Warren Buffett oft-quotes his mentor Benjamin Graham: “Price is what you pay. Value is what you get.”
In the stock market, share prices fluctuate daily based on fear and greed. But price is not the same as value. Successful investors look for Intrinsic Value — the true mathematical worth of a business based on its earnings power and cash generation.
Here is a guide on how to calculate intrinsic value using two legendary models.
1. The Benjamin Graham Formula (Revised)
In his book The Intelligent Investor, Benjamin Graham introduced a quick formula to value growth stocks, which he later revised in 1974 to adjust for corporate bond yields:
$$V = \frac{EPS \times (8.5 + 2g) \times 4.4}{Y}$$
- EPS: Trailing Twelve Months (TTM) Earnings Per Share.
- 8.5: The baseline P/E multiple assumed for a company with 0% growth.
- 2g: Expected annual growth rate of earnings over the next 7-10 years multiplied by 2.
- 4.4: The average yield of high-grade corporate bonds in the US back in 1962 (representing a historical risk-free baseline).
- Y: The current yield of AAA corporate bonds today (around 7.5% in India).
Example Calculation:
Assume a stock has an EPS of â‚ą50, an expected growth rate of 10%, and corporate bond yield is 7.5%.
- $V = [ 50 \times (8.5 + 20) \times 4.4 ] / 7.5$
- $V = [ 50 \times 28.5 \times 4.4 ] / 7.5$
- $V = 6,270 / 7.5 = \text{â‚ą}836$
If the current market price is â‚ą600, the stock is undervalued. If it is trading at â‚ą1,200, it is overvalued.
2. The Discounted Cash Flow (DCF) Model
While the Graham formula is excellent for quick filters, the Discounted Cash Flow (DCF) model is the gold standard for investment bankers and Warren Buffett.
The core premise of DCF is simple: A business is worth the sum of all the cash it will generate in the future, discounted back to the present day.
Steps in a DCF Model:
- Project Free Cash Flows (FCF): Estimate the company’s cash generation over the next 10 years based on historical growth rates.
- Estimate Terminal Value (TV): Estimate the value of the business beyond year 10, assuming it grows forever at a steady rate matching the country’s GDP growth (typically 4-5% in India).
- Discount to Present Value: Discount all future cash flows back using a Discount Rate (Cost of Capital or WACC, typically 11-13% for Indian equities).
- Add Cash & Deduct Debt: Add cash reserves, subtract outstanding debt, and divide by the total number of shares to get the fair price per share.
The Margin of Safety: The Ultimate Shield
Calculations are only as good as their inputs. If you overestimate a company’s growth rate by even 2%, your calculated intrinsic value will be highly inflated.
To protect against assumptions errors, value investors apply a Margin of Safety (usually 20% to 30%).
- If your calculated intrinsic value is â‚ą1,000, and you apply a 20% Margin of Safety, your Maximum Buy Price is â‚ą800.
- This buffer ensures that even if growth slows down or the market crashes, you bought at a cheap enough price to avoid permanent capital loss.