If you follow the world famous investment guru, Warren Buffett’s investment philosophy, you will see that his main investment principle is to invest in a company at its intrinsic value, which will then allow you a desired margin of safety. This is what he meant by paying a fair price for any investment, just like his famous saying ‘invest in a great company at a fair price rather than a fair company at a great price’.
One of the most popular tools used in the world of value investing is the concept of intrinsic value. Intrinsic value is the underlying fair value of a stock based on its future earnings power. It was first introduced by Benjamin Graham. Sometime in 1930s, he wrote a book entitled Securities Analysis, which is still one of the main books on the subject today. Graham was also the mentor to the legendary investor Warren Buffett, who started investing following Graham’s investment principle, further adapting it based on his own interpretation and investment philosophy.
At the end of this article, you will be able to define and calculate intrinsic value as well as identify how it affects your investment decisions.
Definition of ‘intrinsic value’ and margin of safety
According to Graham, intrinsic value is the value of the company to a private owner. It is the price of a company that the owner will sell, which will reflect all the facts, including the value of its assets, earnings, dividends as well as potential future prospects. In stock investment, the concept behind the ‘intrinsic value’ is basically the value that can be taken out from a business. But, having the possibility of error in calculating intrinsic value, the careful investor should also provide for a margin of error by only buying the business, or shares, at a substantial discount to the intrinsic value. Based on Graham’s principle, if you can pay as little as two-thirds of the stock’s value, you’ve really got nothing to lose.
Now that we have an idea of what intrinsic value means, the trickier part is to determine how we are to arrive at this value for each business or stock. Since it relies on future earnings projection, an investor must decide upon their own methods and assumptions of arriving at the intrinsic value of a share and the margin of safety that they want for themselves.
Calculating ‘intrinsic value’
Since the intrinsic value is estimation rather than the precise value, there is no systematic or standard way to arrive at this number. It is highly variable depending on the timing and individual’s methodology. If you refer to the published stock research reports, you will notice that different analysts compute different intrinsic values for the same listed company and the intrinsic values vary as the stock market and economic situations change.
A lot of investors may be interested to know how the investment gurus like Graham and Buffett arrive at the intrinsic value when they decide on any investments.
Based on Graham’s principle, the intrinsic value can be determined by the earnings power of a company during normal business conditions. He suggested that in the calculation of intrinsic value for a company, normalized earnings and normalized market valuation for that the company should be used. Therefore, the best way to arrive at the normalized earnings is to estimate based on the company’s past earnings trends taking into considerations future potentials while the historical market valuation can be used to estimate the normalized market valuation for the company.
Buffett has a slight variation from Graham by suggesting that the intrinsic value of a company can be derived from discounting all future free cash flows of the company to present value based on the discounted cash flow (DCF) valuation method, which he terms as free cash flows as owners’ earnings. But, as he pointed out, since it is difficult to predict future cash flows, therefore, it will be better to stick to investment in companies that are consistent, well managed, and simple to understand. A company that is hard to understand or changes frequently does not allow for easy prediction of future earnings and outgoings. This is also the main reason why he tries to avoid investing in technologies companies.
For an investor who follows fundamental analysis in investment decisions, the intrinsic value method provides a useful way of gauging the value of a stock. Eventually, as there is no one way in deriving this number, intrinsic value ultimately relies on the investor’s own discretion and intuition in coming up with his own number. This however can also be its main criticism as it leads to inconsistency in valuing.
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