What is Intrinsic Value?
Intrinsic value is an estimate of a business’s value.
This estimate isn’t a precise number that can be scientifically calculated. Instead, it's a subjective estimate of value that takes into account a number of inputs.
Intrinsic value is most important to value investors who are primarily interested in buying businesses at a discount from their calculated intrinsic value. This calculation is a rough indicator of what an investor is willing to pay.
Many Ways to Measure Intrinsic Value
Many techniques are used to calculate the intrinsic value of a business or asset. The goal of using these techniques is to determine what something is worth; therefore, most intrinsic value assessments are mathematical calculations.
That being said, there is a large degree of subjective input to interpret financial data and make assumptions about the future prospects of a company.
The three most common techniques used to assess intrinsic value are discounted cash flow analysis (DCF), financial multiple analysis, and sum-of-the-parts (SOTP) analysis.
Pulling together a clear estimate of value is a mix of art and science. Let’s take the DCF valuation method as an example.
In a DCF analysis, the future cash flows of a business are forecasted into the future and discounted back to the present using a discount rate measuring the weighted average cost of capital (WACC).
Producing a cash flow forecast for a business requires making a number of assumptions. These assumptions include how fast the business will grow, how profitable it will be, and what kind of investments it will need to make.
There is certainly some domain expertise and research required to make these estimates, but there is also a great deal of subjectivity and guesswork involved.
Intrinsic Value and Investment Decisions
Value investors are a subset of investors who seek to buy businesses at a discount from their assessed value. For these investors, relying on their own value assertions is more reliable (and accurate) than relying on arbitrary fluctuation daily stock prices.
The deeper the discount at which an investor can buy a business, the greater their margin of safety is on the investment.
“Buy low, sell high” is a common phrase in the investment world that primarily refers to stock price. However, another way to think about buying low and selling high is to think about value.
If a stock trades below its intrinsic value, according to an investor’s own assessment, the stock may be considered “undervalued.” Stocks that are undervalued may be a buying opportunity, as shown in the graphic above.
The flip side of that coin is that a stock may be considered “overvalued” if it trades above the calculated value.
Unlike in the example graphic above, intrinsic value is rarely a static measure.
The intrinsic value of a company changes over time and this change depends on a number of factors. The company’s changing competitive position, growth rate, profitability, and other external factors all impact intrinsic value. This forces investors to constantly rethink what a company is worth and how attractive stock prices are at different points in time.
Intrinsic Value Investing Risks
There is some inherent risk picking stocks based on intrinsic value only.
The first is that, while the fundamental analysis required to determine the intrinsic value of a company isn't particularly hard, it can be a subjective process that is vulnerable to human error. No amount of fundamental analysis can prepare investors for the unpredictable and picking stocks can produce portfolios that aren't sufficiently diversified or have inherent risk.
Another risk is that not everyone is equipped with the patience that a value investor requires to turn a profit. Simply deciding that a stock is undervalued based on your own analysis is no guarantee that company will realize its true value within your investing horizon.
Some value investors wait years to see a healthy return on their investments—if you are looking to get in and get out, value investing might not be for you.