Before looking at concepts on this page, you should first get a basic understanding of concepts presented in Investing Principles section of this site.
To determine intrinsic value of a business we will use John Burr Williams's dividend discount model presented in his book The Theory of Investment Value. Warren Buffet uses this method to determine value of a business. This concept is key in determining if a stock should be bought or sold.
Value of a business is determined by adding the total owner earnings that the
business will generate over its life, discounted by an appropriate interest
rate.
This is a concept championed by Warrent Buffet and is the best way to
analyze different investment types by reducing each investment type to a number
that can be compared with another number. This is how, as an investor, you can
compare apples with apples. You should
look for companies whose future earnings are predictable by doing the analysis
described in Investing Principles section of
this site.
A very important concept for determining value of any business is Net Present
Value or NPV. Suppose you want 100 dollars in your bank account one year from
now. How much money will you have to put in your bank today so it grows to 100
dollars in one year? Assume that the interest rate that bank pays you is 10% per
annum (you wish!). That would mean that you will have to deposit $100 ÷ (1 +
0.10) = $90.90
You can check that your calculation is correct because 10% of $90.90 is $9.09.
Therefore if you deposit $90.90 and it earns $9.09 in interest, you will have
$90.90 + $9.09 = $99.99 ≈ $100 in bank after
one year. In other words, Present Value (PV) of $100 is $90.90 if discounted at
10% for one year.
Obvious next question is, how much money do you have to put in bank if you were
willing to wait for two years, everything else remaining same as mentioned
above? Since we already know that we have to put $90.90 in bank for it to become
$100 after one year at 10% interest rate. All we need to do is determine how
much money do we put in bank today, so it becomes $90.90 after end of first year
at 10% interest rate. That would mean that you will have to deposit
$90.90 ÷ (1 + 0.10) = $82.64. In other words, Present Value(PV) of $100 is
$82.64 if discounted at 10% for two years. That translates to a general formula:
Present Value (PV) = FV ÷ (1 + r)n
where FV = Future Value
r = interest rate
n = number of years
The sum of all the present values is the net present value (NPV)
The discount rate in this formula is the rate that you would get by investing in
a risk free investment like a bank CD or a government bond PLUS a margin of
safety because you are taking a risk by investing in an entity whose future
earnings are not guaranteed. We consider 9 percent as the discount rate on this
site, because the assumption is that you should get a better than 9% return for
your money to make it worth your while to invest in stock market.
Buffet believes that price tells us nothing about the true intrinsic value of a
business.
To determine Value of Business, we will use a three-stage formula:
Stage 1: For first 5 years we assume that company is able to grow owner earnings by
the Analysts' estimates of next 5 years
growth rate as explained in previous section of this site. In previous
section we have already determined that
owner earnings of Google
Inc. for 2006 is $1,746 million. We have also determined that Analysts'
estimates of next 5 years growth
rate of Google Inc. is 33.65%. We will use this information, as well as the
present value formula that we have learned above. Please remember that we use 9%
as the discount rate on this site.
| Year | Growth Rate (%) | Discount Rate (%) | Owner Earnings (million USD) | Discounted Value per annum (million USD) |
| 0 | 0 | 9 | 1746.00 | |
| 1 | 33.65 | 9 | 2333.53 | 2140.85 |
| 2 | 33.65 | 9 | 3118.76 | 2625.00 |
| 3 | 33.65 | 9 | 4168.22 | 3218.63 |
| 4 | 33.65 | 9 | 5570.83 | 3946.52 |
| 5 | 33.65 | 9 | 7445.42 | 4839.01 |
Stage 2: For next 5 years we assume that company is able to grow owner earnings by
5 percent less than the Analysts' estimates of
next 5 years
growth rate. We will use the same calculations as we have done for previous
stage, as well as assume same discount rate of 9%.
| Year | Growth Rate (%) | Discount Rate (%) | Owner Earnings (million USD) | Discounted Value per annum (million USD) |
| 6 | 28.65 | 9 | 9578.53 | 5711.36 |
| 7 | 28.65 | 9 | 12322.78 | 6740.98 |
| 8 | 28.65 | 9 | 15853.25 | 7956.21 |
| 9 | 28.65 | 9 | 20395.21 | 9390.52 |
| 10 | 28.65 | 9 | 26238.44 | 11083.40 |
Stage 3: Next we assume that from year 11 onwards company will be able to
grow owner earnings at the rate of 5% till infinitum. We will assume same
discount rate of 9%.
We will subtract 5% growth rate from 9% discount rate to arrive at the
capitalization rate of 4%. This will give us the residual value of the
company.
We will have to use the present value formula at the end of year 10 to determine
the present value of residual value.
Owner Earnings at the end of year 11 = $26238.44 + $26238.44 X 5%
= $26238.44 + $1311.92
=$27550.36
Residual Value of Google Inc. at the capitalization rate of 4% = Owner Earnings
at the end of year 11 ÷ Capitalization rate
= $27550.36 ÷ 0.04
= $688759.05
Present Value of Residual Value = Residual Value ÷ (1 + 0.09)10
= $688759.05÷ (1 + 0.09)10
= $688759.05÷ 2.3673
= $290939.26
We already know that the sum of all the present values is the net
present value (NPV). To determine Market Value of Google Inc. we will sum up all
the
present value of owner earnings:
Market Value of Google Inc
= $2140.85 + 2625.00 + $3218.63 + $3946.52 + $4839.01 + $5711.36 + $6740.98 +
$7956.21 + $9390.52 + $11083.40 + $290939.26
= $348591.76
Market Value of Google Inc. = $348,591.76 thousand i.e $348.59 billion
Market Capitalization is the total dollar price of the company. It is obtained by
multiplying the current share price with the number of shares outstanding of the
company. Think of market cap as the money you will need to buy 100% of the
company.
Market Capitalization = Share price X Shares Outstanding
To determine market capitalization of any publicly listed company go to
finance.yahoo.com, type
the stock symbol of the company and click on "Get Quotes". Click on "Key
Statistics" on the left navigation bar and look at the section titled "Valuation
Measures". Look at the value under "Market Cap (intraday)". The value
that you will see here is calculated using the Shares outstanding from the most
recently filed quarterly or annual report.
Suppose you want to determine Market Capitalization of Google Inc. Go to
finance.yahoo.com and
type symbol GOOG in the text box that states "Enter symbol(s)" and click on "Get
Quotes" to see data for Google Inc.. Click on "Key Statistics" on the left
navigation bar. Find the section labeled "Valuation Measures". Look at the value under "Market
Cap (intraday)". In this case you will see $177.06 billion.
Market Capitalization of Google Inc. = $177.06 billion
We have already learned how to determine the intrinsic
value of business in previous section. Remember
Value of a business is determined by adding the total owner earnings that the
business will generate over its life, discounted by an appropriate interest
rate. We also know that market capitalization
is the total dollar price of the company. All that is left now is to determine
the discount at which the company is currently selling to make an investment
decision. If a company is selling for less than its intrinsic value, you can
buy the stocks of that company. If a company is selling at more than its intrinsic
value, you must sell the stocks of that company.
Discounted Price = (Market Capitalization ÷ Value of Business) X 100
Suppose you want to determine if Google Inc. is a good investment decision now.
Using the Value of Business example
above, we have determined that intrinsic value of Google Inc. is $348.59
billion. We have also determined that market capitalization of Google Inc. is
$177.06 billion.
Discounted Price of Google Inc. = ($177.06 ÷ $348.59) X 100 = 50.79%
In other words, Google Inc. is currently selling at 50% discount to its
intrinsic value. That's a great buy. Main thing to note here is what was mentioned before. How
confident are you that Google Inc. will be able to keep its growth rate as predicted
by Analysts? You can always adjust the growth rate and determine intrinsic value
of Google for best-case and worst-case scenario. If you determine that company
is selling substantially below its intrinsic value, you should buy the stock.
The smaller the discounted price of company, the better it is to buy that stock.
The greater the discounted price of a company, the better it is to sell that
stock.