Many years ago, Benjamin Graham (teacher of Warren Buffett) coined the term Value Investing, the methodology for profiting from the stock market was very speculative and based on guessing the direction of the market. But after Benjamin Graham created ONE special idea, Value Investing was born.

What is that one special idea that gave birth to Value Investing?

The idea is that each stock has a numerical Value, which is known as the Intrinsic Value. Just imagine looking through the list of stocks and being able to give a value to each stock. When you can do that, your life as a Value Investor becomes very easy… When a stock is below the Intrinsic Value, you will buy the stock. Eventually, the market will price the stock correctly which means that the stock price will rise and you can sell it and make a profit. This, by the way, was how Warren Buffett and many other value investors make their fortune.

So what is the Intrinsic Value of a stock and how can we calculate it?

There  many ways to calculate intrinsic value and one of it is to look at business and calculate how much profits they can produce for us over their lifetime.

Let me give you an example. How much is a business worth if it starts operating today, makes $100,000 in net profit one year later and then vanishes? What is the maximum amount you will pay for it?

If you answer anything less than $100,000, you are a sensible and logical investor. Why would anyone put in more than he/she can get back? Now, lets get into the details so that we can understand the concept. What is the maximum amount we would invest in?

Think hard for a moment: Will you invest $100,000 into it if the business is guaranteed to give you a $100,000 back?

If we think logically enough, we will not put in $100,000 just to get $100,000 back. Because the Returns on our investment is 0%. We would rather put it into the bank and earn interest on it. So if the bank is giving us a 1% per annum of interest on our deposit of $100,000, we will get back $101,000.

Another way to think about it is that if you have only 2 choices, would you rather Invest $100,000 in the business (stock) and get $100,000 1 year later or would you deposit your $100,000 in the Bank at 1% and get $101,000 back?

In this case, the choice is obvious. We rather put it into the bank. The 1% in this example is known as the Risk Free Rate. Well, we know today that there really isn’t such a thing as Risk Free investment, so lets change the term to the Opportunity Cost of Investment (OCI). Simply put, the Opportunity Cost of Investment is the returns you are missing out if you choose to invest in a certain vehicle.

Moving on, to find the maximum logical amount we will be willing to pay for the business that gives us $100,000 1 year later, we will need to discount it using the OCI, which is 1%. By discounting a future value (which is $100,000 in this case), we are able to find the Present Value (which means today’s value) of the business.

Using the discounting formula, we find the Present Value of this Business to be

= Future Value  / (1+OCI)

= $100,000/1.01

= $99,009.9

This means if we buy the business at $99,009.9 and get back $100,000, we make 1% which is the same as the bank’s interest. Thus, we will not pay anything more than $99,009.9 since paying anything more will give us less than our OCI which is 1%.

Do note that since the profit from the business is fixed based on our study, to be $100,000 in this example, the Higher we pay for the Business, the Lesser our returns and vice versa.

In our example, the Intrinsic Value of the Business is worth $99,009.9. So for Value Investors, we will be willing to buy the business when it is selling less than that amount.

Now that we have understood the idea of discounting for Present Value, we will add in a more variables.

1) Continuous Profits from a Business Affects the Intrinsic Value. The example we used to illustrate the idea of intrinsic value has only 1 year of profit. When we look for businesses to invest, we are looking for one that will continue operate for years (or even the kind Warren Buffets wants ~ to last forever). So if a business continues to operate for more than 1 year, the Intrinsic Value will change. Using the example above, if the business now operates for 2 years and continue to make a net profit $100,000 each year, we will need to calculate the Intrinsic Value of the Net Present Value by discounting the 2 years of profits back to today’s value. Using OCI of 1%, the picture will look like this:

The Net Present Value is calculated by adding the Present Value of the Profit from 1 yr later with the Present Value of the Profit from 2 years later. If you noticed the $100,000 that is generated 2 years from now will be discounted 2 times. When we break the calculation down, it will look like this:

Present Value from Profit 1 Year Later = Future Value/ (1+OCI) = $100,000/1.01 = $99,009.9

Present Value from Profits 2 Yrs Later = Future Value/ (1+OCI)ⁿ = $100,000/1.01² = $98,029.60

Where n = number of years later, thus the number of times to discount.

The Net Present Value = Sum of all the Present Values of Future Profits = $99,009.9 + $98,029.60 = $197,039.5

In this example, the Intrinsic Value of the Business is $197,039.5. As a rule of thumb, we can use a 10 year period to calculate the Present Value of a Business.

 

In my next post, I will share an example of how to use this one idea to calculate when to buy a stock that we want.

Or what is even better is that you can join us at our free workshop and learn this live from me.

Click HERE to book a Free Investing Workshop.

To your dreams,

Mind Kinesis Research Team

Master Trainer (Value Investing Options Strategy)
Investment in Stocks Blog
Value Investing Academy – the Warren Buffett Way
https://www.investment-in-stocks.com,