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warren buffett is considered one of the greatest investors of all time amassing a net worth of over 100 billion dollars today i'm going to explain how buffett uses discounted cash flow to calculate the intrinsic value of a stock this is the second video in a series where i analyzed different methods of calculating intrinsic value in the first video i explained the technique of ben graham who is actually warren buffett's mentor so that's definitely worth watching to build some foundational ideas now let's roll the intro my name is zach you should leave a like and subscribe to the channel if you enjoy the video so what is discounted cash flow it's a method used to calculate the value of investment based on its expected future cash flows the main idea here is that you're projecting out the future cash flows of the business then applying a discount rate giving you the present value of those future earnings let's listen to warren buffett explain this concept it's how do you find intrinsic value in a company well intrinsic value is what is the number that if you were all knowing about the future and could predict all the cash that a business would give you between now and judgment day discounted at the proper discount rate that number is what the intrinsic value of businesses in other words the only reason for making investment and laying out money now is to get more money later on right that's that's what investing is all about now when you look at the stock when you look at a bond so means united states government it's very easy to tell them what you're going to get back it says it right on the bond it says when you get the interest payments says when you get the principal so it's very easy to figure out the value of a bond it can change tomorrow if interest rates change but you are the cash flows are printed on the bond the cash flows aren't printed on a stock certificate that's the job of the analyst is to print out change that stock certificate which represents an interest in the business and change that into a bond and say this is what i think it's going to pay out in the future if you buy coca-cola today the company is selling for about a hundred and ten to fifteen billion dollars in the market the question is if you had 110 or 15 billion you wouldn't be listening to me but i'd be listening to you incidentally but the question is would you lay it out today to get what the coca-cola company is going to deliver to you over the next two or three hundred years the discount rate doesn't make much difference after as you get further out but and that is the question how much cash they're going to give you this isn't a question of you know any question about how many analysts are going to recommend it or what the volume in the stock is or what the chart looks like or anything it's a question how much cash it's going to get you that's the only reason it's a true if you're buying a farm it's true if you're buying an apartment house any financial asset oil in the ground you're laying out cash now to get more cash back later on and the question is is how much you're going to get when are you going to get it and how sure are you berkshire selling for we'll say 100 or so billion now uh what can we distribute from that 100 if you're going to buy the whole company for 105 billion now can we distribute enough cash to you soon enough to make it sensible at present interest rates to lay out that cash now and that's that's what it gets down to it if you can't answer that question you can't buy the stock you know you can gamble in the stock if you want to or your neighbors can buy it but if you don't answer that question and i i can't answer that for for internet companies for example there's a lot of companies there all kinds of companies i can't answer it for but i just stay away from those number two so you get formulas involved in finding intrinsic values on certain companies i mean you've got a mathematical system set up discounted present value of future cash you know i i use what i've just been talking about i use the illustration of esop because here esop was in 600 bc smart man wasn't smart enough to know it was 600 bc though i mean would take a little foresight but he's up you know in between tortoises and hares all these other things he found time to write about you know birds and he said a bird in the hand is worth two in the bush now that isn't quite complete because the question is how sure are you that there are two in the bush and how long you have to wait to get them out now he probably knew that but he just didn't have time because he had all these other problems to write and had to get on with it so but he was halfway there in 600 bc that's all there is to investing is how many birds are in the bush when are you going to get them out and how sure are you now if interest rates are 15 roughly you've got to get two birds out of the bush in five years to equal the bird in the hand but if interest rates are three percent and you can get two birds out in 20 years it still makes sense to give up the bird in the hand because it's all gets back to discounting against an interest an interest rate problem is often you don't know you know not only how many birds are in the bush but in the case of the internet companies there weren't any birds in the bush let's summarize buffett's major points intrinsic value is the summation of all future cash flows in a business discounted back at a discount rate we'll explain this idea of a discount rate later in the video the main idea of investing is that you will lay out cash now to get more cash back in the future this is the fundamental concept of investing in any financial asset the main questions you think about are how much future cash will it produce when will you get it and how short are you so how do we actually calculate discounted cash flow i built out this handy little calculator to help understand the main inputs are free cash flow per share the reasonable annual growth rate of free cash flow the total number of years simulated and the discount rate let's explain these in more detail free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures it represents the cash flow that is available to all investors before cash is paid out to make debt payments dividends or share repurchases this is preferable to operating cash flow because capital expenditures can often be a recurring cost in a business also many investors prefer free cash flow per share over earnings per share because it's harder to manipulate and often provides a better view into the business free cash flow is the metric that buffett tends to look at and is represented in the equation by fcf then you have g which is the reasonable annual growth rate of free cash flow reasonable is the key word here it's important to be conservative with projections and only choose numbers which you can pick with a high degree of certainty n is the total number of years to simulate in the model for a business the number of years is theoretically forever or until the business no longer operates keep in mind that it becomes harder to predict over long periods of time because of so many unknowns however discounted cash flow is also used to value many different kinds of investments not just businesses in those cases the number of years you project out can often be far more defined the variable k represents the discount rate which allows you to calculate the present value of those future earnings depending on who you ask you may get a different answer on what to set this as buffett and munger suggest using the us treasury bond as the base rate ben graham suggested using the aaa corporate bond yield many modern investors use things like the weighted average cost of capital or average return of the s p 500 buffon and munger think there are problems with the latter two options but we'll discuss that later the main idea here is that the discount rate represents the opportunity cost of investing the u.s treasury bond is the risk-free return you could earn on your money making that the base rate to beat obviously you wouldn't want to invest in something that is likely to have a lower return than the so-called guaranteed return of u.s treasuries this method takes into account interest rate changes which are a gigantic contributing factor to stock values a change in interest rates will impact bond yields thus changing the opportunity cost of investing in stocks let's listen to warren buffett and charlie munger discuss discount rates we don't formally have discount rates i mean every time i start talking about all this stuff charlie reminds me that i've never prepared a spreadsheet but i do you know in effect in my mind i do but uh we are going to want to get a significantly higher return obviously in terms of cash produced relative to the amount we're out laying now for a business than we are from a government bond i mean we you know we're gonna that that has to be the yardstick at a base then how much more do we want well if government bond rates were two percent we're not going to buy a business to earn three or three and a half percent expectancy over the years we just don't want to commit our money that way we'd rather sit around and wait a little while uh if they're four and three-quarters percent you know what do we hope to get over time well we want to get a fair amount more than that but i can't i can't tell you that we sit down every morning and and i call charlie in los angeles and say what's our hurdle rate today i mean we have never used the term uh you know it's a little bit of the the we want enough so that we feel very comfortable if they close on the stock market for a couple of years if interest rates go up another 100 basis points or 200 basis points we're still happy with what we bought and above that i really you know i know it sounds kind of fuzzy but it is fuzzy i think in the last analysis everything we do comes back to opportunity cost but it to some extent in fact to some considerable extent we are guessing at our future opportunity cost warren is basically saying that he's guessing that it's in due course to to uh put out money at pretty attractive rates of return and therefore he's not gonna waste a lot of firepower now at lower returns but that's an opportunity cost calculation and if interest rates were to more or less permanently settle at one percent or something like that and warren were to reappraise his notions of future opportunity cost he would change the numbers like kane said what do you do when you change your view of the facts or you change your conduct like buffett said it's a bit fuzzy as munger said they're guessing the main idea is that they know they want to earn a significant amount more than the risk-free rate of government bonds but they are unsure of future changes in that rate so the discount rate is an area where they like to have a strong margin of safety so why do buffett and monger disagree with using weighted average cost of capital as a discount rate well it takes in variables they view as irrelevant to valuing a business for example the capital asset pricing model formula uses the volatility of stock price and historical return of the stock market in its calculation if it explains why this is a mistake here if you have the capital you think you can create more than a dollar how do you create the most with the least risk and that gets to business risk it doesn't get any calculation of the volatility i don't know the the risk in seized candy is measured by its stock volatility because the stock hasn't been outstanding since 1972 does that mean i can't determine how risky a business sees is because we don't have a daily quote on it no i can determine it by looking at the business and the competitive environment which it operates and so on i have listened to cost-to-capital discussions at all kinds of corporate board meetings everything else and and you know i've never found anything that made very much sense in it except for the fact that that is what they learned in business school and that's what the consultants talked about and and and most of the board members would nod their head without knowing what the hell was going on and that's been my history with the cost of capital his see's candy example is perfect here you look to the characteristics of the actual business to determine risk not things like volatility of stock price here you can see the general formula for discounted cash flow the present value is equal to the summation of future cash flows each discounted by the proper discount rate you have the first chunk of free cash flow then the second all the way up to the nth year to perform the calculation on this calculator i use the summation shown here the free cash flow per share is multiplied each year with the given growth rate the exponential is needed for the growth rate and discount rate calculation because both of them compound over time this is equivalent logic of the formula shown here but allows for the input of the growth rate and actual summation calculation all right now that we understand the concept of discounted cash flow let's actually do an example like walgreens boots alliance i've actually been buying that stock recently i did a stock review video and you should check that out for more info the current price is 47.55 the free cash flow per share is 5.76 based on the trailing 12 months i will put the growth rate at 2 which is leaning on the conservative side we'll have the number of years set as 100.
i've seen this as the default in other calculators but you'll soon see it doesn't make as big of a difference as you'd think finally we have the discount rate the current us 10-year treasury yield is 1.26 percent over the last 10 years it's mainly hovered between 1.5 and 3 however historically it's been much higher remember what buffett said you want your discount rate to be significantly above this risk-free rate i'm going to be very conservative for this environment and set my discount rate at 10 percent so we hit calculate and it shows a present value of 73.40 which means the stock is trading at a price 35.22 percent below so-called intrinsic value let's change some of the variables and see how that alters the output if we have a growth rate of three percent then the present value is now 84.64 cents at four percent it's 99.47 let's put the growth rate back at two percent and change the number of years when changed to 50 years the present value is 71.76 at 25 years it's 62.32 let's put it back at 100 years and now change the discount rate at seven percent the present value is 116.52 cents at 5 the present value is 185.05 the discount cash flow projection is not an exact science the reason is that you are not all knowing about the future you don't know the exact future earnings for a company or the opportunity cost environment that's why warren buffett suggests staying in your circle of competence and only investing in things you can determine with a high degree of certainty also you need to invest with a large margin of safety to protect against errors in calculation this includes leaning on the conservative side of your inputs remember this is just a model so garbage in equals garbage out business valuation is more of an art than a science let's listen to warren buffett explain this about discounted cash flow well that's that's a a very good question and it's it's i mean it's the heart of investing or buying businesses which we regard as the same thing but and it is the framework in which we operate i mean we are trying to look at businesses in terms of what kind of cash can they produce if we're buying all of them or will they produce if we're buying part of them and there's a difference and then at what discount rate do we do we bring it back and and then i think your question was how far out do we look and all that despite the fact that we can define that in a very kind of simple and direct equation you know we are we've never actually sat down and and written out a set of numbers that uh to write that equation we do in our heads in a way uh obviously i mean that's that's what it's all about but uh there's no piece of paper uh and and and we never there never was a piece of paper that shows what our calculation on helzberg's or c's candy or the buffalo news was in that respect uh so it would be attaching a little more scientific uh quality to our analysis than there really is if i gave you some gobbledygook about well we do it for 18 years and stick a terminal value on and do all of this uh we are sitting at the in the office thinking about that question with each business or each investment and we we have discount rates in a general way in mind but we really like the decision to be obvious enough to us that it doesn't require making a detailed calculation and it's the framework but it's not applied in the sense that we actually fill in all the variables as i mentioned at the beginning this is a second video in a series where i'll go through different methods of calculating intrinsic value next i have planned to do the dividend discount model also if you've been watching this whole video and wondering what website is i'm using this is something i've been building myself once it's ready i will be releasing it to the public so stay tuned thank you for watching dividend data i'd greatly appreciate if you could leave a like and subscribe to the channel if you follow me on twitter link in the description you can get real-time updates on my buys and dividends coming in also you can follow me on instagram dividend data you can support the channel over on patreon where you can gain access to a community discord server the link is in the description please leave a comment below and thank you for watching
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