Warren Buffett claims that the most logical approach to assessing a business is to calculate its intrinsic value. He defines this as the “discounted value of the cash that can be taken out of a business during its remaining life“. A comparison can then be made to its market cap to determine if a company is fairly valued.
The American has never explained in detail how he makes these calculations. However, he’s given plenty of clues over the years.
Let’s see how the theory can be applied to Persimmon (LSE: PSN), the UK’s largest housebuilder. I already own shares in the company. It’s a stock that has taken a bit of a battering lately, so I’m interested to see what Buffett’s theory tells me about the prospects for my investment.
First, I need to estimate owner earnings over the next 10 years.
This is a company’s profit adjusted for some non-cash accounting items that impact the level of earnings. By adding back things like depreciation and impairment charges, it’s possible to get a better estimate of the underlying cash generated.
If profit is fluctuating wildly from one year to the next, it’s better to use an average for, say, the past five years.
Persimmon’s recent full-year profits have been £961m (2021), £784m (2020), £1.029bn (2019), £1.092bn (2018) and £866m (2017) — an average of £966m.
Non-cash accounting adjustments have averaged £16m over the same period.
I also need to look at capital expenditure (CAPEX). This is important because it’s a cash outlay. Persimmon will be buying land and replacing equipment to ensure that it has the capacity to keep building. Annual CAPEX has averaged £20m from 2017 to 2021.
I can therefore estimate owner earnings as being £966m + £16m – £20m = £982m.
I’m going to reduce this by 25% to reflect the rate of corporation tax that will apply from next year. It’s often overlooked that tax is a cash item.
The next task is to come up with the expected annual growth rate in earnings.
This is difficult because profits do fluctuate over time and, of course, they may go down.
With a looming recession, I’m going to assume that Persimmon’s annual earnings will be 20% lower over the next three years. But I’m forecasting modest annual growth of 3% per annum thereafter.
The most complicated bit is choosing the discount rate. For investors, this is the desired rate of return to compensate for the risk taken.
According to IG, from 1984 to 2019, the FTSE 100 provided an annual average return of 7.75%. I want this as a minimum return from my investments, therefore this is going to be my discount rate.
Time for the maths
Plugging all of these numbers into Excel (there are plenty of templates available online) and dividing by the number of shares in issue, gives a valuation for Persimmon of over £24 per share.
That’s a premium of nearly 90% to its current share price, implying the stock is under-valued.
As an existing investor in Persimmon, this gives me some comfort that — over the long term — its share price should rise.
I hope Warren Buffett’s theory is right. Given that he’s worth over $100bn, I’m reassured that he knows a thing or two about investing.
The post I’ve just used a Warren Buffett method to value one of my shareholdings appeared first on The Motley Fool UK.
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James Beard has positions in Persimmon Plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.