How to estimate a stock’s intrinsic value the Buffett way
Intrinsic value is what a business is worth based on the cash it will generate for its owners over its remaining life, brought back to today at the return you require. Warren Buffett calls the relevant cash owner earnings, a concept from his 1986 letter to Berkshire Hathaway shareholders: net income plus depreciation and amortization, minus the capital spending needed just to keep the business running, minus any extra working capital.
The calculation step by step
- Owner earnings today: 1,200 net income + 300 depreciation − 350 maintenance capex − 50 working capital = 1,100 million.
- Ten years of growth: project owner earnings at the growth rate of each scenario (1%, 5% and 9% a year in the example).
- Discount: divide each year by (1 + required return) raised to the number of years. At 9%, a dollar received in year 10 is worth about 42 cents today.
- Terminal value: after year 10, assume the business grows forever at a modest rate (2.5% in the example) and discount that value too.
- Per share: divide the total by the number of shares and weight the three scenarios by their probabilities.
Margin of safety
Every input is an estimate, so Buffett and Graham only buy at a meaningful discount to value. With an intrinsic value of $21.43 per share and a 30% margin, the maximum buy price is $15.00. At $19 the stock is below value, but without the margin you asked for.
Common mistakes
- Using total capex instead of maintenance capex understates owner earnings for growing companies; using no capex at all overstates them.
- A required return close to the terminal growth rate makes the value explode. Keep a gap of several points.
- Optimistic scenarios with high probabilities: be honest about what can go wrong.
- Ignoring the moat. The terminal value is often half the total; it only holds if the competitive advantage lasts.
Intrinsic value is a range, not an exact number. Use it to decide whether the price leaves room for error, not as a target price.