What is Intrinsic Value?

Knowing whether you are paying a fair price for a stock can be challenging. This is where the concept of Intrinsic Value comes in. It is a measure of the true worth of an asset. This is independent of the Market Value which is determined by what investors are willing to pay.

The Intrinsic Value is calculated using various valuation methods. The aim is to estimate the future cash flows of a business discounted back to today’s rate. By evaluating the financial performance and prospects of a business, investors can make informed decisions based on their theoretical value instead of the market’s value.

Intrinsic value can be defined simply. It is the discounted value of the cash that can be taken out of a business during its remaining life.

Warren Buffett

It’s important to note that determining the Intrinsic Value of a stock is subjective and there are many ways to calculate it. It is an estimation of an asset’s perceived value. The aim is to find the underlying value of a business to determine whether it is overvalued or undervalued compared to the market value.

Regardless of the investment style, valuation is essential. The Intrinsic Value is particularly important for value investors as it helps them identify undervalued assets with a margin of safety. Growth investors use it to determine whether there is any potential upside left. It’s important to know how much hope the market has built into the current price. All investment styles can benefit from understanding and estimating a company’s true worth.

Why is it important?

The successful outcome of investing is independence in decision-making. You must be able to stand back from the market that dictates prices and determine for yourself what value means. Even if it is subjective, understanding how to value a business empowers you to make more informed decisions.

Value Investors have adopted the use of Intrinsic Value as the underlying principle of buying bargains. Investors can still make investment decisions based on the current price. However, that may not reflect the real opportunity or the potential danger of the asset’s worth.

Understanding the value of a business is more important than predicting its short-term stock price movements.

Gautam Baid

When analysing the value of a business, it is more than just finding a theoretical price and then placing a term like undervalued or overvalued on it. It is about risk management, prudent investing, and decisions backed by sound fundamental and analytical processes. There would be no need for an investment process if investors just took the market price and went along with it.

As we discussed in the first piece on understanding Stock Valuation, it is about determining what value is to you and making investment decisions based on this. By finding the Intrinsic Value of a business, your thoughts and decisions are not influenced by the volatility of the market.

The opportunity is knowing when Intrinsic Value and Price is dislocated.

The objective of successful investing is to generate profits through the closing of the valuation and the price. The value of a company increases with the growth of its intrinsic value over time. Regardless of the investment style you adopt, the moment of opportunity for all investors is when the trading price dislocates from the intrinsic value. This phenomenon can be observed even in the biggest public companies by analysing their 52-week highs and lows.

Even top-quality growth companies present buying opportunities when this dislocation occurs, and you can purchase growth at discounted prices. That’s why I love Charlie Munger’s quote “All intelligent investing is value investing, acquiring more than you are paying for”.

How to estimate the Intrinsic Value?

There are various ways to value an asset and determine its Intrinsic Value. All these methods aim to estimate the present value of the business by analysing its future earnings and discounting them back. We will cover each of these methods in the valuation section. Each have their own place depending on the business model and stage of the life cycle.

Discounted Cash Flow (DCF).
Reverse Discounted Cash Flow.
Multiples Valuation Analysis.
Dividend Discount Model (DDM)
Total Addressable Market (TAM)
Estimating Yearly Returns.

The ultimate goal is to calculate the present value of the expected future cash flows. Because inflation affects the value of a dollar over time. All present values must be added up with this in mind.

Once you have built a theoretical model and estimated the value, you can compare it to the current price. It will either be more or less than the current trading price. That will then guide a decision whether it is an opportunity or whether to run the other way. This is all dependent on your investment strategy.

What are the downsides of Intrinsic Value?

Many businesses or assets do not have regular cash flow. This makes it difficult or even impossible to determine their intrinsic value. Without earnings, it is not possible to model an asset or business accurately. However, there are other valuation models available, though they are often unreliable.

Valuing companies that are in their early stages and do not have earnings can be challenging. This is because there is no track record or certainty of future earnings. However, we can still determine if a business is expensive or cheap by using alternative valuation methods such as Total Addressable Market or comparative analysis against similar companies. Nonetheless, such methods provide us with little confidence in determining the true value of the business.

The process of estimating intrinsic value is typically reserved for companies that are already earning, have a track record, and have financial statements that can be used to extrapolate future earnings.

In Summary…

The market value of an asset is determined by what others are willing to pay for it. This price isn’t necessarily right or wrong, it simply is what it is. If you want to participate in the markets and take advantage of the wealth creation potential they offer, you may not need or even want to determine the intrinsic value of an asset. Your investment decisions should be grounded in your own strategy, financial goals, risk appetite and investment philosophy.

However, if you’re an investor or analyst looking to determine the intrinsic value of an asset, you should focus on the fundamentals of the business and company-specific information. By looking at where the company is headed, its future outlook, and earnings potential, you can take a different approach to investing. Whether you have a shorter holding period or a longer one, understanding the value of an asset can help you place a target price on your investment. This is the real output of determining a theoretical value.

For example, if you’re buying an undervalued opportunity, you need to have a target price in mind for where you believe the company can revert to. On the other hand, if you’re buying and holding an emerging growth company, having a target price can help you know when to sell. The intrinsic value can be a guide for sell-side decisions, otherwise, how do you know when to sell, let alone buy?