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Creating a Portfolio Like Warren Buffett: A High-Return Investment Strategy by Jeeva Ramaswamy

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CHAPTER 23

Intrinsic Value

Question: Why does anyone buy any business?

Answer: To receive the future earnings of that company.

Question: How can you calculate the future earnings of a company?

Answer: You can get an approximate idea from the historical earnings of the company.

Question: How can you calculate the true worth (intrinsic value) of a company?

Answer: You can project future earnings of a company from the basis of historical earnings. The calculation of earnings that you wish to calculate is in the future, so you need to discount those future earnings to present value in order to get the true worth of the company. Here is the way Ben Graham puts it: “Any business is worth the sum of free cash flow from now, to eternity discounted to present value using a reasonable risk-free interest rate.”

Calculating intrinsic value is not an exact science. You need to assume the earnings, discount rate, and share dilution of the company in the future. Because of this variation, you can get a range of intrinsic values for the business. When you incorporate those variables, you need to be as conservative as possible. Here are the explanations of those variables.

Future Earnings

We can define future earning as the earnings generated from the business in the future. Warren Buffett coined the term owner income. He uses the owner income figure instead of the net income of a business. He also added the non-cash charges and subtracted the capital expenditure from the net income.

Depreciation ...

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