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
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. Stocks priced below their intrinsic value tend to yield better returns.
- Reduced risk. Buying stocks that trade at a discount to their intrinsic value 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.
- Historical Success. 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.
Calculating Intrinsic Value
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.
The absolute method, known as Discounted Cash Flow (DCF) valuation, focuses solely on a company's fundamentals. The DCF approach starts with a basic principle: An asset's value is determined by its expected future cash flows. In simpler terms, companies with stable, high cash flows are generally valued higher than those with low, volatile cash flows.
Read more about DCF Valuation here.
In Relative Valuation, an asset's value is determined by comparing its market price to that of similar assets. For example, when pricing a house, we often compare its cost to similar houses in the neighborhood instead of conducting an absolute valuation. Similarly, in stock investing, the price of a stock is often evaluated by comparing it to the prices of similar stocks within its industry or peer group.
Read more about Relative Valuation here.
Intrinsic Value Calculation
Each valuation method - DCF and Relative Valuation - has its own strengths and weaknesses. To enhance accuracy, we average the results from these two methods. This composite approach yields a more reliable estimate of a stock's intrinsic value.
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.