The Secrets of the Gurus: How to Calculate Stock Intrinsic Value Like Benjamin Graham, Peter Lynch, and Warren Buffett

Posted on June 21, 2023July 27, 2023 by investinternals

Introduction

Determining the intrinsic value of a stock is a crucial aspect of fundamental analysis in investing. Various renowned investors and financial experts have developed formulas to estimate intrinsic value. In this article, we will explore some of the most famous intrinsic value calculation formulas and provide examples to illustrate their application.

1. Benjamin Graham’s Intrinsic Value Formula:

Benjamin Graham, considered the father of value investing, developed a formula to estimate the intrinsic value of a stock. It is calculated as follows: Intrinsic Value = EPS * (8.5 + 2 * (Growth Rate))

Example: Let’s say a company has an earnings per share (EPS) of $4 and a projected growth rate of 7%. Intrinsic Value = $4 * (8.5 + 2 * 7) = $4 * (8.5 + 14) = $4 * 22.5 = $90

2. Peter Lynch’s PEG Ratio:

Peter Lynch, a legendary investor, introduced the Price/Earnings to Growth (PEG) ratio. It considers the P/E ratio and the earnings growth rate to identify potentially undervalued stocks. PEG Ratio = P/E Ratio / Annual Earnings Growth Rate.

Example: Suppose a stock has a P/E ratio of 20 and an annual earnings growth rate of 15%. PEG Ratio = 20 / 15 = 1.33

3. John Greenblatt’s Magic Formula:

John Greenblatt devised the Magic Formula, which combines earnings yield and return on invested capital (ROIC) to identify attractive investment opportunities. Magic Formula Rank = Earnings Yield + ROIC

Example: Consider a company with an earnings yield of 10% and an ROIC of 15%. Magic Formula Rank = 10 + 15 = 25

4. Gordon Growth Model:

The Gordon Growth Model, also known as the dividend discount model, estimates the intrinsic value of a stock based on its dividends and expected growth rate. Intrinsic Value = Dividend per Share / (Discount Rate – Dividend Growth Rate)

Example: Suppose a company pays an annual dividend of $2 per share, the discount rate is 8%, and the dividend is expected to grow at 5% per year. Intrinsic Value = $2 / (0.08 – 0.05) = $2 / 0.03 = $66.67

5. Warren Buffett’s Market Cap/GDP Ratio:

Warren Buffett uses the ratio of total stock market capitalization to the Gross Domestic Product (GDP) of a country to assess market valuation. Market Cap/GDP Ratio = Total Stock Market Capitalization / GDP

Example: If the total stock market capitalization is $20 trillion and the GDP of the country is $25 trillion. Market Cap/GDP Ratio = $20 trillion / $25 trillion = 0.8

6. Dividend Discount Model (DDM):

The Dividend Discount Model estimates the intrinsic value of a stock based on its dividends and a discount rate. The formula is as follows: Intrinsic Value = Dividend per Share / (Discount Rate – Dividend Growth Rate)

Example: Suppose a stock pays an annual dividend of $2 per share, the discount rate is 10%, and the dividend is expected to grow at 5% per year. Intrinsic Value = $2 / (0.10 – 0.05) = $2 / 0.05 = $40

Using the Discounted Cash Flow Model to Calculate Intrinsic Value of a Stock:

The discounted cash flow (DCF) model is a widely used valuation method to estimate the intrinsic value of a stock. It relies on projecting future cash flows and discounting them back to the present value using an appropriate discount rate. In this article, we will delve into the DCF model and provide an example to illustrate its application in calculating the intrinsic value of a stock.

Understanding the Discounted Cash Flow Model:

The DCF model is based on the principle that the value of an investment is determined by the cash flows it generates over its lifetime. The steps involved in using the DCF model to calculate intrinsic value are as follows:

1. Forecasting Cash Flows:Forecasting Cash Flows:

First, you need to estimate the future cash flows the stock is expected to generate. These cash flows can include dividends, interest payments, or any other form of cash distributions.

2. Determining the Discount Rate:

Next, you need to determine an appropriate discount rate to account for the time value of money and the risk associated with the investment. The discount rate is often based on the company’s cost of capital or the investor’s required rate of return.

3. Discounting Cash Flows:

Once you have the projected cash flows and the discount rate, you can discount each cash flow back to its present value using the following formula: PV = CF / (1+r)^n, where PV is the present value, CF is the cash flow, r is the discount rate, and n is the period.

4. Calculating the Intrinsic Value:

Finally, sum up the present values of all the projected cash flows to obtain the intrinsic value of the stock. This represents the amount an investor should be willing to pay for the stock based on its future cash flow potential.

Example

Let’s consider a hypothetical company, ABC Inc., with projected annual cash flows as follows: Year 1: $1,000, Year 2: $1,500, Year 3: $2,000. We will assume a discount rate of 10%.

Using the DCF model, we discount each cash flow back to the present value: PV1 = $1,000 / (1+0.10)^1 = $909.09 PV2 = $1,500 / (1+0.10)^2 = $1,239.67 PV3 = $2,000 / (1+0.10)^3 = $1,652.89

Finally, we sum up the present values to obtain the intrinsic value of the stock: Intrinsic Value = $909.09 + $1,239.67 + $1,652.89 = $3,801.65

Note: The discounted cash flow model is a valuable tool for estimating the intrinsic value of a stock by considering its future cash flows and the time value of money. However, it is important to note that the DCF model relies heavily on accurate cash flow projections and the selection of an appropriate discount rate. Additionally, it is essential to conduct thorough research and consider other factors when making investment decisions. Consulting with a financial advisor or professional is recommended to ensure accurate analysis and interpretation of results.

Conclusion

These famous intrinsic value calculation formulas provide investors with different approaches to assess the worth of a stock. While they can be helpful tools, it is essential to conduct comprehensive fundamental analysis and consider other relevant factors before making investment decisions.

Remember, investing involves risks, and consulting with a qualified financial advisor is always recommended to make informed choices.