Great… Another one of those investing calculations you need to know! But this one is the most important for any value investor. Intrinsic value is one of those terms only the best finance YouTubers talk about. But it is actually a very useful metric to use when figuring out how a stock is likely to trade.
For calculating the intrinsic value of a company using free cash flow, you’ll need a few things:
- A history of the company’s free cash flow.
- A discount rate, which you can choose. A common discount rate is 10%.
- An infinite growth rate which can be based on inflation, normally 2-3%.
- A Calculator… Or our free value calculator created in Excel.
The concept explained below along with the 7 step calculation is what has helped Warren Buffett gain an average annual return of 21% in his 60 year career.
For those here for the juicy stuff, here is the basic equation for intrinsic value:
A Small Introduction to Intrinsic Value
There is no one way to calculate intrinsic value, it is a mix of financial information and future prediction of market conditions. It is a valuation model based on a businesses quantitative, qualitative, and perceptual aspects.
Quantitive Factors Include:
- Fundamental analysis of the company.
- Financial position of the company, such things as debt, equity, revenue, and growth.
Qualitative Factors Include:
- The running of the business, and people involved in that.
- The business model and evolution of business activity.
- Business goals and activities relating to them.
- Board member changes.
- Target demographic and industry competition.
The perceptual aspects of the business are based on your individual opinion of the company. At the end of this article you will be given to way to value a company’s share based on future expectations, but your opinion of the company and where it’s going are just as important.
Just to add on a note, this method is not suitable for day traders or options traders. This is a long term investment metric.
How to Calculate Intrinsic Value using Free Cash Flow
Free cash flow estimates are widely available but for this purpose we are going to calculate ourselves… It’s very easy!
For this article we will be using the company AT&T as our work through example. We will be working in $Millions, so $1 = $1 million.
AT&T Outstanding Shares = 7,125 million as of December 2020
#1. Calculate the Annual Growth Rate
The annual growth rate is what we will use to estimate the future value of the free cash flow in each of the next 5 years.
So first things first… Straight to Morningstar to find the past values of free cash flow for AT&T, I’ve collected them below:
|Free Cash Flows (Millions)||$16,662||$17,828||$18,504||$22,844||$29,233|
Now we can calculate the annual growth rate (AGR) using the equation below:
f1 = Latest Free Cash Flow Value ($29,233)
f5 = Earliest Free Cash Flow Value ($16,662)
Years = Number of Years used (5)
So our example would look something like this:
((29,233/16,662)1/5 – 1) x 100 = 11.98%
This is exactly how you would enter it into a calculator. Bare in mind, the more years of data you use, the more accurate your estimate will be.
#2. Estimate the Future Cash Flows
Like I said at the start, this is just an estimate, but it is the best estimate we have, so here it goes.
Because we know the Annual Growth Rate is 11.98%, we can assume the free cash flow is going to continue to increase at the same rate over the next 5 years.
We need to take the most recent free cash flow value, and extrapolate the value for 5 years.
|Year||Calculation||Estimated Cash Flow|
|2020||29,233 x 1.1198||$32,845|
|2021||29,233 x 1.11982||$36,779|
|2022||29,233 x 1.11983||$41,184|
|2023||29,233 x 1.11984||$46,116|
|2024||29,233 x 1.11985||$51,639|
There we have it, estimated cash flows for the next 5 years. We could go further, but for the purpose of teaching I want to keep it as simple as possible.
Now we need to discount them to show the affect inflation has on money.
#3. Discount the Cash Flows & Add them up
Ok, so you’ve got your cash flow estimates and now we need to account for inflation. Because of inflation, your money today will not be worth the same amount in 10 years time. Just think about how much a pint of milk was 5 years, and how much the price has went up… Thanks inflation!
You need to decide on a discount rate. This should be between 8-12% because this has been the average return of the S&P 500. For this example we’ll go down the middle at 10%. But keep in mind that, the higher the discount rate, the lower the cash flow, meaning the lower the intrinsic value. So try to be fair.
If you wanted to choose a different discount rate based on your desired return, you would just think, what return do I want from this stock? What is a realistic return for this stock? And if that is 10% then choose 10% as you discount rate.
Onto the formula:
DCF = (F2020 / DR) + (F2021 / DR2) + … + (F2024 / DR5)
F2020 = Cash flow for the year 2020 (Same format for future years).
DR = Discount Rate (We show this as a decimal: 10% = 1.1 because it’s growing) The power is how many years into the future the Cash Flow is.
DCF = Discounted Cash Flow.
The “…” in the middle is used to denote the missing years included in the calculation.
Our calculation will look like this:
Discounted Cash Flow =
(32,845/1.1) + (36,779/1.12) + (41,184/1.13) + (46,116/1.14) + (51,639/1.15)
Discounted Cash Flow for AT&T = $189,606.42
This value will come in hand later on, but for now let’s move onto the Terminal Value.
#4. Calculate the Terminal Value
The Terminal Value is the present value of a stock at a point in the future, again this is an estimate. Basically, it is the estimate value of a company if the business was to survive forever.
This is a vital part of calculating intrinsic value.
Before we dive into more equations, we need to decide on an Infinite Growth Rate. This is a percentage increase each year based on the growth of the economy. The GDP growth rate is not usually used in this instance, because companies are expected to grow quicker.
Common values for an infinite growth rate are between 2-5%. If you think a company is going to grow quicker, choose the higher value, but we will stay with 2% to give us a realistic level of growth.
Now that’s decided, here is your equation:
TV = Terminal Value
f5 = Latest Cash Flow value ($51,693)
DR = Discount Rate (10% = 0.1)
i = Infinite Growth Rate (2% = 1.02)
So, for AT&T the Terminal Value is:
(51,693 x 1.02) / (0.1 – 0.02) = $659,085
That is the what the Terminal Value of AT&T will be in 5 years time! Now we need to find the Present Day Terminal Value.
#5. Calculate the Present Day Terminal Value
The terminal value we just calculated is based on the cash flow 5 years into the future and the infinite growth of the company. We need to pull it back to find out what the terminal value of AT&T is today based on the expected growth.
You might just think you can calculate based on the most recent data for the company’s cash flow but you are wrong. We need to base our present day terminal value on the future one. That way we incorporate all the future growth.
It’s a simple calculation:
PDTV = TV ÷ (1+DR)5
PDTV = Present Day Terminal Value
TV = Terminal Value ($659,085)
DR = Discount Rate (10% = 0.1)
The reason we use 5 as the power, is because we have looked 5 years into the future. If you wanted to look 10 years into the future the power would 10.
For our example AT&T the present day terminal value would be:
659,085 ÷ (1+0.1)5 = $409,239
This is the Terminal Value of AT&T at the current day. This means, taking the future growth of the company, this is the value of cashflow. Now we move onto the money maker.
#6. Calculate the Intrinsic Value
This is the easiest part of the process, you just need to add together, the Present Day Terminal Value and the Total Discounted Cash flow. This will give the value of the company’s share based on future estimated growth.
So, the Present Day Terminal Value is $409,239 and the Total Discounted Cash Flow is $189,606.
Together they make:
409,239 + 189,606 = $598,845
So the intrinsic value of AT&T is $598,845 million. Now we can use this to evaluate the share price, as the company value will be split into the outstanding shares which we stated above as 7,125 million.
So onto the final step.
#7. Calculate the Value of 1 Share based on the Company’s Intrinsic Value
This will give you a guideline price of a share based on your estimations. If you are confident in your estimations this figure will tell you a lot.
Effectively, this value is recommended share price based on future activities.
So let’s divide the present day terminal value by the outstanding shares.
598,845 ÷ 7,125 = $84.05
AT&T has an intrinsic value per share of $84.05. Meaning the company is currently undervalued. But like I mentioned earlier in the article, you need to take more than this calculation into account when valuing a stock, this is just a guideline.
I might of blown your mind there a bit, but if you want an easy spreadsheet to use which does the calculation for you, I am offering one for free over on our resources page.
Have a Look at Chris’s Tutorial Video on Intrinsic Value
I created a video outlining how our free cash flow intrinsic value calculator works and how you can use it to value any company you want. The value calculator is available in our Investing Essentials section.
Why Intrinsic Value isn’t Everything
Even Warren Buffett thinks intrinsic value isn’t everything. Don’t get me wrong it is a fantastic metric to use when screen companies for potential investments.
Even if you find a company with a humongous intrinsic value, the CEO could leave, the innovation team could produce a bad product, they could lose major suppliers, or the world economy could crash because of a global pandemic…
Intrinsic value is a good estimation of which way a company is going, but your estimations are only correct if the business is ran well and market conditions don’t change to drastically.
This section is not made to scare you away from using intrinsic value to find good companies, it is just a warning to make you complete the other necessary research.
Try Simply Wall St
Simply Wall Street is a free online stock analysing tool you can use. The free subscription lets you research up to 10 companies per month, if you need more, the subscription price is $59 per year.
You can enter your portfolio and Simply Wall St will update on how you performed compared to the wider market.
It also has it’s own method of calculating intrinsic value (which is not as good as mine). You can instantly get data and metrics directly to your computer screen. You can check out Simply Wall St here.
Along with that, the system will also recommend companies based on goals and requirements you enter when creating an account.
They even have a Beta Stock Valuator you can use for free to value stocks based on your opinions of future profits.