Warren Buffett: How to Know if a Stock is Undervalued
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Published 2021-06-16
How do you calculate the intrinsic value of a stock? This may be the single most important question in all of investing. Everyone knows that the secret to good investing is finding undervalued stocks, but how exactly do you determine if a stock is undervalued? To do this, you have to find the true value of a stock, referred to as its intrinsic value, and compare that to what the stock is currently selling for. Let’s listen to this clip of Warren Buffett explaining the theory behind calculating the intrinsic value of a stock. Then, we will use an example company to demonstrate the concept Warren Buffett laid out with a tangible demonstration. But first, make sure to like this video and subscribe to the channel if you aren't already because it is my goal to help you better understand investing by studying the greatest investors.
While Warren Buffett did a great job explaining the theory behind calculating intrinsic value, this tangible example I am about to provide should help explain the concept even further. Keep in mind this example is simplified, but it demonstrates the concepts Warren Buffett laid out in the clip in a way that may make more sense for you. This is the general framework that I personally use in my job as a professional investor at a large investment fund to think about valuing any type of cash flow producing asset: whether it is a stock, bond, or an apartment building. Now, let’s take a hypothetical company, called ABC Corp. ABC Corp stock is selling at 75 dollars per share and we want to know if the stock is undervalued compared to its intrinsic value. Let's say ABC Corp will operate over a 10 year period and make 10 dollars per share in the first year, growing its annual earnings by 1 dollar every year, all the way to 19 dollars per share at the end of year 10, in which it will stop operating. The next important variable is the interest rate in which you discount the cash flows back by. Let’s use 5% in this example. In the clip, Warren Buffett mentioned that he uses the long term risk free rate as his discount rate. In the US, the risk free rate is the interest rate on long-term government bonds.
With the variables that we laid out, that means ABC corp stocks intrinsic value is about 109 dollars per share. In this example ABC Corp stock is selling at a roughly 30% percent discount to its intrinsic value. Meaning that it is undervalued and a savvy, value-oriented investor would want to make this purchase. It is important to note and as Warren Buffett and Charlie Munger point out in the clip, that there needs to be a significant discount between the intrinsic value and what the stock is selling for to account for the uncertainty involved in predicting the future cash flows of the business and potentially using the wrong interest rate. This is known in value investing as the Margin of Safety. So there we have it. I hope you found this video helpful in your understanding of investing. Talk to you soon!
All Comments (21)
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Are you fan of Warren Buffett? Here’s Warren Buffett’s top 5 investments of all time: https://youtu.be/TnDcC04jFiM
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If you ask me, this is a high-level educational video, I agree with Warren Buffet. A blend of different ETFs is my favorite way of inveesting. For example, you could have some covered call etfs for dividends and other etf`s for growth. A combination such as : JEPI , DIVO , QYLD, SCHD and JEPQ. You have to combine them according to your own personal situation. I tallied my dividends for the previous year; $102k. Blessed, grateful, disciplined and focused.
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Could you do the actual math of how you got those calculations that would be very helpful. What #s are yiu adding subtracting and multiplying?
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Wonderful -- thank you so much! You often just hear snippets of Buffet's wisdom but these longer clips give so much more wisdom and context, also making the principals easier to commit to memory.
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At 15:30 some example parameters are shown. Then, we are told those parameters equate to $109/share instrinsic value. HOW WAS THIS CALCULATION PERFORMED? Please SHOW THE CALCULATION.
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Nice video, but it would have been nice to see the actual math leading to the share price.
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As Warren Buffet advises buying companies at a big discount to intrinsic value, how should we judge Berkshire shares trading at a significant premium to NAV?
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Hi, based on your example provided at the end, this is where I get confused... does the balance sheet have any bearing on the intrinsic value of the company? If a company is loaded with debt vs. if a company is very financially responsible, that surely has an impact on the intrinsic value, right?
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Thanks for the awesome short example at the end!
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I think when to sell is equally as important to when to buy.
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Sure... but he actually says that you can only apply DCF model to companies with a clear future. How do you define that? Very few companies are that predictable. Also... why using the 10-yr bond, and not a WACC rate?
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i googled the npv calculation what would be the cash outflow?? i still don't understand how you get to the intrinsic value of $109
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That example at the end was helpful. Thank you.
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where did you find this risk free rate of 5%, isn't it a bit low and we should use the average long term market return, which is about 7-8%?
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Why use the risk free rate to discount a much riskier asset?
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Very nice information
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Uncle buffet. Knows best. ,So my strategy is if I buy one company ,buy some of the competition , coke. Vs. PepsiCo. Ford vs. . Gm. Etc. Competition. Is American business at it's best
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Hello but you dont show the formula that you implement with those variable Lisa
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Do I always take the 10 years to calculate the NVP or is it always different?
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Today it's not about return ON capital. Today it is about return OF capital.
