered":"

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.<\/p>\n","protected":false},"author":9,"featured_media":85987,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[31,33],"tags":[1073],"class_list":["post-106261","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-money","category-people","tag-the-warren-buffett-way","","tg-column-two"],"yoast_head":"\nWarren Buffett's Intrinsic Value Formula: How He Finds Good Deals - Shortform Books<\/title>\n<meta name=\"description\" content=\"Warren Buffett developed his own intrinsic value formula to determine which companies he should invest in. 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