Intrinsic value is a fundamental analysis framework used to determine the actual, true value of an asset. The intrinsic value of a company, for example, is more than just what the company itself is worth on the stock market. Therefore, the specific calculation will also consider other factors, such as its perceived future cash flow minus its discount rate, to arrive at the actual intrinsic value properly.
A good contrast to intrinsic value would be relative value, where similar assets are compared. This is similar to how a real estate appraiser will pull comparable listings to determine a home’s value. Intrinsic value goes way beyond that.
To put it into simpler terms, the intrinsic value of an asset is the amount that any sane and reasonable investor will pay for an asset, given its current level of risk. In contrast, market value is what the asset is trading at. Thus, value investing is about uncovering assets with a vast difference between intrinsic value and market value.
Let’s dumb it down even more:
Bob’s Used Car Lot is up for sale. We know how much his land, building, and inventory are worth based on similar used car lots in the area. This gives us relative value. However, we also have to factor in his decades-long predictable profit. We can do this by predicting how much the car lot will probably bring in over the next 3 years. Of course, we also know that, as a whole, used car sales fluctuate heavily with the economy. So there are some risks. However, knowing the relative value and knowing what the future cash flow will look like, we can come to an intrinsic value, despite the potential risks.
The example above covers intrinsic and relative values. The third one in the list of relevant values is the liquidation value. This would be how much Bob gets when he sells his building, all of his office equipment, and all of the cars on the lot. The liquidation value does not include his trademark name, customer list, or even the commercial he paid for.
Please take this example purely for its face value, as it is the simplest way we could explain intrinsic value. This same idea behind intrinsic value translates well to other aspects of various investments and assets.
Where Did Intrinsic Value Come From?
We can’t give you a history lesson about investing without talking about the grandfather of ‘value investing,’ Mr. Warren Buffett. Maybe you’ve heard of him? Benjamin Graham authored the book “The Intelligent Investor,” which laid the groundwork for Intrinsic Value that Graham and other value investors, including Buffett, have successfully used for decades now.
Using the pre-intrinsic value method that Graham presented in his book, Buffett tweaked it a little bit to develop the best way to calculate intrinsic value. Buffett also knows how to use that calculation to determine which companies he should be investing in. And, well, as you can see, it has paid off very well.
What Is The Formula For Intrinsic Value?
There are multiple ways to calculate intrinsic value. However, the most effective formula uses the net present value formula. The NPV formula is the value of all future cash flows, whether positive or negative, over the entire life of the investment.
NPV = Net Present Value
FV# = Net Cash Flow, whereby the # represents a period of time. (# = 0 for present time)
I = Annual Interest Rate
N = Number of Total Periods Included
Intrinsic Value and Risk Adjustment
Risk adjusting the intrinsic value is how we can (try to) account for possible downward variations with the cash flow calculations. This part of intrinsic value calculations is very subjective. Part of it is science, but the other part comes with experience and a thorough understanding of financial statements. Or just with a good eye.
There are two methods to try and account for volatility and possible fluctuations.
Remember how in the opening paragraph we mentioned the discount rate? This is where a risk premium will be included in the calculation to properly discount the estimated cash flow in the discounted cash flow (DCF) model.
A financial analyst will typically use the company’s Weighted Average Cost of Capital when using this risk adjustment method. This includes considerations for the equity premium and the risk of a stock based on its volatility.
This is basically just a percentage (0%-100%) of how likely it is to materialize the forecasted cash flow. Financial analysts using this method will typically take every single cash flow stream and assign it a certainty factor.
For example, a treasury bond comes with a 100% certainty factor. So you know with absolute certainty that the treasury department will pay you a yield on that bond. For example, a 3% annual return (Coincidentally, this is what analysts call a risk-free rate).
Compare that to a company in a high-risk, ever-evolving sector (such as communications or utilities) whose certainty factor may only be 50%. And why is their risk factor 50%? We know the return is not guaranteed like that of a bond, but how do they know it’s only 50%? Well, that’s a good question to segue into our next section:
Intrinsic Value Calculation Fallbacks
The biggest issue with intrinsic value is that so much of it is completely subjective to the financial analysts doing the calculations. For example, take the same company, give the same data to three analysts, and all three come back with different valuations.
Most of these variations in value will come from the risk adjustment variables, discount rate, and certainty factor. For example, one analyst may feel there’s an 80% chance of seeing the forecasted cash flow, whereas another believes it is only 70%. Now, 70% and 80% are pretty good chances, depending on the industry, but both will lead to wildly different intrinsic value calculations.
One of the key takeaways from seeing how subjective these calculations can be is that nobody can predict the future. Of course, some people, like Warren Buffett, can make scarily accurate financial predictions. But if every single college-educated analyst could do this, billionaires wouldn’t be such a rare breed. Lucky for you, we’ve got a simplified breakdown of how Buffett does what he does best.
How Does Warren Buffett Calculate His Own Intrinsic Values?
Whenever he is trying to determine whether or not a company will be worth his time (and money), Buffett will ask himself a few questions. Of course, these aren’t the only factors used to determine what will be added to the Berkshire Hathaway portfolio. However, it gives you an idea of how Buffett will find what he feels to be the true, intrinsic value of a company.
- Does the company perform well? – Buffett calculates a company’s Return On Equity by dividing its net income by the shareholder’s equity. This gives him a calculation that’s similar to a stockholder’s return on investment numbers. Calculating Return On Equity is necessary for at least the previous 10 years.
- What does the company’s debt look like? – Another thing he looks at is the company’s Debt to Equity ratio. This way he can see whether the company is operating using its own funds or taking on debt to control its operations.
- Are the profit margins growing? Looking at the growth rate of a company’s profits is one way to gauge its success. However, Buffett prefers to look and see if the profit margins themselves are consistently increasing as well. This shows the company is able to continue growing their profits.
- Is the company public? There are very few companies in the Berkshire holdings that were not public companies when Buffett invested in them. As a matter of fact, most of them were public for at least a decade. Despite the success of many of the new tech IPOs, they are typically not welcome in Buffett’s portfolio.
- Does the company rely on commodities? If a potential company relies on commodities, such as oil and gas, points are deducted from Buffett’s intrinsic value calculations.
- How unique are the products or services? Another way to get fewer points is by not offering a truly unique product or service. Now, we don’t mean how McDonalds and Burger King both offer hamburgers. A McDonald’s hamburger is inherently different from a Burger King hamburger. However, if the company’s products or services are not completely indistinguishable, points will be deducted.
- Is the company being sold for a cheap price? Here’s where many potential companies get eliminated from Buffett’s investment list. With hard work and determination, you can find plenty of companies that will meet the first 6 points above. However, you will probably be hard pressed to find one that’s being sold at a cheap price. To be clear, Buffett measures cheapness by calculating the difference between the intrinsic value and the market price of the company.
How does Warren Buffett determine if a company is cheap? This is pretty simple. He uses the standard intrinsic value formula that we mentioned before. Then, by comparing it to the current market capitalization, he determines if the company truly will be a great deal. These days, investors have access to the same company information, yet not all of them will become wildly successful. Company valuation and intrinsic value take a carefully trained eye, lots of experience, some basic math, and a little bit of luck.
Ashwath Damodaran has a great excerpt from his book “The Little Book of Valuation” that is worth reading.