In this post I will summarize how one can compute the intrinsic value of a company according to the below quote from Warren Buffet:

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

The sum of cash that can be taken out of the business over the next ten years is going to be the dividends plus the equity growth. Let us consider Disney (NYSE: DIS) over the period 2002 – 2011:

Year EPS Book Value Dividend
2002 NA $11.61 NA 2003$0.65 $11.82$0.21
2004 $1.11$13.05 $0.24 2005$1.19 $13.06$0.27
2006 $1.60$15.42 $0.31 2007$2.24 $15.67$0.35
2008 $2.28$17.73 $0.35 2009$1.76 $18.55$0.35
2010 $2.03$19.78 $0.40 2011$2.52 $21.21$0.60
SUM $15.38$9.60 $3.08 We can see that Disney’s book value grew over by \$9.60 in the period of 2002 – 2011 and the total dividends collected were \$3.08. In other words the total earnings per share of \$15.38 materialized in a total \$12.68 for the shareholders over that period. Using the above table we can easily calculate the Compound Annual Growth Rate, $r$, of Disney’s book value in order to estimate how much the book value will be in 10 years if we were to compound its current value, $Current\_Book\_Value$, which is \$21.21 as of 2011, at that rate for 10 years ($Future\_Book\_Value$):

$Future\_Book\_Value = Current\_Book\_Value\times(1 + r)^{10}$

Once we have our future book value, $Future\_Book\_Value$, we will discount it with a rate $d$ in order to compute the present value of that future value. $d$ is usually the yield of  the 10 year federal note. The reason we are discounting with $d$ is, because we want to compare it with something that we have total confidence in. In other words, how much money would we need to invest now in a 10 year federal note (which is a lot less risky than stock in a company), with a yield of $d$ in order to have $Future\_Book\_Value$ (which is what Disney’s book value will be) in ten years from now.

$Present\_Value\_Of\_Future\_Book\_Value = \frac{Future\_Book\_Value}{(1 + d)^{10}}$

For our example above, we have already computed $r$, which is $r=0.0692$. This will give us a:

$Future\_Book\_Value=21.21\times(1 + 0.0692)^{10}=41.4123\$

Discounting it with the 10 year federal note yield of $d = 1.71\%$ will give us:

$Present\_Value\_Of\_Future\_Book\_Value = \frac{41.4123}{(1 + 0.0171)^{10}} = 34.9536\$

That is, investing \$34.95 now in a 10 year federal note with a yield of $d = 1.71\%$, will lead to \$41.41 in 10 years from now, guaranteed. If Disney is trading above \$34.95, then we are better of investing in the sure thing, the 10 year federal note, assuming Disney does not pay any dividends. But, because we still get paid dividends from Disney, let ‘s go ahead and include them in our calculations as well before we decide if we want to invest in the company. Next, we will also want to include any future dividends. If we assume that Disney will continue to pay its \$0.60 dividend for each of the next ten years, we will see the following stream of cash flows in our pockets:

$DCF_1 + DCF_2 + \dots + DCF_{10}$

with $DCF_i$ being the dividend cash flow on year $i$. Similar to the $Future\_Book\_Value$ we will want to discount it with $d$. So the present value of all future dividend cash flows will be:

$Present\_Value\_Of\_Future\_Dividend\_Cash\_Flow = \frac{DCF_1}{(1 + d)^1} + \frac{DCF_2}{(1 + d)^2} + \dots + \frac{DCF_{10}}{(1 + d)^{10}}$

or in short:

$Present\_Value\_Of\_Future\_Dividend\_Cash\_Flow = \sum_{i=1}^{10} \frac{DCF_i}{(1 + d)^i}$

For $d = 1.71\%$ and our assumption that Disney will pay out a \$0.60 dividend each year, this would be (using this calculator): $Present\_Value\_Of\_Future\_Dividend\_Cash\_Flow = \frac{0.60}{(1 + 0.0171)^1} + \frac{0.60}{(1 + 0.0171)^2} + \dots + \frac{0.60}{(1 + 0.0171)^{10}} = \5.47$ Once we have our $Present\_Value\_Of\_Future\_Book\_Value$ and $Present\_Value\_Of\_Future\_Dividend\_Cash\_Flow$, all that is left to do in order for us to figure what Disney is worth today (intrinsic value) is to sum up those two values, which is $\34.95+\5.47=\40.42$. In other words, if we were to buy Disney at a price of \$40.42, we would make a 1.7% annual return on our money for the next ten years. As of the time where this data was taken, Disney was trading at \\$44.33, which makes it overvalued. So if we were to choose between the 10 year federal note and Disney, we would go for the 10 year federal note because we are getting our 1.7% annual return at zero risk.

You can use the following Python script to fetch ten year data from Morningstar for a given stock symbol and compute its intrinsic value: