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What is Intrinsic Value?

Intrinsic value is a philosophical concept that refers to some fundamental, objective value contained in a stock. It refers to what a stock is actually worth and is based on the fundamentals of the company (such as revenue, net income, cash, debt, etc.).

The discrepancy between market price and an estimated intrinsic value becomes a measure of investing opportunity. Those who would take investing action based on those estimations are known as value investors.

Value investing starts from the premise that an investor who buys stock in a company owns part of the business. While this may seem obvious, many investors “play the market” without regard to the underlying fundamentals of the companies they own.

“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Warren Buffett, probably the best-known value investor

Why intrinsic value matters

The basic concept behind value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale.

  • Higher returns and reduced risk. Buying stocks that trade at a discount to their intrinsic value gives you a better chance at earning a profit and makes you less likely to lose money if the stock doesn’t perform as you had expected.
  • Confidence in your investments. Knowing that the companies you invest in are backed by sound financials gives you confidence in your investment.
  • Proven success record. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole.

How intrinsic value calculated

There is no universal standard for calculating the intrinsic value of a company, but all stock valuation methods can be primarily categorized into two main types: absolute and relative.

DCF Valuation

The absolute method relies only on the company’s fundamentals and is called Discounted Cash Flow valuation (DCF). In DCF valuation, we begin with a simple proposition: The value of an asset is a function of the expected cash flows on that asset. Put simply, companies with high and predictable cash flows should have higher values than companies with low and volatile cash flows. You can read more about DCF Valuation here.

Relative Valuation

In relative valuation, we value an asset by looking at how the market prices similar assets. Thus, when determining what to pay for a house, we look at what similar houses in the neighborhood sold for rather than doing an absolute valuation. Extending this analogy to stocks, investors often decide whether a stock is cheap or expensive by comparing its pricing to that of similar stocks (usually in its peer group). You can read more about Relative Valuation here.

Intrinsic Value calculation

Both of these methods have their advantages and disadvantages. To calculate the intrinsic value of a stock, we take the average of the stock DCF Value and Relative Value. Thus, the estimate of Intrinsic Value is more accurate.

The bottom line

Intrinsic value reflects some objective, “true” value of a stock, which is based on the company’s financial performance. Buying stocks that trade at a discount to their intrinsic value increases the probability of making a profit and reduces the chance of a loss.

Updated on May 5, 2022

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