“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. 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

Intrinsic value is an important concept to evaluate the relative attractiveness of investments and businesses.

Intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during its remaining life, explains investing guru Warren Buffett, Chairman and CEO, Berkshire Hathaway. It measures the value of an investment based on its current and future cash flows. Where market value tells you the current price per share other investors are willing to pay for an asset, intrinsic value shows you the asset’s value based on an analysis of its future cash flows and its actual financial performance.

Essentially, valuing a company intrinsically allows you to look analytically at a business and determine how much cash that business will generate over time, and then you discount the cash flows back to the present day.

Book value vs intrinsic value

In most cases, a company’s book value tends to understate its intrinsic value because many businesses are worth much more than their ‘carrying value’. The ‘carrying value’ is the original cost of an asset as reflected in a company’s books or balance sheet, minus the accumulated depreciation of the asset.

As a result, a company’s intrinsic value often exceed its book value, a result that proves capital was wisely deployed. In many cases, book value is not a reliable indicator of intrinsic value or a true representation of an asset’s fair value or market value. Thus, a company’s book value alone is somewhat meaningless as an indicator of its intrinsic value.

However, intrinsic value tend to be only effective on stocks that are stable and less volatile so that you can reliably valuate. If you see the book value growth and dividends all over the place, your estimates would be very uncertain.

You need 3 factors to determine a company’s intrinsic value:

• Current free cash flow or owner’s earnings
• Free cash flow growth rate over an eight to ten year period. Determine free cash flow growth rates by looking at past 5 year and 10 year growth rate.
• Discount rate to discount future free cash flow to present day.

Discounted future cash flows

Cash taken out of a business in the future is not worth the same as it is today. If you had the money today you could invest it today. Money in the future is partly eaten up by inflation, but more importantly more uncertain if it is there at all.

The calculation of intrinsic value is not so simple. Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.

To calculate owner earnings, or another way to look and to calculate free cash flow, one adds things back in such as depreciation, changes in working capital and such. Buffett feels that “owner’s earnings” more accurately reflects the actual cash flow that an owner receives.

Net present value for the ten years and your discounted terminal value for the 10th year we can calculate the intrinsic value.

When investing in a company, you first must determine the value of the company according to your estimates of discounted cash flow. You want the biggest difference between its intrinsic value (high as possible) and its market price which is the current price of the stock that is traded on the exchange (low as possible). Over time, you should expect the market value to intersect its intrinsic value.

When you arrive at an intrinsic value it will not necessarily match the current market value or price of the stock. In most cases you will find that there is a vast difference. You have potentially found a great company at a bargain and with a margin of safety. If the market price is much higher than the intrinsic value, it is also great. You can avoid the common mistake made by many retail investors of overpaying for a stock.

Knowing the value of a stock is perhaps the most desired skill. And in summary, intrinsic value is simply the discounted value of the cash that can be taken out of a business during its remaining life, according to Warren Buffett.

References:

1. https://einvestingforbeginners.com/intrinsic-value-warren-buffett-aher/
2. https://acquirersmultiple.com/2017/02/warren-buffett-how-to-calculate-intrinsic-value/
3. https://corporatefinanceinstitute.com/resources/knowledge/accounting/carrying-amount/
4. https://www.buffettsbooks.com/how-to-invest-in-stocks/intermediate-course/lesson-21/