Find the Next Winning Stock Using This Warren Buffett Technique

At the core of Warren Buffett's investing technique is a concept called intrinsic value. Intrinsic value is important for investors who want to evaluate stocks to see if they are worth buying. I also believe the key factors for building intrinsic value can be used to build personal wealth.

Buffett is so convinced of his own company's intrinsic value that he is willing to buy back shares of Berkshire Hathaway (NYSE: BRK-B  ) if they fall below 120% of their book value.

"Per-share intrinsic value exceeds that percentage of book value by a meaningful amount," Buffett wrote in his 2013 Annual Report. "We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive."

Intrinsic value components
When Buffett examines intrinsic value, he looks at two very critical aspects of a business.

"The first component of value is our investments: stocks, bonds and cash equivalents. At yearend these totaled $158 billion at market value," Buffett wrote.

The second component of intrinsic value is earnings that come from sources other than investments and insurance underwriting. These earnings are delivered by Berkshire's 68 non-insurance companies, such as BNSF Railway and MidAmerican Energy.

"In Berkshire's early years, we focused on the investment side," Buffett wrote. "During the past two decades, however, we've increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue."

Intrinsic value is defined by Buffett as the discounted value of the cash that can be extracted from a business during its remaining life.

Benjamin Graham's formula
Buffett's mentor Benjamin Graham developed a formula for measuring intrinsic value. This formula was updated to include prevailing interest rates, but for our purpose, we will look at his original formula. In addition, let's apply the formula to two of the best cash-producing stocks in recent years: Hershey  (NYSE: HSY  )  and Union Pacific  (NYSE: UNP  ) .

V = EPS X (8.5 + 2g)

V = Intrinsic Value
EPS = Trailing 12 Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected seven to 10 year growth rate

Based on estimated growth rates of 10% for Hershey, and 7% for both Union Pacific and Berkshire, here are the valuations of those companies based on this formula.

 

From this method, we can see that Hershey is trading around its intrinsic value, while Union Pacific and Berkshire both offer plenty of upside.

The power of earnings
According to Buffett, earnings will ultimately drive stock prices. Over 40 years, Berkshire's compounded annual gain in pre-tax, non-insurance earnings per share was 21%. During the same period, Berkshire's stock price increased at a rate of 22.1% annually. Over time, you can expect the stock price to move in rough tandem with Berkshire's investments and earnings. Market price and intrinsic value often follow very different paths – sometimes for extended periods – but eventually they meet.

As seen by Graham's formula, this earnings growth is a key determinant of intrinsic value. Much like Hershey and Union Pacific, keep an eye out for those companies that are consistently generating higher and higher levels of earnings over time. As a result, you can then employ the Benjamin Graham formula to derive that intrinsic value and find the right time to jump in.


Read/Post Comments (2) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 23, 2014, at 10:28 AM, MattTheMayor wrote:

    Maybe im reading this wrong but...... how are they figuring a 8.5 p/e rate for these growth stocks???

  • Report this Comment On March 24, 2014, at 11:33 AM, ScoopHoop wrote:

    8.5 is simply a number used in the formula representing the P/E ratio of a hypothetical no-growth company, 8.5 doesn't represent the P/E ratio of the stocks featured here. I think Graham was looking for a way to measure the value of a company's future earnings, but there are other factors that he looked for, such as history of paying dividends, consistent earnings growth, strong financial condition and a stock price of no more than 15 P/E. BRKB has P/E of 15.8, HSY 28.9 P/E and UNP 19.8 P/E.

Add your comment.

DocumentId: 2872977, ~/Articles/ArticleHandler.aspx, 7/31/2014 7:29:36 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 10 hours ago Sponsored by:
DOW 16,880.36 -31.75 -0.19%
S&P 500 1,970.07 0.12 0.01%
NASD 4,462.90 20.20 0.45%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

7/30/2014 4:00 PM
BRK-B $127.74 Up +0.38 +0.30%
Berkshire Hathaway CAPS Rating: *****
HSY $90.36 Down -0.93 -1.02%
The Hershey Compan… CAPS Rating: ***
UNP $99.47 Down -0.13 -0.13%
Union Pacific Corp CAPS Rating: *****

Advertisement