Intrinsic value

Buy when the price is low. Sell when the price is high. This is the prescription given to those who are interested to invest in the stock market. But the underlying question is: when is it low or high? Fundamental analysts will prescribe comparing observed price versus intrinsic value. If the intrinsic value is higher than the price, buy the stock. If it is less, sell it. And if it is equal to price, hold it.
Intrinsic value is what the security of a company is worth given its present and future performance, business model, economic condition, financials, marketability of products and services, and management quality. Intrinsic value is also often referred to as fundamental value, the estimate of a company’s real worth. In its most basic sense, it is the present value equivalent to all future net cash flows expected from the business, discounted by the required rate of return. And the required rate of return is the ratio of income over the investment adjusted for the risk of the business. The required return represents what the investor demands as reward given the riskiness of the investment.
Warren Buffett puts it simply: “Intrinsic value is the discounted value of cash that can be taken out of a business during its remaining life.”
The concept of intrinsic value is powerful, even as calculating the same is at best an estimate. It is calculated using a quantitative model adjusted by appreciation of the qualitative aspects. The more popular tool involves computing the present value of expected future dividends or free cash flows from operations. Others will look at balance sheet items and calculate replacement value, market value, or even liquidation value of assets less liabilities. There is also valuation through comparables, most popular of which is price-to-earnings analysis. Thus, its accuracy can never be exact, and it will rely on underlying assumptions.
Intrinsic value is likewise not constant. The determinants of value such as cash flows, growth trajectory, and risk change over time. Earnings forecast reflects new information about the company such as management changes. Product lifecycle, mergers, and acquisitions will affect future cash flows. The price of risk and the appropriate risk premiums in the market are sensitive to market and other extraneous forces.
The essence of value is that it comes from a company’s earning power evidenced by what is happening within the corporation. Such information is what causes cash flows to move and risks to be examined closely. This information will influence the value of the asset. Fundamental analysis looks at a company’s intrinsic value and long-term viability.
Pricing, on the other hand, is a market process. Simply put, price represents the point at which demand and supply intersect at any time. Because the market is not necessarily rational, price is often influenced by non-fundamental behavioral factors such as market mood, sentiment, and momentum shifts. Prices can then move up and down based on some patterns not necessarily related to the intrinsic value of the asset. In the short run, the price may be out of sync with real value, but the long run must correct such deviation.
So, to aspiring market investors, your chances of making money really depend on your appreciation of the disparity between intrinsic value, or the stock’s real worth, and price. Whoever is able to gauge this precisely has the best chance of earning a lot.
But while the principles are clear and indeed rational, the reality is that the market is fickle and unpredictable. Two investors looking at the same numbers and information regarding a firm or a project can end up with different estimates of intrinsic value. One can see this in bids for large infrastructure projects. The bidders’ offers are their estimates of intrinsic value. The bids vary significantly even when they are proposed by conglomerates, which are expected to be staffed with well-trained analysts having blue-chip academic credentials.
To digress a bit, note that intrinsic value has a philosophical meaning. It is at the heart of ethics as it represents what is valuable “for its own sake” or “in its own right.” One cannot help but observe that the ethical notion of value that the thing has in itself can stand alone. But for finance people, the usefulness of financial intrinsic value is that it has to be measured against price. Only then will it have practical significance.
The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as the faculty and administration of DLSU.
 
Benel D. Lagua is executive vice-president at the Development Bank of the Philippines. With an AIM-MBM and a Harvard-MPA, he is a part-time faculty of the College of Business, De La Salle University.
benellagua@alumni.ksg.harvard.edu