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Understanding how we calculate a company's intrinsic value

Intrinsic value is our estimate of what a company is truly worth based on its future ability to generate cash. Here's a step-by-step explanation of how we calculate it:

1. Analyzing Free Cash Flow (FCF) Growth

We begin by looking at the company's historical Free Cash Flow. The cash left over after operating expenses and capital expenditures. By comparing FCF year over year, we calculate the company's historical growth rate:

  • Each year's FCF is compared to the previous year's to calculate the growth percentage.
  • We then average these growth rates to get the historical growth rate.

2. Projecting future free cash flows

Using the historical growth rate, we project Free Cash Flow into the future over a 5-year period. Each year, we assume the cash flow grows at the same average rate.

3. Discounting future cash flows

Money in the future is worth less than money today due to inflation and risk. To account for this, we discount each projected future cash flow using a discount rate of 15% (i.e., a discount factor of 1.15).

  • Each future cash flow is divided by 1.15n, where n is the year number.

4. Estimating terminal value

After 5 years, we assume the company continues to generate cash, but instead of forecasting each year, we estimate a lump-sum value called the terminal value. This is calculated by multiplying the last projected cash flow by a multiple (based on the company’s current market value and cash flows).

We then discount this terminal value back to present value using the same discount rate.

5. Adding the company’s cash reserves

We add the most recent cash amount from the company’s balance sheet. This is money the company already has today.

6. Applying a safety margin

To be conservative, we apply a safety margin of 30%. That means we only take 70% of our calculated value. This helps protect against incorrect assumptions or unexpected business issues.

Final intrinsic value

The sum of all the discounted cash flows, the discounted terminal value, and the current cash adjusted for the safety margin gives us the intrinsic value of the company. Keep in mind this is an estimate, and actual market prices can vary significantly.

This model helps investors decide whether a company's stock is overvalued or undervalued compared to its true potential.