Intrinsic value is an estimation of a stocks value in a set future time period. The big word there is ‘estimation’. We can calculate intrinsic value based on cash flow, earnings, net equity, and almost any other metric that directly relates to a company’s financial health and potential growth.
Warren Buffett uses discounted cash flow to calculate his intrinsic value, which is considered the best way of estimating a company’s growth. But I recommend using at least 2 different calculation methods, so you have multiple sources of positive evidence for the company’s future.
The main figures you will need to complete this calculation are:
- The Current Share Price of the Company your are Researching.
- A Chosen Discount Rate which I set as 3%.
- At History of the Company’s EPS for at least 10 years.
- And Finally… How Long you want to Project the Growth, we will be using 10 years in the examples shown.
I like this method of calculating intrinsic value because it’s simpler than free cash flow. But I always do both, just to make sure the earnings potential of the company somewhat matches the cash flow potential. After all, if both calculations show completely different values, something is either wrong with the figures or the company.
How to Calculate Intrinsic Value using a Company’s Earnings
This is a fairly straight forward process, you can either calculate the figure on paper, in put you data into a spreadsheet, or utilise our calculator which you can download from our resources page.
The first thing we need to do is choose a company to analyse. On this blog we choose the fan favourite… AT&T. So let’s get some data.
|Current Share Price||$29.17|
|Outstanding Shares||7,348 Million Shares|
Ok, now that we have the basic information, we can move onto the good stuff… Our 4 Step Calculation.
Calculate Intrinsic Value Based on Earnings in 5 Steps
These are the 5 steps outlined in our free spreadsheet calculator. The equations might seem complicated, but all you need to do is plug in the numbers I tell you to.
#1. Collect the Historic EPS Data from MacroTrends
MacroTrends is a great research tool to use when collecting data, it’s completely free and goes back almost 15 years for all companies publicly traded. All you need to do is search for the company you want on their site.
Here are the figures I found for AT&T:
For ease, you could collect data for the first and last year, as these are the only figures we need to move forward.
So keep $0.66 & $1.96 in your mind.
#2. Calculate the Company’s EPS Growth Rate
This is where we use an actual calculator. Get on your phone, get out your scientific calculator, or get on Excel.
The formula looks like this:
((Y10/Y1)(1/x) – 1) * 100
- Y1 = Year 1 EPS ($0.66)
- Y10 = Year 10 EPS ($1.96)
- X = Total Number of Years we are Looking at (10)
So for our example we would get this:
(1.96/0.66)1/10 – 1 * 100 = 11.50%
This means, over the last 10 years, AT&T’s EPS has grown 11.5%. We can use this figure to estimate future growth of earnings.
However, this is a very important stage of the analysis of the company… I’m hoping by this point you have done all of your company research, you have an understanding of the company, and you think it is going to perform well in the coming years.
But the question you have to ask yourself before moving on is… Is this growth realistic for the next 10 years? If it is, you’re fine, if it’s not, it might be worth finding out why.
You can fill out this checklist we offer, which will give you a company score for the stock you are researching. If you think this growth rate is un-realistic, the score sheet will tell you where the company lacks growth potential.
For the sake of this riveting article, we’ll assume AT&T will continue growing at the rate as previous years.
#3. Calculate the Project Earnings Based on your Growth Rate
This part will take up most of your time if you are calculating on paper, I highly recommend you get our free calculator template with all of these formula already inputted into an Excel spreadsheet.
We are basically going to extrapolate the future earnings per share value using our growth rate. But we need to discount the future values as we go to account for inflation, which we’ll do in step 4.
So to get the future EPS’s, the formula looks like this:
Y * (1 + GR/100)
- Y = The prior year’s EPS
- GR = Growth Rate
For example, our final years EPS was $1.96, so next years (Year 11) based on a growth rate of 11.5% would be:
1.96 * (1 + 11.5/100) = $2.19
Now we need to repeat this for all the future years, so the year after next (Year 12) our calculation would be 2.19 * (1 + 11.5/100) = $2.44.
For ease, I have done the calculations for us:
So now we know, based on our estimated growth rate, in 10 years, AT&T’s EPS is likely to grow to a value of $5.82. Now we need to account for inflation and discount these figures.
#4. Discount the Earnings to Account for Inflation
As mentioned above, our discount rate is 3%. You can chose whatever discount rate you wish, however I would stick to the 2% – 5% range, as this is typically the annual rate of inflation, of which we are trying to mimic in our calculation.
Remember, you can’t just discount each year by 3%, you need to make your discount 3% annually, which is where it can messy.
For example, if you are using an old fashioned calculator, you would utilise the ‘power button’ or the indices function. To discount something 1 year, you simply takeaway 3%, to discount something 5 years, you need to takeaway 3% to the power of 5.
Have a look at the table below and you’ll get the idea:
|Year||Discount Calculation||Discount Rate|
|11||1/(1 + 0.03)||0.971|
|12||0.971/(1 + 0.03)||0.943|
|13||0.943/(1 + 0.03)||0.915|
|14||0.915/(1 + 0.03)||0.888|
|15||0.888/(1 + 0.03)||0.863|
|16||0.863/(1 + 0.03)||0.837|
|17||0.813/(1 + 0.03)||0.813|
|18||0.789/(1 + 0.03)||0.789|
|19||0.766/(1 + 0.03)||0.766|
|20||0.744/(1 + 0.03)||0.744|
That’s how easy it is! Now that we have the discount rate for each year, we can go ahead and apply it to the Projected Earnings:
|Projected Earnings||Discount Rate||Present Value of Earnings|
There we have it, all you need to do is multiple the Projected Earnings with the same years Discount Rate. Then you will get a present day value of earnings.
The next step is the easiest, I promise!
#5. Calculate the Intrinsic Value of the Stock
We already have the estimated value of earnings for the next 10 years, so to equate that to a share price, we need to figure out how much we will earn by holding the stock for that long.
It’s a simple addition. You just add up all the Present Value of Earnings figures from the table above…
2.12 + 2.30 + 2.49 + … + 4.00 + 4.33 = $31.11
$31.11 is the value you stand to earn by holding AT&T stock for the next 10 years, if your estimates are correct!
Considering the company is currently trading for around $29.17 it could be a buying opportunity investors, but you must do other research and due diligence before investing.
Like I mentioned before, you should consider getting 2 intrinsic value calculations using different methods. Just to make sure your assumptions of growth and inflation are correct. If both intrinsic value calculations point upwards, you should be in the clear to develop your knowledge about the company further.
My finishing touch to this article is to tell you that, intrinsic value is not a guarantee that the company will perform well. It is an assumption that the company will repeat prior success.
A great example of this will be oil companies. Oil is on the way out with the developments made in green energy, so prior success made by oil companies cannot be assumed for the future anymore. It would take a major shift in an oil companies business model to make them continue to grow when even Governments are putting provisions in place to reduce oil consumption.
So just keep in mind… Intrinsic Value is a good indicator of a solid company, but more needs to be checked off the list before you go and buy shares.