Intrinsic Value of Company

This is the heart of Warren Buffett’s philosophy. Let’s slow this down and make it crystal clear 👇

🧩 The Key Sentence

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

This sentence looks intimidating, but it’s actually simple once we break it apart.

💵 Step 1: What does “cash that can be taken out” mean?

This means the real cash profits that a business will produce for its owners (shareholders) — not accounting profits, not revenue, but actual money left after paying all expenses, taxes, and reinvestment needs.

Think of it like this:

You own a shop. Each year, after paying rent, salaries, and buying new inventory, you’re left with ₹10 lakh that you can take home.

That ₹10 lakh is cash that can be taken out — your owner’s earnings.

Buffett calls this “owner earnings.”

⏳ Step 2: “During its remaining life”

Every business has a lifetime — it may last 5 years, 20 years, or indefinitely.

So Buffett is asking:

How much cash will this business give me, year after year, until it eventually stops operating?

For example:

Those future cash amounts are the birds in the bush 🐦.

💸 Step 3: “Discounted value”

Here’s the crucial part.

A rupee today is worth more than a rupee next year — because:

• You can invest it elsewhere and earn interest.

• There’s uncertainty (you might not actually get it later).

So we discount future cash back to its present value — that means reducing its value by a certain percentage each year (the discount rate).

This rate depends on the risk and interest rate (like U.S. bonds or safe returns).

🧮 Step 4: Putting it together

Imagine a business will give you:

• ₹10 lakh next year

• ₹10 lakh the year after

• ₹10 lakh the third year

But you use a 10% discount rate (to adjust for risk and time value).

Then those future ₹10 lakh payments are worth less today:

• Year 1 → ₹9.09 lakh

• Year 2 → ₹8.26 lakh

• Year 3 → ₹7.51 lakh

• Total intrinsic value today = ₹24.86 lakh

That’s what Buffett means:

The intrinsic value is the total of all those future cash flows, converted into today’s money.

🧠 Step 5: The big takeaway

So Buffett’s definition means:

💬 “A company’s true worth = all the real cash it will generate in the future, brought back to today’s value.”

That’s how an investor knows whether a stock is cheap or expensive.

• If the market price is below this intrinsic value → it’s undervalued (a good buy).

• If it’s above → it’s overvalued (speculative).

🪶 Example in Plain Words

Imagine you’re buying a coconut tree 🌴.

• You’ll get coconuts (cash) every year for 10 years.

• You calculate how much those coconuts are worth today, considering time and uncertainty.

• The total present value of all those coconuts = the intrinsic value of that tree.

• If someone offers the tree at a price lower than that value, you buy it.

That’s exactly what Buffett does with businesses.

Follow up Question: 

Why we need to do it.

But you use a 10% discount rate (to adjust for risk and time value).

Excellent question — this is the core reason why investors discount future cash.

Let’s unpack this slowly and clearly 👇

💰 Why We Discount Future Cash Flows

When Buffett says we must “discount” future money, he’s really asking a simple question:

“If I can get ₹1 next year, how much is that worth today?”

To answer that, we must consider two forces:

1️⃣ The

Time Value of Money

This is the idea that:

💬 “Money today is worth more than the same amount in the future.”

Because:

• You can invest it now and earn interest.

• There’s inflation, which reduces future buying power.

• There’s risk — you might not actually receive that future cash.

So, ₹1 today might be worth only ₹0.90 a year from now if the safe interest rate is 10%.

That’s why we “discount” it — we reduce its value the further away it is in time.

2️⃣ The Risk Factor

Every business is uncertain — some cash flows are more predictable than others.

• A government bond is nearly risk-free.

• A startup’s profits 5 years from now are much more uncertain.

To capture that uncertainty, we add a risk premium on top of the safe interest rate.

For example:

• If U.S. government bonds yield 4%, but a company is riskier, we might use 10% (4% + 6% risk premium).

• The higher the risk, the higher the discount rate → the less future cash is worth today.

🧮 Example to Make It Concrete

Imagine two offers:

Option A: ₹100 today.

Option B: ₹110 next year.

If you can invest money elsewhere and earn 10% safely, then ₹100 today becomes ₹110 next year.

So both options are equal in value.

But if someone promises ₹110 two years from now, that’s worse — because if you invested your ₹100 for two years at 10%, you’d have ₹121.

So you’d discount ₹110 back to today’s value:

₹110 ÷ (1.10)² = ₹90.9

So ₹110 in two years = ₹90.9 today.

3️⃣ The Formula (Simplified)

To find today’s value of future cash:

\text{Present Value} = \frac{\text{Future Cash}}{(1 + r)^n}

Where:

• r = discount rate (risk + time value)

• n = number of years ahead

So if you expect ₹10 lakh in 3 years and use a 10% discount rate:

PV = \frac{10,00,000}{(1.10)^3} = ₹7,51,000

That’s what that ₹10 lakh is worth today.

4️⃣ Buffett’s Perspective

Buffett says:

“The interest rate acts on valuation like gravity does on matter.”

Meaning:

• When interest rates go up, the value of future cash (and hence stock prices) goes down.

• When rates go down, the value of future cash rises.

That’s why he and Charlie Munger always emphasize the discount rate — it connects finance to physics.

🪶 In Simple Words

• We discount because money today is more powerful than money tomorrow.

• The discount rate measures both time and risk.

• The higher the risk or the longer the wait, the less future money is worth today.